The following tables set forth selected consolidated historical financial information of Conifer Holdings, Inc. and Subsidiaries as of the dates and for the periods indicated. The selected financial data for the years ended December 31, 2020, 2019, 2018, 2017, and 2016 were derived from our audited consolidated financial statements and related notes thereto.
Certain statements contained in this Annual Report on Form 10-K, which are not statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, as Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements give current expectations or forecasts of future events or our future financial or operating performance. Words such as “anticipate,” “believe,” “estimate,” “expect,” "will," “intend,” “may,” “plan,” “seek” and similar terms and phrases, or the negative thereof, may be used to identify forward-looking statements.
COVID-19 (the “Pandemic”) is causing significant disruption to public health, the global economy, financial markets, and commercial, social and community activity generally. Our exposure to the Pandemic is manifold. The majority of our employees are now working remotely in observance of “shelter-in-place” or “stay-at-home” government orders. A significant portion of our revenues are generated from the hospitality sector of the U.S. economy, which has seen unprecedented contraction, at least in the near term, in an effort to mitigate the effects of the Pandemic. We have continued to provide customer service, process new and renewal business, handle claims and otherwise manage all operations even though the vast majority of the staff is working remotely. At this time, however, we are not able to provide additional forward-looking guidance as there is significant uncertainty regarding the ultimate impact of the Pandemic.
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.
Incurred but not reported ("IBNR") reserves, which are (1) unpaid loss and LAE amounts that have been incurred but not yet reported; and (2) the expected development on case reserves.
Any other information considered pertinent to estimating the indemnity and expense exposure presented by the claim.
Committee (which includes our Chief Executive Officer, President, Chief Financial Officer, other members of executive management, and key actuarial, underwriting and claims personnel) meets each quarter to review our actuaries’ estimated ultimate expected loss and LAE.
Our reserves consist entirely of reserves for property and liability losses, consistent with the coverages provided for in the insurance policies directly written or assumed by us under reinsurance contracts. Several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the specific line of business, particularly related to the speed with which claims are reported and outstanding claims are paid. Lines of business for which claims are reported slowly will have a higher percentage of IBNR reserves than lines of business that report and settle claims more quickly.
The following table displays ultimate net loss and LAE and net loss and LAE reserves by accident year for the year ended December 31, 2020. 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 2020 reported pre-tax income and on net income and shareholders’ equity at December 31, 2020. 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.
As of December 31, 2020, we have federal and state income tax net operating loss (“NOL”) carryforwards of $59.2 million and $17.1 million, respectively. Of the NOL carryforwards, $49.3 million will expire in tax years 2028 through 2039 and $9.9 million will never expire. Of the federal NOL amount, $14.1 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.
For the year ended December 31, 2020, we continued to see growth in our commercial and personal lines in areas where we have had the most success. Our commercial lines gross written premiums increased by $8.4 million, or 8.9%, to $102.8 million in 2020, compared to $94.4 million in 2019. Personal lines gross written premiums increased by $1.1 million, or 14.9% to $8.6 million in 2020, compared to $7.5 million in 2019.
The Company’s commercial lines experienced low claims activity during 2020 due to COVID-19. While substantially all businesses maintained their insurance, liability losses were lower as restaurants, bars, and other small businesses were required to limit business or totally shut down for a period of time. This reduced the potential to incur liability losses and contributed to the lower current accident year loss ratio. Potential exposures to COVID-19 losses were minimal as we include strict exclusions to business interruption coverage related to bacterial or viral causes on most policies and require physical property damage for the business interruption coverage to be effective on all policies. We also do not provide coverage relating to event cancellations, travel insurance or other coverages that could directly generate such losses. We believe we also have limited exposures relating to our workers compensation coverages which are generally companion coverages with our existing commercial policies, which represents a small amount of our overall premiums and does not appear to be heavily exposed to COVID-19-related losses.
The 2020 results were mainly driven by net realized investment gains, and net investment income of $8.1 million and $3.2 million, respectively. The largest difference between net income and the adjusted operating loss is related to the $8.4 million of net realized investment gains, and other gains, net of tax.
The impact from Hurricanes Harvey and Irma continued to recede in 2020. Loss development on Hurricane Harvey was $89,000 in 2020 compared to $313,000 in 2019. Catastrophe reinstatement costs from Irma were $195,000 in 2020, compared to $495,000 in 2019.
The expense ratio is the ratio, expressed as a percentage, of policy acquisition costs and operating expenses to net earned premiums and other income from underwriting operations.
Personal lines gross written premiums increased $1.1 million, or 14.9%, to $8.6 million for the year ended December 31, 2020, compared to $7.5 million for the same period in 2019. This increase was largely driven by our low value dwelling business.
Other income consists primarily of fees charged to policyholders by the Company for services outside of the premium charge, such as installment billings or policy issuance costs. Commission income is also received by the Company’s insurance agencies for writing policies for third party insurance companies. Other income increased by $506,000, or 24.0%, to $2.6 million for the year ended December 31, 2020, as compared to $2.1 million in 2019. The increase in other income was primarily due to commissions from the growing wholesale agency business as well as increased fees charged on existing business.
The $15.6 million of adverse development in 2020 consisted of $15.2 million from commercial lines and $352,000 from personal lines and mostly related to the 2018 and 2017 accident years.
Our expense ratio is a measure of the efficiency and performance of the commercial and personal lines of business (our risk-bearing underwriting operations). It is calculated by dividing the sum of policy acquisition costs and other underwriting expenses by the sum of net earned premiums and other income of the underwriting business. Costs that cannot be readily identifiable as a direct cost of a segment or product line remain in Corporate for segment reporting purposes. The expense ratio excludes wholesale agency and Corporate expenses.
Policy acquisition costs are costs we incur to issue policies, which include commissions, premium taxes, underwriting reports and underwriter compensation costs. The Company offsets direct commissions with ceded commissions from reinsurers. The percentage of policy acquisition costs to net earned premiums and other income increased by 2.1%, from 28.2 in 2019 to 30.3% in 2020. The acquisition cost ratio was higher mostly due to higher ceded premium rates in 2020 compared to 2019.
Net investment income decreased by $875,000, or 21.7%, to $3.1 million for the year ended December 31, 2020, compared to $4.0 million for the year ended December 31, 2019. This decrease was due to a decrease in interest income in our debt securities. This occurred because of the decreasing yields driven by the decrease in prevailing market interest rates. Average invested assets as of December 31, 2020 were $176.5 million compared to $154.9 million for the same period in 2019. The averaged invested asset balance was comprised 80.2% debt securities, 7.1% equity securities and 12.7% short-term investments as of December 31, 2020. The average invested asset balance was comprised of 81.1% debt securities, 5.8% equity securities and 13.1% short-term investments as of December 31, 2019.
The portfolio’s average quality was AA+ and AA at December 31, 2020 and 2019, respectively. The portfolio produced a tax-equivalent book yield of 1.6% and 2.6% for the years ended December 31, 2020 and 2019, respectively. The option adjusted duration of the debt securities portfolio was 3.6 years and 2.8 years at December 31, 2020 and 2019, respectively.
Premiums are earned ratably over the term of the policy, whereas written premiums are reflected on the effective date of the policy. Almost all commercial lines and homeowners products have annual policies, under which premiums are earned evenly over one year. The resulting net earned premiums are impacted by the gross and ceded written premiums, earned ratably over the terms of the policies.
Commercial lines gross written premiums decreased $3.3 million, or 3.4%, to $94.4 million for the year ended December 31, 2019, as compared to $97.7 million for the year ended December 31, 2018. Our hospitality programs’ gross written premiums decreased $6.6 million, or 12.0%, to $48.4 million for the year ended December 31, 2019, as compared to $55.0 million for the year ended December 31, 2018. However, gross written premiums for our small business programs increased by $3.3 million, or 7.7%, to $46.0 million for the year ended December 31, 2019, as compared to $42.7 million for the year ended December 31, 2018.
Personal lines gross written premiums increased $788,000, or 11.8%, to $7.5 million for the year ended December 31, 2019, as compared to $6.7 million for the same period in 2018. This was largely driven by an increase in our low value dwelling business.
Other income consists primarily of fees charged to policyholders by the Company for services outside of the premium charge, such as installment billings or policy issuance costs. Commission income is also received by the Company’s insurance agencies for writing policies for third party insurance companies. Other income increased by $527,000, or 33.3%, to $2.1 million for the year ended December 31, 2019, as compared to $1.6 million in 2018. The increase in other income was primarily due to additional commission income in the wholesale agency operations as well as increased fees charged on existing business.
Our expense ratio is a measure of the efficiency and performance of the commercial and personal lines of business (our risk-bearing underwriting operations). It is calculated by dividing the sum of policy acquisition costs and other underwriting expenses by the sum of net earned premiums and other income of the underwriting business. Costs that cannot be readily identifiable as a direct cost of a segment or product line remain in Corporate for segment reporting purposes. The expense ratio excludes wholesale agency and Corporate expenses. In prior periods the wholesale agency operations and Corporate expenses were included in the expense ratio calculation. We have changed the calculation to remove wholesale agency operations and Corporate expenses to provide a better measure of the underwriting operations’ efficiency. The 2018 ratios have been recast to reflect the new presentation. Refer to Note 17 ~ Segment Information for further details.
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 15.8% and 16.7% for the years ended December 31, 2019 and 2018, respectively.
Net realized investment gains increased by $1.1 million to $1.2 million for the year ended December 31, 2019, compared to $61,000 for the year ended December 31, 2018. The increase was mostly attributed to the increase in value of the Company’s equity securities in 2019.
Interest expense was $2.9 million and $2.6 million for the years ended December 31, 2019 and 2018, respectively. We issued $25.3 million of Notes in 2018. Proceeds from the Notes were used to pay down $19.5 million of the $30.0 million of subordinated notes that were issued in the third quarter of 2017. Interest expense includes the amortization of debt issuance costs relating to the new Notes which is $260,000 per annum over the 5-year life of the Notes. The interest expense relating to the amortization of debt issuance costs for the existing $10.5 million of the subordinated notes is $50,000 per annum over the 20-year life of the subordinated notes.
The Company has a $10.0 million line of credit, which it drew upon and paid down at various times throughout 2019, and which contributed to interest expense.
There is a $13.6 million valuation allowance against 100% of the net deferred tax assets at December 31, 2019, which would increase book value by $1.41 per share if reversed in the future. The valuation allowance was $12.6 million as of December 31, 2018. As of December 31, 2019, the Company has net operating loss carryforwards for federal income tax purposes of $60.0 million, of which $50.0 million expire in tax years 2020 through 2039 and $10.0 million never expire. Of this amount, $14.1 million are limited in the amount that can be utilized in any one year and may expire before they are realized under Section 382 of the Internal Revenue Code. The Company has state net operating loss carryforwards of $17.7 million, which expire in tax years 2021 through 2039.
In 2018, the Company recognized a measurement period adjustment of $42,735 related to loss reserve discounting, which reduced deferred tax expense. The Company also recognized a measurement period adjustment of $42,735 related to the loss reserve discounting transitional adjustment, which increased deferred tax expense. The measurement period adjustments were based upon obtaining additional information about facts and circumstances that existed as of the enactment date that, if known, would have affected the income tax effects initially reported as provisional amounts under the Act. The measurement period adjustments had no effect on the effective tax rate for the year ended December 31, 2018. The
accounting for the income tax effects of the Act pursuant to SAB 118 has been completed as of the end of the December 22, 2018, measurement period and for the year ended December 31, 2018.
We conduct our business operations primarily through our Insurance Company Subsidiaries. Our ability to service debt, and pay administrative expenses is primarily reliant upon our intercompany service fees paid by the Insurance Company Subsidiaries to the holding company for management, administrative, and information technology services provided to the Insurance Company Subsidiaries by the Parent Company. Secondarily, the Parent Company may receive dividends from the Insurance Company Subsidiaries; however, this is not the primary means in which the holding company supports its funding as state insurance laws restrict the ability of our Insurance Company Subsidiaries to declare dividends to the Parent Company. Generally, the limitations are based on the greater of statutory net income for the preceding year or 10% of statutory surplus at the end of the preceding year. No dividends were paid from our Insurance Company Subsidiaries in 2020, 2019 or 2018.
We are aware that our outstanding debt securities are currently trading at a discount to their face amount. In order to reduce future cash interest payments, as well as future amounts due at maturity or upon redemption, we may, from time to time, purchase such debt for cash, in exchange for common stock, or for a combination of cash and common stock, in open market or privately negotiated transactions. We will evaluate any such transactions in light of then-existing market conditions, taking into account our current liquidity and prospects for future access to capital. The amounts involved in such transactions, individually or in the aggregate, may be material.
Operating Activities. Cash provided by operating activities for the year ended December 31, 2020 was $3.0 million, compared to $15.4 million for the same period in 2019. The decrease in cash provided by operating activities was primarily due to a $6.0 million increase in paid claims, a decrease of $3.0 million of cash received from agencies, and a $2.1 million decrease in cash received under certain fronting arrangements. These reductions in cash flow provided by operating activities were partially offset by a $3.1 million increase in premiums collected, net of reinsurance premiums.
Cash provided by operating activities for the year ended December 31, 2019, was $15.4 million as compared to cash used in operating activities of $17.0 million for the year ended December 31, 2018. The $32.4 million increase in cash from operations was mostly due to a $28.4 million increase in cash received from reinsurers due to ceded losses, including $12.5 million of cash received in 2019 from the ADC. Also, ceded premiums paid to reinsurers decreased by $2.6 million in 2019 compared to 2018.
Investing Activities. Cash used in investing activities for the years ended December 31, 2020 and 2019, was $7.3 million and $25.0 million, respectively. The $17.7M increase in the use of cash from investing activities over the prior year is due to increased activity across the Company's investment portfolio to take advantage of 2020 market conditions.
Cash used in investing activities for the year ended December 31, 2019, was $25.0 million as compared to cash provided by investing activities of $12.2 million for the year ended December 31, 2018. The increase in funds used in investing activities was due to an increase in funds available to be invested in our investment portfolio in the insurance subsidiaries.
The Company also has outstanding $10.5 million of subordinated notes maturing on September 30, 2038. The subordinated notes bear an interest rate of 7.5% per annum until September 30, 2023, and 12.5% thereafter, and allow for four quarterly interest payment deferrals. Interest is payable quarterly at the end of March, June, September and December. Beginning September 30, 2021, the Company may redeem the subordinated notes, in whole or in part, for a call premium of $1.1 million. The call premium escalates each quarter to ultimately $1.75 million on September 30, 2023, then steps up to $3.05 million on December 31, 2023, and increases quarterly at a 12.5% per annum rate thereafter.
The Company maintains a $10.0 million line of credit with a national bank (the “Lender”). The line of credit bears interest at the London Interbank rate ("LIBOR") plus 2.75% per annum, payable monthly. The agreement includes several financial debt covenants, including a minimum tangible net worth, a minimum fixed-charge coverage ratio, and minimum statutory risk-based capital levels. As of December 31, 2020, the Company had $7.75 million outstanding on the line of credit (including the PPP loan described above), and was in compliance with all of its financial debt covenants. On June 19, 2020, the line of credit was renewed with a maturity of June 18, 2021.
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.