Adjusted net operating income is a non-GAAP measure. We define adjusted net operating income as net income excluding net realized investment gains and losses, expenses related to due diligence costs for various merger and acquisition activities, severance costs associated with terminated employees, impairment charges on goodwill and intangible assets, gains on extinguishment of debt, expenses on a leased building we are deemed to own for accounting purposes, and professional services and other expenses associated with securities offerings and the payment of special dividends. We use adjusted net operating income as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Adjusted net operating income should not be viewed as a substitute for net income in accordance with GAAP. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Reconciliation of Non-GAAP Measures” for a reconciliation of adjusted net operating income to net income in accordance with GAAP.
James River Group Holdings, Ltd. is a Bermuda-based holding company. We own and operate a group of specialty insurance and reinsurance companies with the objective of generating compelling returns on tangible equity while limiting underwriting and investment volatility. We seek to accomplish this by consistently earning profits from insurance and reinsurance underwriting and generating meaningful risk-adjusted investment returns, while managing our capital opportunistically.
The Specialty Admitted Insurance segment focuses on niche classes within the standard insurance markets, such as workers’ compensation coverage for residential contractors, light manufacturing operations, transportation workers and healthcare workers and fronting and program business. In our fronting business, we retain a small percentage of the risk and seek to earn fee income by allowing other carriers and producers to use our licensure, ratings, and infrastructure. Given market conditions and availability of reinsurance for program opportunities, we began de-emphasizing program business in 2017. Through Falls Lake National Insurance Company and its subsidiaries, this segment has admitted licenses in 49 states and the District of Columbia and distributes through a variety of sources, including independent retail agents, program administrators and MGAs. The Specialty Admitted Insurance segment produced 29.2% of our gross written premiums and 8.0% of our net written premiums for the year ended December 31, 2017.
Our Casualty Reinsurance segment generally establishes case reserves based on reports received from ceding companies or their brokers. For excess of loss contracts, we are typically notified of insurance losses on specific contracts, and we record
The table below quantifies the impact of extreme reserve deviations from our expected value at December 31, 2017. The total carried net reserve for losses and loss adjustment expenses is displayed alongside 5th, 50th and 95th percentiles of likely
The impact of recording the net reserve for losses and loss adjustment expenses at the highest value from the sensitivity analysis above would be to increase losses and loss adjustment expenses incurred by $97.2 million, reduce after-tax net income by $91.4 million, reduce shareholders’ equity by $91.4 million and reduce shareholders’ tangible equity by $91.4 million, in each case at or for the period ended December 31, 2017.
The impact of recording the net reserve for losses and loss adjustment expenses at the lowest value from the sensitivity analysis above would be to reduce losses and loss adjustment expenses incurred by $123.9 million, increase after-tax net income by $112.7 million, increase shareholders’ equity by $112.7 million, and increase tangible equity by $112.7 million, in each case at or for the year ended December 31, 2017. Such changes in the net reserve for losses and loss adjustment expenses would not have an immediate impact on our liquidity, but would affect cash flow and investment income in future periods as the incremental or reduced amount of losses are paid and investment assets adjusted to reflect the level of paid claims.
Loss reserve estimates are subject to a high degree of variability due to the inherent uncertainty of ultimate claims settlement values. In recording our best estimate of our reserve for losses and loss adjustment expenses, our Reserve Committee typically selects an amount above the actuarial recommendation due to the inherent variation associated with our reserve estimates and the likelihood that there are unforeseen or under-valued liabilities in the actuarial recommendations. We believe that the insurance that we write is subject to above-average variation in reserve estimates. The Excess and Surplus Lines market is subject to high policyholder turnover and changes in underlying mix of exposures. This turnover and change in underlying mix of exposures can cause actuarial estimates based on prior experience to be less reliable than estimates for more stable, admitted books of business. As a casualty insurer, losses on our policies often take a number of years to develop, making it difficult to estimate the ultimate losses associated with this business. Judicial and regulatory bodies have frequently interpreted insurance contracts in a manner that expands coverage beyond that which was contemplated at the time that the policy was issued. In addition, many of our policies are issued on an occurrence basis, and insureds suffering a loss frequently seek coverage beyond the policies’ original intent. The difficulty in pinpointing actual ultimate losses and loss adjustment expenses (“LAE”) is illustrated by the fact that at December 31, 2017, 68.0% of our net reserve for losses and loss adjustment expenses in the Excess and Surplus Lines segment is for claims that have not been reported.
In 2015, the Company held two municipal bonds issued by the Commonwealth of Puerto Rico. These bonds were backed by future sales tax revenues in Puerto Rico. Puerto Rico’s weak economic conditions and heavy debt burden, combined with the passage of new legislation that allowed public corporations to defer or reduce payments on outstanding debt, heightened the risk of default on the bonds. We concluded that the bonds, which had been downgraded to below investment grade, were other-than-temporarily impaired, and we recognized impairment losses of $660,000 on these bonds in 2015 before selling them during the second quarter of 2015. We concluded that none of the other fixed maturity securities in an unrealized loss position at December 31, 2016 or 2015 had experienced an other-than temporary impairment. At December 31, 2017, all of our fixed maturity securities had a fair value greater than 80% of their cost or amortized cost. We concluded that our fixed maturity securities were not other-than-temporarily impaired at December 31, 2017 based in part on the fact that they had never missed a scheduled principal or interest payment, and that they were rated investment grade by a nationally recognized statistical rating organization.
Management concluded that based on the severity and duration of the impairment associated with an equity security, the security had experienced an other-than-temporary impairment. Accordingly, the Company recorded an impairment loss of $1.5 million in 2017 on the equity security. Management concluded that none of the other equity securities with an unrealized loss at December 31, 2017, 2016, and 2015 experienced an other-than-temporary impairment. Management evaluated the near-term prospects of these other equity securities in relation to the severity and duration of the impairment, and management has the ability and intent to hold these securities until a recovery of their fair value.
Bank loan participations held-for-investment are managed by a specialized outside investment manager and are generally stated at their outstanding unpaid principal balances net of unamortized premiums or discounts and net of any allowance for credit losses.
The Company holds a participation in a loan issued by a company that produces and sells power to Puerto Rico through a power purchase agreement with Puerto Rico Electric Power Authority (“PREPA”), a public corporation and governmental agency of the Commonwealth of Puerto Rico. PREPA’s credit strength has been affected by the economic conditions in Puerto Rico, thus raising doubt about its ability to make full and timely payments on the debt obligations held by the Company. In July 2017, PREPA filed a petition for relief in U.S. District Court under Title III of the Puerto Rico Oversight, Management and Economic Stability Act. Also, in 2017, the devastation caused by Hurricane Maria on Puerto Rico raised additional doubt about PREPA's ability to make payments to the issuer. We determined that a credit allowance was needed at December 31, 2017, 2016, and 2015 on loans issued by companies that produce and supply power to Puerto Rico. Accordingly, we established credit allowances totaling $759,000, $177,000, and $414,000 at December 31, 2017, 2016, and 2015, respectively. At December 31, 2017, the loan had a carrying value of $0 and unpaid principal of $807,000.
Management concluded that one non-energy sector loan was impaired at December 31, 2017 and this loan had an allowance for credit losses of $145,000 at that date. Management also concluded that three non-energy sector loans were impaired at December 31, 2016. The impaired loans had an allowance for credit losses of $221,000. At December 31, 2015, one non-energy sector loan was impaired with an allowance for credit losses of $34,000.
Intangible assets are initially recognized and measured at fair value. Specifically identified intangible assets with indefinite lives include trademarks and state insurance licenses and authorities. Intangible assets with indefinite useful lives are reviewed for impairment at least annually. In evaluating whether there has been impairment to the intangible asset, management determines the fair value of the intangible asset and compares the resulting fair value to the carrying value of the intangible asset. If the carrying value exceeds the fair value, the intangible asset is written down to fair value, and the impairment is reported through earnings. During the fourth quarters of 2017, 2016 and 2015, the indefinite-lived intangible assets for trademarks and insurance licenses and authorities were tested for impairment. There were no impairments recognized in 2017, 2016 or 2015. The Relief From Royalty method utilized in our evaluation of the value of our trademarks requires a number of assumptions including the projected gross written premium base against which the royalty savings rate is applied, the size of the royalty rate to be applied, the discount rate and the terminal value (if any) of the trademarks at the end of the projection period.
Other specifically identified intangible assets with lives ranging from 7.0 to 27.5 years include relationships with customers and brokers. These intangible assets are amortized on a straight-line basis over their estimated useful lives. We evaluate intangible assets with definite lives for impairment when impairment indicators are noted that indicate that the carrying value of these assets may not be recoverable. If indicators of impairment are present, fair value is calculated using estimated future cash flows expected to be generated from the use of those assets. An impairment loss is recognized only if the carrying amount of a long-lived asset or asset group is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset or asset group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group. That assessment is based on the carrying amount of the asset or asset group at the date it is tested for recoverability. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset or asset group exceeds its fair value. Intangible assets for customer and broker relationships that have specific lives and are subject to amortization were reviewed for impairment during the fourth quarters of 2017, 2016 and 2015. There were no impairments recognized in 2017, 2016 or 2015.
Certain of the Company’s reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses, are recorded based upon the projected experience under the contracts.
In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). The guidance applies to all companies that either enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards, such as insurance contracts. Under this guidance, a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. Judgments required in adopting this update may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The Company has completed its evaluation of ASU 2014-09 and determined that adopting this standard will have no impact on reported fee income. The Company will adopt this ASU in the first quarter of 2018, with no cumulative effect of initially applying the update.
Effective January 1, 2017, we adopted ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting using the prospective method. The guidance requires that all tax effects related to share-based payments be made through the income statement at the time of settlement as opposed to excess tax benefits being recognized in additional paid-in capital under the previous guidance. Additionally, all tax related cash flows resulting from share-based payments are now reported as operating activities on the statement of cash flows, a change from the previous requirement to present tax benefits as an inflow from financing activities and an outflow from operating activities. For the years ended December 31, 2016 and 2015, net cash provided by operating activities increased by $3.2 million and $3.6 million, respectively, and net cash used in financing activities increased by $3.2 million and $3.6 million, respectively, for the adoption of ASU 2016-09. We have elected to recognize forfeitures as they occur in accordance with ASU 2016-09. The adoption of ASU 2016-09 did not materially impact the Company’s consolidated income statement.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments to address the diversity in practice of how certain cash receipts and payments are classified in the statement of cash flows. The update addresses specific issues, including distributions received from equity method investees and the classification of cash receipts and payments that have aspects of more than one class of cash flows. This ASU is effective for annual and interim reporting periods beginning after December 15, 2017. Upon adoption, the update will be
The following table summarizes our results for the years ended December 31, 2017 and 2016:
The combined ratio is a measure of underwriting performance and represents the relationship of incurred losses, loss adjustment expenses and other operating expenses to net earned premiums. Our combined ratio for the year ended December 31, 2017 was 99.2%. A combined ratio of less than 100% indicates an underwriting profit, while a combined ratio greater than 100% reflects an underwriting loss. In 2017, the combined ratio included $21.5 million, or 2.9 percentage points, of adverse reserve development on direct and assumed business underwritten by the Company on prior accident years, including $20.0 million of adverse reserve development from the Excess and Surplus Lines segment and $4.2 million of adverse reserve development from the Casualty Reinsurance segment offset partially by $2.7 million of favorable reserve development from the Specialty Admitted Insurance segment. The combined ratio for the year ended December 31, 2017 also includes $6.9 million, or 0.9 percentage points, of catastrophe losses from Hurricanes Harvey, Irma, and Maria.
All of the Company’s U.S. domiciled insurance subsidiaries are party to an intercompany pooling agreement that distributes the net underwriting results among the group companies based on their approximate level of statutory capital and surplus. Additionally, through December 31, 2017, each of the Company’s U.S. domiciled insurance subsidiaries was a party to a quota share reinsurance agreement that ceded 70% of their premiums and losses to JRG Re. We report all segment information in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” prior to the effects of intercompany reinsurance, consistent with the manner in which we evaluate the operating performance of our reportable segments.
Commercial Auto division (representing 46.8% of this segment’s 2017 business) which increased $137.9 million (or 125.3%) over the prior year. This division is focused on underwriting the hired and non-owned auto liability exposures for a variety of industry segments with a particular niche for insuring organizations that operate networks connecting independent contractors with customers.
Excess Casualty division (representing 9.7% of this segment’s 2017 business) which increased $7.6 million (or 17.4%) over the prior year.
Allied Health division (representing 3.6% of this segment’s 2017 business) which increased $4.8 million (or 33.1%) over the prior year.
Environmental division (representing 1.5% of this segment’s 2017 business) which increased $2.6 million (or 48.8%) over the prior year; and
The components of gross written premiums for the Specialty Admitted Insurance segment (which represents 29.2% of our 2017 consolidated gross written premiums) are as follows:
The net retention for the Casualty Reinsurance segment includes adjustments to the estimates of both gross and net written premiums from the prior year that caused this segment’s net premium retention to slightly exceed 100% in both periods.
Expense Ratio. The expense ratio of the Casualty Reinsurance segment decreased from 34.8% for the year ended December 31, 2016 to 34.5% for the year ended December 31, 2017, as net earned premiums increased 29.3% in 2017 while underwriting expenses increased by 28.4%.
For the years ended December 31, 2017 and 2016, the total operating expenses of the Corporate and Other segment were $25.3 million and $20.4 million, respectively. The increase in these expenses was primarily related to increases in stock
Net investment income was $61.1 million for the year ended December 31, 2017 compared to $52.6 million in the prior year. The change in our net investment income is as follows:
The Company’s bank loan portfolio includes loans to oil and gas companies in the energy sector. The market values of these loans have been impacted by declining energy prices. At December 31, 2017, the Company’s oil and gas exposure in the bank loan portfolio was in four loans with a carrying value of $7.9 million and an unrealized loss of $180,000. Management concluded that three of these loans were impaired as of December 31, 2017, and accordingly, an allowance for credit losses of $2.3 million was established on the loans. After recording this impairment, the loans had a carrying value of $4.6 million at December 31, 2017 and unpaid principal of $6.9 million. All of the other loans are current at December 31, 2017. At December 31, 2016, one loan was impaired with a carrying value of $1.6 million, unpaid principal of $2.2 million and an allowance for credit losses of $545,000.
The aggregate allowance for credit losses was $3.2 million at December 31, 2017 on five impaired loans with a total carrying value of $5.1 million and unpaid principal of $8.4 million. At December 31, 2016, the aggregate allowance for credit losses was $943,000 on five impaired loans with a total carrying value of $6.5 million and unpaid principal of $7.6 million.
The Company completed its impairment tests and fair value analysis for goodwill and other intangible assets during the fourth quarter of 2017 and 2016. No impairment was present for the years ended December 31, 2017 or 2016.
The following table summarizes our results for the years ended December 31, 2016 and 2015:
Net retention is defined as the ratio of net written premiums to gross written premiums.
Underwriting profit includes fee income of $14.2 million and $5.0 million for the year ended December 31, 2016 and 2015, respectively.
We had an underwriting profit of $29.5 million for the year ended December 31, 2016. This compares to an underwriting profit of $27.6 million for the prior year. On a consolidated basis, the Company recognized $23.7 million and $16.3 million of net favorable reserve development for the years ended December 31, 2016 and 2015, respectively.
$7.6 million of net realized investment gains and $4.5 million of net realized investment losses for the years ended December 31, 2016 and 2015, respectively. Net realized investment gains in 2016 include net realized gains from equity securities of $4.8 million and net realized gains from fixed maturity securities of $1.8 million. Net realized investment losses in 2015 were primarily from the sale of fixed maturity securities and bank loan participations. We sold fixed maturity securities and bank loan participations in 2015 to fund the $47.4 million of dividends paid to our common shareholders in 2015. Also included in net realized investment losses in 2015 are $3.9 million of impairment losses on two bank loans to oil and gas companies in the energy sector whose market values had declined significantly in response to declining energy prices.
$1.6 million and $730,000 of other expenses the years ended December 31, 2016 and 2015, respectively. Other expenses for 2016 include $1.5 million of employee severance costs. Other expenses for 2015 include $276,000 of expenses associated with a related party leasing arrangement for a minority-interest in a real estate limited partnership
pursuant to which we were deemed to be an owner for accounting purposes, $170,000 of employee severance costs, and $284,000 of legal, tax, and other professional services related to the formation of James River UK, the December 2015 dividend, and a securities registration statement.
Our income before taxes and net income for the years ended December 31, 2016 and 2015 reconcile to our adjusted net operating income as follows:
Our combined ratio for the year ended December 31, 2016 was 94.3%. It included $23.7 million, or 4.6 percentage points, of net favorable reserve development on direct and assumed business underwritten by the Company on prior accident years, including $24.1 million of favorable reserve development from the Excess and Surplus Lines segment and $3.8 million of favorable reserve development from the Specialty Admitted Insurance segment partially offset by $4.2 million of adverse development from the Casualty Reinsurance segment.
General Casualty division (representing 9.9% of this segment’s 2016 business) which increased $5.9 million (or 19.0%) over the prior year; and
For the Specialty Admitted Insurance segment, gross written premiums increased 100.3% year over year. Gross written premiums for 2016 included $142.6 million ($20.0 million on a net basis) from fronting and program business where there had been $55.0 million ($12.4 million on a net basis) of gross written premiums in 2015. We cede a significant portion of the specialty admitted fronting and program business to third-party reinsurers. As a result, neither our net written premiums nor level of assumed risk for this segment has increased at a rate which corresponds to the increase in our gross written premiums. In addition, workers’ compensation gross written premiums increased 10.2% for 2016 over 2015.
For the Casualty Reinsurance segment, gross written premiums increased 6.9%, from $172.5 million for the year ended December 31, 2015 to $184.3 million for the year ended December 31, 2016. The Casualty Reinsurance segment generally writes large casualty-focused treaties that are expected to have lower volatility relative to property and catastrophe treaties. We rarely write stand-alone property reinsurance. When treaties that include property exposure are written, it is done with relatively low catastrophe sub-limits.
Combined Ratio. The combined ratio of the Casualty Reinsurance segment for the year ended December 31, 2016 was 100.1%, comprised of a loss ratio of 65.3% and an expense ratio of 34.8%. This compares to the combined ratio in the prior year of 101.4%, comprised of a loss ratio of 68.6% and an expense ratio of 32.8%.
Underwriting Results. As a result of the items discussed above, the underwriting loss for the Casualty Reinsurance segment for the year ended December 31, 2016 was $194,000 compared to an underwriting loss of $2.6 million for the year ended December 31, 2015.
The $7.8 million increase in net investment income year-over-year was largely driven by the performance of the Company’s private investments. Strong performance by our other private investments, most notably a limited partnership that invests in equity tranches of collateralized loan obligations (CLOs), more than offset a decline in income from the renewable energy investments. The limited partnership, with a carrying value of $17.5 million at December 31, 2016, reported income of $4.6 million in 2016 compared to a loss of $958,000 in 2015. Excluding the private investments, our net investment income increased by $4.2 million over the prior year due to a 6.8% increase in our cash and invested assets from $1,350.7 million at December 31, 2015 to $1,442.1 million at December 31, 2016 and an increase in investment yield.
The Company invests selectively in private debt and equity opportunities. These investments comprise the Company’s other invested assets and are primarily focused in renewable energy, limited partnerships, and bank holding companies. Equity interests in various renewable energy LLCs managed by an affiliate of the Company’s largest shareholder, the D.E. Shaw Affiliates, generated investment income of $3.5 million and $3.9 million for the years ended December 31, 2016 and 2015, respectively. These investments had a carrying value of $27.1 million at December 31, 2016. Investments in bridge loans for renewable energy projects, primarily with affiliates of D.E. Shaw, had investment income $450,000 and $3.1 million for the years ended December 31, 2016 and 2015, respectively. In 2016, the Company received a $6.5 million repayment on one note. During 2015, the Company invested a total of $36.3 million in these notes and received maturities and repayments totaling $30.8 million. The Company has invested in several limited partnerships that invest in concentrated portfolios of publicly-traded small cap equities, loans of middle market private equity sponsored companies, and equity tranches of collateralized loan obligations (CLOs). Income from these partnerships was $5.3 million in 2016 compared to losses of $1.5 million in 2015. Together, these limited partnerships had a carrying value of $23.9 million at December 31, 2016. Income from the Company’s investments in renewable energy LLCs and limited partnerships is recognized under the equity method of accounting. The Company also holds $4.5 million of subordinated notes issued by a bank holding company affiliated with the Chairman and Chief Executive Officer of the Company. Interest income from the notes was $343,000 for the years ended December 31, 2016 and 2015.
Market values of energy sector holdings were negatively impacted in 2015 by declining oil and gas prices. Net realized investment losses of $4.5 million for the year ended December 31, 2015 were principally related to impairments of two energy loans totaling $3.9 million and $3.6 million of net realized losses on sales of bank loans, mostly in the energy sector. Sales of fixed maturities and equities, a portion of which were used to fund the special dividend in the fourth quarter, generated net realized gains of $2.0 million and $1.0 million, respectively, offsetting some of the energy sector losses.
In conjunction with its outside investment managers, the Company performs quarterly reviews of all securities within its investment portfolio to determine whether any impairment has occurred. The Company previously held two municipal bonds issued by the Commonwealth of Puerto Rico. Puerto Rico’s weak economic conditions and heavy debt burden heightened the risk of default on the bonds and management concluded that the bonds, which had been downgraded to below investment grade, were other-than-temporarily impaired. The Company recognized impairment losses of $660,000 on these bonds for the year ended December 31, 2015. The bonds were sold during the second quarter of 2015 and a net realized gain of $22,000 was recognized on the sales.
Management concluded that one of these loans was impaired with a carrying value of $1.6 million, unpaid principal of $2.2 million and an allowance for credit losses of $545,000. All of the other loans are current at December 31, 2016.
Management also concluded that three non-energy sector loans were impaired at December 31, 2016. At December 31, 2016, the impaired loans had a carrying value of $3.2 million, unpaid principal of $3.5 million, and an allowance for credit losses of $221,000. At December 31, 2015, one non-energy sector loan was impaired with a carrying value of $689,000, unpaid principal of $722,000, and an allowance for credit losses of $34,000.
The aggregate allowance for credit losses was $943,000 at December 31, 2016 on five impaired loans with a total carrying value of $6.5 million and unpaid principal of $7.6 million. At December 31, 2015, the aggregate allowance for credit losses was $4.3 million on five impaired loans with a total carrying value of $6.3 million and unpaid principal of $11.1 million.
At December 31, 2016, our available-for-sale investment portfolio of fixed maturity and equity securities had net unrealized gains of $2.7 million representing 0.3% of the cost or amortized cost of the portfolio. Additionally, at December 31, 2016, 99.0% of our fixed maturity security portfolio was rated “BBB-” or better (“investment grade”) by Standard & Poor’s or had an equivalent rating from another nationally recognized statistical rating organization. Fixed maturity securities with ratings below investment grade by Standard & Poor’s or another nationally recognized statistical rating organization at December 31, 2016 had an aggregate fair value of $9.2 million and an aggregate net unrealized loss of $979,000. The average duration of our investment portfolio was 3.6 years at December 31, 2016.
Corporate available-for-sale fixed maturity securities include public traded securities and privately placed bonds is shown below as of December 31, 2016:
Interest expense was $8.4 million and $7.0 million for the years ended December 31, 2016 and 2015, respectively. See “-Liquidity and Capital Resources-Sources and Uses of Funds” for information regarding our senior bank debt facility and trust preferred securities.
At December 31, 2017, our Bermuda holding company had $2.8 million of cash and cash equivalent assets. At December 31, 2017, our U.S. holding company had $57.9 million of cash and invested assets, comprised of cash and cash equivalents of $6.1 million, fixed maturity securities of $3.8 million, other invested assets of $46.8 million, and short-term investments of $1.2 million, which are not subject to regulatory restrictions. Additionally, our U.K. intermediate holding company had no invested assets and cash of less than $10,000 at December 31, 2017.
The Company has a $215.0 million senior revolving credit facility (the “Facility”). The Facility is comprised of the following at December 31, 2017:
A $102.5 million secured revolving facility utilized by JRG Re to issue letters of credit for the benefit of third-party reinsureds. At December 31, 2017, the Company had $98.5 million of letters of credit issued under the secured facility.
which is subject to change according to terms in the credit agreement. At December 31, 2017 and 2016, the Company had a drawn balance of $73.3 million outstanding on the unsecured revolver.
The senior revolving credit facility contains certain financial and other covenants (including risk-based capital, minimum shareholders’ equity levels, maximum ratios of total debt outstanding to total capitalization and minimum fixed charge coverage ratios) with which the Company was in compliance at December 31, 2017.
On August 2, 2017, the Company, and its wholly-owned subsidiary, JRG Re, together as borrowers, entered into a credit agreement that provides the Company with a revolving line of credit of up to $100 million, which may be used for loans and letters of credit made or issued, at the borrowers' option, on a secured or unsecured basis. Obligations under the credit agreement will carry a variable rate of interest subject to terms in the credit agreement and will mature 30 days after notice of termination from the lender. The credit agreement contains certain financial and other covenants which we are in compliance with at December 31, 2017. The loans and letters of credit made or issued under the revolving line of credit may be used to finance the borrowers' general corporate purposes. At December 31, 2017, unsecured loans of $10.0 million and secured letters of credit totaling $6.9 million were outstanding under the facility.
On May 26, 2004, James River Group issued $15.0 million of unsecured, floating rate senior debentures (the “Senior Debt”), due April 29, 2034 unless accelerated earlier, through an indenture. The Senior Debt is not redeemable by the holder and is not subject to sinking fund requirements. Interest accrues quarterly and is payable in arrears at a per annum rate of the three-month LIBOR on the Determination Date (as defined in the indenture) plus 3.85%. The Senior Debt is redeemable prior to its stated maturity in whole or in part, at the option of James River Group. The terms of the indenture generally provide that so long as the Senior Debt is outstanding, neither James River Group nor any of its subsidiaries may:
assume or permit to exist any indebtedness that is secured by any encumbrance on the capital stock of James River Group or any of its subsidiaries which is senior to the Senior Debt; or
The following table summarizes the nature and terms of the junior subordinated debt and trust preferred securities outstanding at December 31, 2017 (including the Company’s repurchase of a portion of these trust preferred securities):
At December 31, 2017 and December 31, 2016, the ratio of total debt outstanding, including both senior debt and junior subordinated debt, to total capitalization (defined as total debt plus total stockholders’ equity) was 22.6% and 21.7%, respectively. Having debt as part of our capital structure allows us to generate a higher return on equity and greater book value per share results than we could by using equity capital alone.
Our insurance segments enter into reinsurance contracts to limit our exposure to potential losses arising from large risks, to protect against the aggregation of several risks in a common loss occurrence, and to provide additional capacity for growth. Our reinsurance is contracted under excess of loss and quota share reinsurance contracts. In excess of loss reinsurance, the reinsurer agrees to assume all or a portion of the ceding company’s losses in excess of a specified amount. The premiums payable to the reinsurer are negotiated by the parties based on their assessment of the amount of risk being ceded to the reinsurer because the reinsurer does not share proportionately in the ceding company’s losses. In quota share reinsurance, the reinsurer agrees to assume a specified percentage of the ceding company’s losses arising out of a defined class of business in exchange for a corresponding percentage of premiums. For the years ended December 31, 2017, 2016, and 2015 our net premium retention was 70.9%, 75.6% and 82.3%, respectively.
The following is a summary of our Excess and Surplus Lines segment’s ceded reinsurance in place as of December 31, 2017:
We also have a clash and contingency reinsurance treaty to cover both the Excess and Surplus Lines and Specialty Admitted Insurance segments in the event of a claims incident involving more than one of our insureds. The treaty covers $6.0 million in excess of a $2.0 million retention for loss occurrences within the treaty term. This coverage has two reinstatements in the event we exhaust any of the coverage.
The Company’s insurance segments remain liable to policyholders if its reinsurers are unable to meet their contractual obligations under applicable reinsurance agreements. We establish allowances for amounts considered uncollectible. At December 31, 2017, there was no allowance for such uncollectible reinsurance recoverables. To minimize exposure to significant losses from reinsurance insolvencies, the Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk. The Company generally seeks to purchase reinsurance from reinsurers with A.M. Best financial strength ratings of “A-” (Excellent) or better. The Company’s reinsurance contracts generally require reinsurers that are not authorized as reinsurers under U.S. state insurance regulations or that experience rating downgrades from rating agencies below specified levels to fund their share of the Company’s ceded outstanding losses and loss adjustment expense reserves, typically through the use of irrevocable and unconditional letters of credit. In fronting arrangements, which the Company conducts through its Specialty Admitted Insurance segment, we are subject to credit risk with regard to insurance companies who act as reinsurers for us in such arrangements. We customarily require a collateral trust arrangement to secure the obligations of the insurance entity for whom we are fronting.
The Company is also exposed to credit risk relating to a set of insurance contracts with an insured group of companies under which the Company pays losses and loss adjustment expenses on the contract. The Company has indemnity agreements with this group of insured parties (non-insurance entities) and is contractually entitled to receive reimbursement for a significant portion of the losses and loss adjustment expenses paid on behalf of the insured parties and other expenses incurred by the Company. The insured parties are required to collateralize all amounts currently due to the Company and to provide additional collateral sufficient to cover the amounts that may be recoverable under the indemnity agreements, including among other things case loss and loss adjustment expense reserves, IBNR loss and loss adjustment expense reserves, extra contractual obligations and excess of policy limits liabilities. This collateral is currently provided through a collateral trust arrangement established in favor of the Company by a captive insurance company affiliate of the insured group. At December 31, 2017, the cash equivalent collateral held in the collateral trust arrangement was approximately $780.9 million, which exceeds the amount of claims receivable and unpaid reported losses and loss adjustment expenses outstanding. This is a rapidly growing relationship, and as such, there is ongoing exposure to estimated losses and expenses on these contracts growing at a faster pace than growth in our collateral balances. In addition, we have credit exposure if our estimates of future losses and loss adjustment expenses and other amounts recoverable, which are the basis for establishing collateral balances, are lower than actual amounts paid or payable. The amount of our credit exposure in any of these instances could be material. To mitigate these risks, we closely and frequently monitor our exposure compared to our collateral held, and we request additional collateral when our analysis indicates that we have uncollateralized exposure.
Our sources of operating funds consist primarily of premiums written, investment income, reinsurance recoveries and proceeds from offerings of debt and equity securities and from sales and redemptions of investments. We use the operating cash flows primarily to pay operating expenses, losses and loss adjustment expenses, and income taxes. Cash flow from operations may differ substantially from net income. The potential for a large claim under an insurance or reinsurance contract means that substantial and unpredictable payments may need to be made within relatively short periods of time. We have generated positive cash flow from operations in each of the three years ended December 31, 2017, 2016, and 2015. The following table summarizes our cash flows:
For the years ended December 31, 2017, 2016 and 2015, the Company recognized $7.7 million, $5.5 million and $3.7 million, respectively, of share-based compensation expense. The amount of unrecognized share-based compensation expense to be recognized over the remaining weighted-average service period of 1.9 years at December 31, 2017 is $6.9 million.
The Company granted 205,244, 706,203 and 10,627 non-qualified share options at an exercise price of $42.24, $32.07 and $24.32 per option during 2017, 2016 and 2015, respectively. In addition, 62,489 options with a weighted average exercise price of $30.80 per share, 33,039 options with a weighted average exercise price of $27.68 per share and 9,810 options with a weighted average exercise price of $21.00 per share were forfeited during 2017, 2016 and 2015, respectively.
The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2017 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than those indicated in the table.
One of our key financial measures that we use to assess our longer term financial performance is our percentage growth in tangible equity per share and return on tangible equity. We believe tangible equity is a good measure to evaluate the strength of our balance sheet and to compare returns relative to this measure. Tangible equity before dividends increased 11.1% from $472.5 million at December 31, 2016 to $525.1 million at December 31, 2017, largely due to net income of $43.6 million and $9.2 million of unrealized gains, net of taxes, on available-for-sale securities. Tangible equity after dividends increased 0.4% from $472.5 million at December 31, 2016 to $474.5 million at December 31, 2017. Tangible equity per common share was $15.98 at December 31, 2017, net of $1.70 of dividends per share paid by the Company during 2017. The 2017 adjusted net operating income return on average tangible equity was 9.7%, which compares to 14.6% for the full year 2016.