We began operations in June of 2007 by participating in a “take-out program” through which we assumed insurance policies held by Citizens Property Insurance Corporation (“Citizens”), a Florida state-supported insurer. The take-out program is a legislatively mandated program designed to reduce the state’s risk exposure by encouraging private companies to assume policies from Citizens. Policies were assumed in eight separate assumption transactions which took place in July and November 2007, February, June, October and December 2008, December 2009, and December 2010. Substantially all of our premium revenue since inception comes from these assumptions. We currently have approximately 65,000 policies in force. Of those policies assumed, approximately 86% are homeowners’ insurance policies, and the remaining 14% are a combination of policies written for condominium-owners and tenants. Our current policies in force represent approximately $135 million in annualized premiums.
Citizens requires us to offer renewals on the policies we acquire for a period of three years subsequent to the initial expiration of the assumed policies. The policyholders have the option to renew with us or they may ask their agent to place their coverage with another insurance company. With respect to the assumptions through December 31, 2009, policyholders could also elect to return to Citizens, i.e. opt out, prior to the policy renewal date. With respect to the December 31, 2010 assumption, the opt-out provision was limited to thirty days from the assumption date. We strive to retain these policies by offering competitive rates to our policyholders.
On January 26, 2011, the Company’s Board of Directors declared a quarterly dividend of $0.10 per common share. The dividends were paid March 18, 2011 to stockholders of record on February 18, 2011.
Premiums Ceded for the years ended December 31, 2010 and 2009 were $57.3 million and $44.7 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 $12.6 million increase in premiums ceded during 2010 is primarily due to the increase in our policy exposure base. Premiums ceded were 47.9% and 40.6% of gross premiums earned during the years ended December 31, 2010 and 2009, respectively.
Net Premiums Earned for the years ended December 31, 2010 and 2009 were $62.4 million and $65.3 million, respectively, and reflect the gross premiums earned less reinsurance costs as described above. Net premiums earned decreased by $2.9 million in 2010 as compared to 2009 as a result of the $9.7 million increase in gross premiums earned offset by the increase of $12.6 million in premiums ceded.
Net Premiums Written during the years ended December 31, 2010 and 2009 totaled $59.0 million and $66.6 million, respectively. Net premiums written represent the premiums charged on policies issued during a fiscal period less reinsurance costs.
Our Losses and Loss Adjustment Expenses amounted to $37.7 million and $35.2 million, respectively, during the years ended December 31, 2010 and 2009.
Policy Acquisition and Other Underwriting Expenses for the years ended December 31, 2010 and 2009 of $14.9 million and $9.6 million, respectively, primarily reflect the amortization of deferred acquisition costs, commissions payable to agents for production and renewal of policies, and premium taxes and policy fees. The $5.3 million increase in 2010 is primarily attributable to an increase in our commissions, premium taxes, and other underwriting expenses directly attributable to policy renewals and an increase in our payroll and other underwriting expenses required to manage our policies in force.
The expense ratio applicable to the year ended December 31, 2010 (policy acquisition and other underwriting expenses related to net premiums earned plus compensation, employee benefits, and other operating
expenses) was 35.8% compared to 23.6% for the year ended December 31, 2009. We have experienced an increase in our expense ratio due to increases in our premium taxes, payroll, and other underwriting expenses required to manage our policies in force as we have renewed more policies in 2010 than in 2009 (see Policy Acquisition and Other Underwriting Expenses above). In addition, our expense ratio was negatively impacted by a significant increase in our reinsurance costs during 2010, which reduced our net premiums earned.
The combined loss and expense ratio (total of all expenses related to net premiums earned) is the key measure of underwriting performance traditionally used in the property and casualty industry. A combined ratio under 100% generally reflects profitable underwriting results. A combined ratio over 100% generally reflects unprofitable underwriting results. Our combined ratio for the year ended December 31, 2010 was 96.2% compared to 77.5% for the year ended December 31, 2009.
Due to the impact our reinsurance costs have on net premiums earned from period to period, our management believes the combined loss and expense ratio measured to gross premiums earned is more relevant in assessing overall performance. The combined loss and expense ratio to gross premiums earned for the year ended December 31, 2010 was 50.1% compared to 46% for the year ended December 31, 2009.
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. In addition, we raised approximately $11.3 million in net proceeds from our preferred stock offering, which was completed on March 25, 2011. We intend to use the net proceeds from this offering primarily for general corporate purposes, which may include contribution of capital to our insurance subsidiary, investments, and the pursuit of growth opportunities.
In the future, we anticipate our primary use of funds will be to pay claims and operating expenses. In addition, we expect to spend between $1.5 million to $1.75 million on enhancements to our new building.
Our cash flows from operating, investing and financing activities for the years ended December 31, 2010 and 2009 are summarized below.
The main objective of our investment policy is to maximize our after-tax investment income with a minimum of risk given the current financial market. Our excess cash is invested primarily in money market accounts, certificates of deposit (i.e., CDs maturing in less than thirteen months), time deposits (i.e. CDs maturing in more than twelve months), and fixed maturity and equity security available-for-sale investments.
At December 31, 2010, we have $29.4 million of available-for-sale investments, which are carried at fair value. Changes in the general interest rate environment affect the returns available on new fixed maturity
investments. While a rising interest rate environment enhances the returns available on new investments, it reduces the market value of existing fixed maturity investments and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new fixed maturity investments but increases the market value of existing fixed maturity investments, creating the opportunity for realized investment gains on disposition.
Reserves for Losses and Loss Adjustment Expenses. We establish reserves for the estimated total unpaid costs of losses including loss adjustment expenses (LAE). Unless otherwise specified below, the term “loss reserves” shall encompass reserves for both losses and LAE. Loss reserves reflect management’s best estimate of the total cost of (i) claims that have been incurred, but not yet paid, and (ii) claims that have been “incurred but not yet reported” (“IBNR”). Loss reserves established by us are not an exact calculation of our liability. Rather, loss reserves represent management’s best estimate of our company’s liability based on application of actuarial techniques and other projection methodology and taking into consideration other facts and circumstances known at the balance sheet date. The process of establishing loss reserves is complex and necessarily imprecise, as it
involves using judgment that is affected by many variables such as past loss experience, current claim trends and the prevailing social, economic and legal environments. The impact of both internal and external variables on ultimate loss and LAE costs is difficult to estimate. Our exposure is impacted by both the risk characteristics of the physical locations where we write policies, such as hurricane and tropical storm-related risks, as well as risks associated with varying social, judicial and legislative characteristics in Florida, the state in which we operate. In determining loss reserves, we give careful consideration to all available data and actuarial analyses, and this process involves significant judgment.
The liability for losses and LAE represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported to our insurance company. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the kind of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and LAE are determined using historical homeowners insurance information as adjusted to current conditions. Inflation is ordinarily implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.
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 respect to the current and prior year. In addition, a claims committee of our board of directors meets periodically to review any major claims. As we develop historical data regarding paid and incurred losses, we use this data to develop expected ultimate loss and loss adjustment expense ratios. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for our homeowners line of business. In connection with the determination of these reserves, we will also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends regarding liability. Most of our business was assumed from Citizens. Therefore, we use the loss ratio method, among other methods, to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses.
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 gross premium earned, related investment income, unpaid losses and LAE and certain other costs expected to be incurred as the premium is earned.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2010 and
Homeowners Choice Managers, Inc. (HCM), a wholly-owned subsidiary, acts as HCPC’s exclusive managing general agent in the state of Florida. HCM currently provides underwriting policy administration, marketing, accounting and financial services to HCPC, and participates in the negotiation of reinsurance contracts. Southern Administration, Inc., a wholly-owned subsidiary, provides policy administration services. Claddaugh Casualty Insurance Company Ltd. (“Claddaugh”), a wholly-owned subsidiary, provides reinsurance coverage to HCPC. HCPCI Holdings LLC, a wholly-owned subsidiary of HCPC, owns and manages the Company’s real estate.
Property and Equipment. Property and equipment is stated at cost less accumulated depreciation and amortization. Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the lease term or the asset’s useful life. Expenditures for improvements are capitalized to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred.
Policy Fees. Policy fees represent nonrefundable application fees for insurance coverage, which are intended to reimburse a portion of the costs incurred to underwrite the policy. The fees and related costs are recognized when the policy is written.
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, 2010, management is not aware of any uncertain tax positions that would have a material effect on the Company’s consolidated financial statements.
Fair Value of Financial Instruments. The carrying amounts for the Company’s cash and cash equivalents and short-term investments approximate their fair values at December 31, 2010 and 2009 due to their short-term nature. Fair value for securities are based on the framework for measuring fair value established by ASC Topic 820, Fair Value Measurements and Disclosures (see Note 3 - “Investments”).
Accounting Standards Update No. 2010-28. In December 2010, the FASB issued Accounting Standards Update No. 2010-28 (“ASU 2010-28”), Intangibles - Goodwill and Other (Topic 350), When to perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. The objective of ASU 2010-28 is to address questions about entities with reporting units with zero or negative carrying amounts because some entities concluded that Step 1 of the test is passed in those circumstances because the fair value of their reporting unit will generally be greater than zero. The amendments in ASU 2010-28 modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is now required to perform Step 2 of the goodwill test if it is more likely than not that a goodwill impairment exists. The amendments in ASU 2010-28 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of this guidance is not expected to have a material effect on the Company’s consolidated financial statements.
The Company holds investments in fixed maturity securities as well as equity securities, which are classified as available for sale. At December 31, 2010 and December 31, 2009, the amortized cost, gross unrealized gains and losses, and estimated fair value of the Company’s available-for-sale securities by security type were as follows (in thousands):
During the quarter ended June 30, 2010, upon the sale of one security held to maturity, the Company reclassified all remaining held to maturity securities to available for sale. The Company does not anticipate using the held to maturity classification in the future. While the Company continues to have the ability to hold these securities to maturity, the transfers to available for sale were made as a result of a change in management’s objectives with respect to its investment portfolio, which was newly established in the second quarter of 2009.
* Amounts reported for the year ended December 31, 2010 include the gross realized gains and losses from equity option contracts. During the year ended December 31, 2010, the Company entered into equity contracts for exchange traded call and put options to meet certain investment objectives. With respect to these option contracts, the Company received net proceeds of $391,000 and realized a gain of $327,000, which is included in the realized investment gains in the Consolidated Statements of Earnings. There were no open option contracts at December 31, 2010.
During the year ended December 31, 2009, the Company sold one fixed maturity security for gross proceeds of $863,000, resulting in a realized investment loss of less than $1,000.
The following time deposits and short-term investments exceeded 10% of consolidated stockholders’ equity at December 31, 2010 and 2009 (in thousands):
The following table presents information about the Company’s available-for-sale fixed maturity securities measured at fair value as of December 31, 2010 and 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (in thousands):
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 on a month-to-month basis a small office space in a building adjacent to the corporate office location. This lease requires the Company to pay base rent of approximately $2,200 per month. The Company is required to provide a 30-day notice to terminate this lease. Rental expense under all facility leases was $191,000 and $181,000 during the years ended December 31, 2010 and 2009, respectively.
On June 1, 2010, the Company purchased property in Tampa, Florida for a total purchase price of $7.1 million. The property consists of 3.5 acres of land, a building with gross area of 122,000 square feet, and a three-story parking garage valued at $1.2 million, $5.3 million, and $0.6 million, respectively. This facility will be used by the Company and its subsidiaries, all of which will be headquartered in the new facility. The Company expects to complete the relocation of its employees and infrastructure by early 2011 upon completion of various building improvements, which are expected to cost the Company between $1.50 million and $1.75 million. In addition, the Company expects to lease to non-affiliates up to forty-nine percent of the building’s office space, which includes space occupied by existing tenants under lease agreements assumed by the Company at acquisition.
At December 31, 2010 and 2009, assumed reinsurance balances receivable amount to $26,000 and $19.5 million, respectively. Such receivables were related to the December assumption transactions in each year of certain policies assumed from Citizens.
The liability for losses and loss adjustment expenses (“LAE”) is determined on an individual case basis for all claims reported. The liability also includes amounts for unallocated expenses, anticipated future claim development and losses incurred, but not reported.
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, 2009, 2008, and 2007 remain subject to examination by our major taxing jurisdictions. There have been no interest or penalties recognized for the years ended December 31, 2010 and 2009. In February 2011, the Company received notice from the Internal Revenue Service with respect to an examination of the Company’s 2008 and 2009 federal income tax returns. The examination is expected to commence during the second quarter of 2011.
Significant components of our net deferred income tax asset are as follows (in thousands):
For the year ended December 31, 2009, 40,000 options to purchase 40,000 shares of common stock were excluded from the computation of diluted earnings per share because the exercise price of $7.00 exceeded the average market price of the Company’s common stock. For the years ended December 31, 2010 and 2009, 1,738,335 and 1,738,668 warrants, respectively, to purchase 905,001 and 945,334 shares of common stock, respectively, were excluded from the computation of diluted earnings per share because the exercise price of $9.10 exceeded the average market price of the Company’s common stock.
Effective March 18, 2009, the Company’s Board of Directors authorized a plan to repurchase up to $3.0 million (inclusive of commissions) of the Company’s common shares. The repurchase plan allowed the Company to repurchase shares from time to time through March 19, 2010. This repurchase plan was supplemented in December 2009 upon approval by the Board of Directors to extend the repurchase authority by an additional $3.0 million and continue until the repurchase plan is terminated by the Company or the maximum number of dollars has been expended. The shares may be purchased for cash in open market purchases, block transactions and privately negotiated transactions in accordance with applicable federal securities laws. The share repurchase plan may be modified, suspended, terminated or extended by the Company any time without prior notice. During the year ended December 31, 2010, the Company repurchased and retired a total of 311,239 shares at an average price of $7.00 per share and a total cost, inclusive of fees and commissions, of $2,196,392, or $7.06 per share, under this authorized repurchase program. During the year ended December 31, 2009, the Company repurchased and retired a total of 452,033 shares at an average price of $6.83 per share and a total cost, inclusive of fees and commissions, of $3,111,000, or $6.88 per share. At December 31, 2010, a total of $692,784 is available in connection with this plan.
In addition, in January 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 (see Note 15 - “Related Party Transactions”). Such repurchase was not part of a publicly announced plan or program.
At December 31, 2010, the Company has reserved 905,001 shares of common stock for issuance upon the exercise of its common stock warrants, all of which were issued coincident with the Company’s initial public offering (“IPO”). A summary of the warrant activity for the years ended December 31, 2010 and 2009 is presented below:
At December 31, 2010 and 2009, there was approximately $50,000 and $185,000, respectively, of total unrecognized compensation expense related to nonvested stock-based compensation arrangements granted under the plan. The Company expects to recognize the remaining compensation expense over a weighted-average period of sixteen (16) months. During the years ended December 31, 2010 and 2009, a total of 260,000 and 16,000 options, respectively, were exercised. The total fair value of shares vesting and recognized as compensation expense was approximately $87,000 and $483,000, respectively, for the years ended December 31, 2010 and 2009 and the associated income tax benefit recognized was $0 and $164,000, respectively. The total intrinsic value of options exercised during the years ended December 31, 2010 and 2009 was $1,097,600 and $42,000, respectively, and the income tax benefit recognized was $301,000 and $9,000, respectively.
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, 2010 and 2009, HCPC collected and paid assessments to the Florida Hurricane Catastrophe Fund (FHCF) amounting to $987,000 and $947,000, respectively. Additionally, HCPC collected and paid assessments to Citizens of $1,382,000 and $1,326,000, respectively, for the years ended December 31, 2010 and 2009. 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.
Claddaugh has been required since inception to maintain minimum capital and surplus of $2.0 million.
Under Florida law, a domestic insurer may not pay any dividend or distribute cash or other property to its stockholders except out of that part of its available and accumulated capital and surplus funds which is derived from realized net operating profits on its business and net realized capital gains. A Florida domestic insurer may not make dividend payments or distributions to stockholders without prior approval of the Florida Office of Insurance Regulation (OIR) if the dividend or distribution would exceed the larger of (1) the lesser of (a) 10.0% of its capital surplus or (b) net income, not including realized capital gains, plus a two year carry forward, (2) 10.0% of capital surplus with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains or (3) the lesser of (a) 10.0% of capital surplus or (b) net investment income plus a three year carry forward with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains. At December 31, 2010 and 2009, no dividends are available to be paid by HCPC.
As discussed in Note 5, 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 each of the years ended December 31, 2010 and 2009 totaled $160,000.
On January 26 2011, the Company’s Board of Directors declared a quarterly dividend of $0.10 per common share. The dividends were paid March 18, 2011 to stockholders of record on February 18, 2011.
On February 1, 2011, the Company filed Amendment No. 2 on Form S-3 with the Securities and Exchange Commission under which the Company offered for sale a minimum of 1,200,000 shares up to a maximum of 1,500,000 shares of its 7% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred”). On March 25, 2011, the offering was completed with a total of 1,247,700 shares of Series A Preferred being issued by the Company for gross proceeds of approximately $12.5 million before deducting offering expenses, which are expected to total approximately $1.2 million including placement agent fees and expenses. The Company intends to use the net proceeds from this offering of approximately $11.3 million for general corporate purposes. Dividends on the Series A Preferred will be cumulative from the date of original issue and will accrue on the last day of each month at an annual rate of 7% of the $10.00 liquidation preference per share. Each share of the Series A Preferred will be convertible, at the holder’s option at any time, initially into one share of the Company’s common stock based upon an initial conversion price of $10.00 per share. The Company may terminate this conversion right on or after March 31, 2014, if, for at least twenty trading days within any period of thirty consecutive trading days, the market price of the Company’s common stock exceeds the conversion price of the Series A Preferred by more than 20% and the Company’s common stock is then traded on the New York Stock Exchange, the NASDAQ Global Select Market, the NASDAQ Global Market, the NASDAQ Capital Market, or the NYSE Amex. Shares of the Series A Preferred will have no voting rights except under limited circumstances.