* Approximately 75% of the building in Clearwater is leased to unaffiliated tenants. Following our planned relocation to our new Tampa headquarters, which is expected to occur in the second half of 2021, we intend to sublease the remaining available space at the Clearwater location to unaffiliated tenants.
Heritage Insurance Holdings, Inc., is a super-regional property and casualty insurance holding company that primarily provides personal and commercial residential insurance products across its multi-state footprint. We provide personal residential insurance in sixteen states and commercial residential insurance in three of those states, while maintaining licenses in one additional state. As a vertically integrated insurer, we control or manage substantially all aspects of underwriting, customer service, actuarial analysis, distribution and claims processing and adjusting. Our financial strength ratings are important to the Company in establishing our competitive position and can impact our ability to write policies.
With regard to the COVID-19 pandemic, our first priority remains the health and safety of our employees and their families. Approximately 78% of our total personnel are either working from home full-time or on a hybrid schedule between office and home. Our corporate and remote offices remain operational, we are practicing social distancing, and have enhanced cleaning protocols and are using personal protective equipment in addition to employing other preventative measures.
We continue to monitor the short-and long-term impacts of COVID-19 virus and its variants, a global pandemic that has caused a significant slowdown in the global economy beginning in March 2020. For the year ended December 31, 2020, we saw virtually no impact to our business. As a residential property insurer, we view our business as somewhat insulated because property owners and renters generally view our products as a necessity. The majority of our gross and net premiums written are from renewals of expiring policies. New business, which accounts for a smaller portion of our revenue, may be impacted if consumers are not buying as many new homes in our geographies, but this could be partially or fully offset by increased retention in our renewal portfolio. In a prolonged recessionary and social-distancing environment, we could experience disruptions to our independent agency distribution channel, which may have a negative impact on our revenues and financial condition.
Global credit and financial markets experienced extreme volatility and disruptions during the second quarter of 2020 as a result of the COVID-19 pandemic, including diminished liquidity and credit availability, declines in consumer confidence, increases in unemployment rates and uncertainty about economic stability. Although we were relatively unaffected by the condition of the credits markets, if the credit and financial markets again experience significant deterioration at a time when we need additional liquidity, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive. Notwithstanding these actual and potential impacts, we currently believe that our cash on hand, revolving credit facility and expected earnings give us sufficient liquidity to fund our operations. However, if we need additional liquidity at a time when equity and credit markets deteriorate, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive.
The CARES Act was enacted on March 27, 2020 in the United States. The CARES Act and related notices include several significant provisions, including delaying certain payroll tax payments, mandatory transition tax payments under the TCJ Act, and estimated income tax payments that we are deferring to future periods. We do not currently expect the CARES Act to have a material impact on our liquidity or our financial results, except for the benefit associated with a 5 year carryback of our 2020 tax net operating loss. We will continue to monitor and assess the impact the CARES Act and similar legislation may have on our business and financial results.
Gross premiums written represent, with respect to a period, the sum of direct premiums written (premiums from policies written during the period, net of any midterm cancellations and renewals of voluntary policies) and assumed premiums written (primarily premiums from state fair plan policies), in each case prior to ceding premiums to reinsurers.
Gross premiums earned represent the total premiums earned during a period from policies written. Premiums associated with new and renewal policies are earned ratably over the twelve-month term of the policy and premiums associated with assumed policies are earned ratably over the remaining term of the policy.
Ceded premiums represent the cost of our reinsurance during a period. We recognize the cost of our reinsurance program ratably over term of the arrangement, which is typically twelve months. Our catastrophe excess of loss reinsurance generally incepts June 1 and runs through May 31 of the following year. Our net quota share treaty incepts December 31. Our other reinsurance programs may be purchased on a calendar or fiscal year basis.
Net investment income represents interest earned on fixed maturity securities, short term securities and other investments, dividends on equity securities, realized gains or losses on investment sales and unrealized gains or losses on equity securities.
Other revenue includes rental income due under non-cancelable leases for space at the Company’s commercial property in Clearwater, Florida, and all policy and pay-plan fees. Our regulators have approved a policy fee on each policy written for certain states; to the extent these fees are not subject to refund, the Company recognizes the income immediately when collected. The Company also charges pay-plan fees to policyholders that pay premiums in more than one installment and record the fees as income when collected.
Provision for income taxes consists of federal and state corporate level income taxes. The effective tax rate can fluctuate throughout the year as estimates used in the quarterly tax provision are updated with additional information throughout the year. The effective tax rate can vary from the 26.5% statutory federal and state blended rate depending on the amount of pretax income in proportion to permanent tax differences as well as state tax apportionment. The 2020 effective tax rate was favorably impacted by the rate benefit associated with the 2020 tax loss carrybacks afforded through the CARES Act enactment.
Ceded premium ratio represents ceded premiums earned as a percentage of gross premiums earned.
Net combined ratio represents the sum of the net loss and expense ratio. The net combined ratio is a key measure of underwriting performance traditionally used in the property and casualty insurance industry. A net combined ratio under 100% generally reflects profitable underwriting results.
Book value per share increased to $15.94, up 1.8% from year-end 2019.
Gross premiums written and gross premiums in force of $1.1 billion, with gross premiums written up 15.2% year-over-year, including 15.8% growth outside Florida and 14.6% growth in Florida.
Realized capital gains of $22.4 million, up from $4.1 million in the prior year.
Repurchased 930,356 shares for $10.0 million at an average price of $10.75 per share, 32.6% below year-end 2020 book value per share.
Extended the Company’s existing share repurchase authorization by one year to a December 31, 2021 expiration and increased the authorization from $23.8 million to $50.0 million.
Began writing homeowners insurance in California, Delaware, Maryland, and Mississippi, resulting in sixteen active states.
In the following section, we discuss the results of our operations for the year ended December 31, 2020 compared to the year ended December 31, 2019. For a discussion of the year ended December 31, 2019 compared to the year ended December 31, 2018, please Refer to Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the SEC on March 10, 2020.
Gross premiums written of $1.1 billion, up 15.2% year-over-year, including 15.8% growth outside Florida and 14.6% growth in Florida. The overall increase relates to growth in each state in which we conduct business as well as expansion to California, Delaware, Mississippi, and Maryland. Growth in existing states was organic, including growth via independent agents and strategic partnerships with national carriers. Rate increases materially benefited 2020 gross premiums written growth, particularly in Florida.
Ceded premiums were $452.1 million for the year ended December 31, 2020, up 1.5% compared to $445.5 million in the prior year. The increase is primarily attributable to an increase in the cost of our catastrophe excess of loss reinsurance program, an increase in total insured value (“TIV”) associated with premium growth and a modest increase to our net quota share reinsurance coverage in the northeast.
Net investment income, inclusive of realized investment gains (losses) and unrealized gains (losses) on equity securities, was $34.7 million for the year ended December 31, 2020, up 86.6% compared to $18.6 million in the prior year. The increase relates primarily to higher realized gains as well as improved pricing on invested assets, and a higher average invested asset balance, partly offset by a lower yield on invested assets, a function of the continued low interest rate environment.
Total revenue was $593.4 million for the year ended December 31, 2020, up 16.1% compared to $511.3 million in the prior year. The increase primarily stems from higher net premiums earned and net investment income, as described above.
Losses and LAE were $373.4 million for the year ended December 31, 2020, up 36.6% compared to $273.3 million in the prior year. The increase primarily stems from higher current accident year catastrophe and non-catastrophe weather losses and lower income from vertically integrated operations which serves to offset losses. Our net losses include claims from six hurricanes, catastrophic non-hurricane losses from severe convective storms, and other weather losses amounting to $134.2 million and $75.9 million for the years ended December 31, 2020 and 2019, respectively.
Policy acquisition costs were $128.3 million for the year ended December 31, 2020, up 18.9% compared to $107.9 million in the prior year. Higher acquisition costs relate to the increase in gross premiums written.
General and administrative expenses were $81.5 million for the year ended December 31, 2020, up 1.2% compared to $80.5 million in the prior year. The increase relates to separation payments to two of our named executive officers, partially offset by reductions in travel related costs, intangible amortization, and purchases of non-capitalized equipment.
The benefit for income taxes was $7.1 million for the twelve months ended December 31, 2020 compared to a provision for income taxes of $12.4 million for the twelve months ended December 31, 2019. The effective tax rate for the current year is (321.3)% compared to 30.1% for the prior year. The variance in the effective tax rate relates to a tax net operating loss for the year ended December 31, 2020, which was carried back five years under The CARES Act and deductible at a 35% corporate income tax rate rather than the current 21% statutory rate. Additionally, the effective tax rate can fluctuate throughout the year as estimates used in the quarterly tax provision are updated with additional information throughout the year, including changes to pre-tax income.
Net income for the twelve months ended December 31, 2020 was $9.3 million ($0.33 per diluted share), down 67.4% from $28.6 million ($0.98 per diluted share) in the prior year. The decrease primarily reflects a higher loss ratio, partly offset by the benefit of the tax net operating loss carryback.
The ceded premium ratio was 45.4% for the twelve months ended December 31, 2020, down 2.8 points from 48.2% in the prior year. The decrease primarily stems from the increase in gross earned premiums over the prior year, partially offset by higher reinsurance costs, as described above.
The net loss and LAE ratio was 68.5% for the twelve months ended December 31, 2020, up 11.4 points from 57.1% in the prior year. The increase relates to higher weather losses and lower income from vertically integrated operations.
The net expense ratio was 38.5% for the twelve months ended December 31, 2020, down .9 points from 39.4% in the prior year. The decrease primarily stems from net premiums earned growth that outpaced expense growth in the current year.
We believe that our sources of cash are adequate to meet our cash requirements for at least the next twelve months.
Net cash provided by operating activities for December 31, 2020 was $170.2 million as compared to net cash provided of $119.7 million during the prior year. The increase was primarily due to an increase in gross written premiums and reinsurance collections as well as timing of payment of claims.
Net cash used in financing activities for the year ended December 31, 2020 was $28.9 million, as compared net cash used in of $45.4 million in the prior year. The variance relates primarily to a repayment on our revolving credit facility and repurchases of a larger amount of stock during 2019.
On December 14, 2018, the Company entered into a credit agreement (the “Credit Agreement”) by and among the Company, as borrower, certain subsidiaries of the Company from time to time party thereto as guarantors, the lenders from time to time party thereto (the “Lenders”), Regions Bank, as Administrative Agent and Collateral Agent, BMO Harris Bank N.A., as Syndication Agent, Hancock Whitney Bank and Canadian Imperial Bank of Commerce, as Co-Documentation Agents, and Regions Capital Markets and BMO Capital Markets Corp., as Joint Lead Arrangers and Joint Bookrunners.
At our option, borrowings under the Credit Facilities bear interest at rates equal to either (1) a rate determined by reference to LIBOR (based on one, two, three or six-month interest periods), adjusted for statutory reserve requirements, plus an applicable margin (equal to 3.25% as of the Closing Date) or (2) a base rate determined by reference to the greatest of (a) the “prime rate” of Regions Bank, (b) the federal funds rate plus 0.50%, and (c) the LIBOR index rate applicable for an interest period of one month plus 1.00%, plus an applicable margin (equal to 2.25%).
Each of the Revolving Credit Facility and the Term Loan Facility mature on December 14, 2023. The principal amount of the Term Loan Facility amortizes in quarterly installments, which began with the close of the fiscal quarter ended March 31, 2019, in an amount equal to $1,875,000 per quarter, payable monthly or quarterly, with the balance payable at maturity.
The Company issued the Convertible Notes under an Indenture (the “Convertible Note Indenture”), dated August 16, 2017, by and among the Company, as issuer, the Notes Guarantor, as guarantor, and Wilmington Trust, National Association, as trustee (the “Trustee”).
The Convertible Notes bear interest at a rate of 5.875% per year. Interest began accruing on August 16, 2017 and is payable semi-annually in arrears, on February 1 and August 1 of each year, starting on February 1, 2018. The Convertible Notes are senior unsecured obligations of the Company that rank senior in right of payment to the Company’s future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to the Company’s unsecured indebtedness that is not so subordinated; effectively junior to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness or other liabilities incurred by the Company’s subsidiaries other than the Notes Guarantor, which fully and unconditionally guarantee the Convertible Notes on a senior unsecured basis.
The Convertible Notes mature on August 1, 2037, unless earlier repurchased, redeemed or converted.
Holders may convert their Convertible Notes at any time prior to the close of business on the business day immediately preceding February 1, 2037, other than during the period from, and including, February 1, 2022 to the close of business on the second business day immediately preceding August 5, 2022, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2017, if the closing sale price of the Company’s common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the calendar quarter immediately preceding the calendar quarter in which the conversion occurs, is more than 130% of the conversion price of the Convertible Notes in effect on each applicable trading day; (2) during the ten consecutive business-day period following any five consecutive trading-day period in which the trading price for the Convertible Notes for each such trading day was less than 98% of the closing sale price of the Company’s common stock on such date multiplied by the then-current conversion rate; (3) if the
In the second quarter of 2018, the Company repurchased $10.6 million principal amount of Convertible Notes for cash. In the fourth quarter of 2018 and first quarter of 2019, the Company repurchased Convertible Notes in the aggregate principal amount of $81.6 million for a combination of cash and the issuance of an aggregate of 3,880,653 shares of the Company’s common stock, valued at $53.0 million, leaving $23.4 million in aggregate principal amount outstanding. There were no repurchases of Convertible Notes subsequent to the first quarter of 2019.
In December 2018, a subsidiary of the Company pledged U.S. government and agency fixed maturity securities with an estimated fair value of $31.0 million as collateral and received $19.2 million in a cash loan under an advance agreement with the FHLB Atlanta. The loan originated on December 12, 2018 and bears a fixed interest rate of 3.094% with interest payments due quarterly commencing in March 2019. The principal balance on the loan has a maturity date of December 13, 2023. In connection with the agreement, the subsidiary became a member of FHLB. Membership in the FHLB required an investment in FHLB’s common stock which was purchased on December 31, 2018 and valued at $1.4 million. The subsidiary is permitted to withdraw any portion of the pledged collateral over the minimum collateral requirement at any time, other than in the event of a default by the subsidiary. The proceeds from the loan was used to prepay the Company’s Senior Secured Notes due 2023 in 2018.
The following table summarizes our material contractual obligations and commitments as of December 31, 2020:
Amounts represent principal and interest payments to debt obligations. Debt obligations are classified based on their stated maturity date. For further information on long-term debt, Refer to Note 14 “Long Term Debt” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.
We consider accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimates in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our consolidated financial statements.
Impairment of Long-Lived Assets Including Intangible Assets Subject to Amortization. We assess the recoverability of long-lived assets when events or circumstances indicate that the assets might have become impaired. We determine whether the assets can be recovered from undiscounted future cash flows and, if not recoverable, we would recognize impairment to reduce the carrying value to fair value. Recoverability of long-lived assets is dependent upon, among other things, our ability to maintain profitability, so as to be able to meet its obligations when they become due. No impairment was recognized in any period presented.
Premiums. We recognize direct and assumed premiums written as revenue, net of ceded amounts, on a daily pro rata basis over the contract period of the related policies that are in force. For any portion of premiums not earned at the end of the reporting period, we record an unearned premium liability.
Premiums receivable represents amounts due from our policyholders for billed premiums and related policy fees. Our billing system is equity based such that policies are cancelled if the unpaid premium exceeds the amount of premium earned. When we receive payments on amounts previously charged off, we credit bad debt expense in the period we receive the payment. Balances in premiums receivable and the associated allowance account are removed upon cancellation of the policy due to non-payment. We
recorded approximately $161,300 and $290,300 allowance for uncollectible premiums in 2020 and 2019 and we recorded no allowance for the year ended 2018.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and loss adjustment expenses, also referred to as loss reserves, represent the most significant accounting estimate inherent in the preparation of our financial statements. These reserves represent management’s best estimate of the amount we will ultimately pay for losses and loss adjustment expenses and we base the amount upon the application of various actuarial reserve estimation techniques as well as considering other material facts and circumstances known at the balance sheet date. We establish two categories of loss reserves as follows: Case reserves-When a claim is reported, we establish an initial estimate of the losses that will ultimately be paid on the reported claim. Our initial estimate for each claim is based upon the judgment of our claims professionals who are familiar with property and liability losses associated with the coverage offered by our policies. Then, our claims personnel perform an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss and adjust the reserve, as necessary. As claims mature, we increase or decrease the reserve estimates as deemed necessary by our claims department based upon additional information we receive regarding the loss, the results of on-site reviews and any other information we gather while reviewing the claims. IBNR reserves-Our IBNR reserves include true IBNR reserves plus “bulk” reserves. True IBNR reserves represent amounts related to claims for which a loss occurred on or before the date of the financial statements, but which have not yet been reported to us. Bulk reserves represent additional amounts that cannot be allocated to particular claims, but which are necessary to estimate ultimate losses on known claims. We estimate our IBNR reserves by projecting our ultimate losses using industry accepted actuarial methods and then deducting actual loss payments and case reserves from the projected ultimate losses. We review and adjust our IBNR reserves on a quarterly basis based on information available to us at the balance sheet date.
Insurance premiums are established before we know the amount of loss and LAE and the extent to which inflation may affect such expenses. Consequently, we attempt to anticipate the future impact of inflation when establishing rate levels. While we attempt to charge adequate rates, we may be limited in raising our premium levels for competitive and regulatory reasons. Inflation also affects the market value of our investment portfolio and the investment rate of return. Any future economic changes which result in prolonged and increasing levels of inflation could cause increases in the dollar amount of incurred loss and LAE and thereby materially adversely affect future liability requirements.
Consolidated Balance Sheets as of December 31, 2020 and December 31, 2019
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2020, 2019 and 2018
We have audited the accompanying balance sheets of Heritage Insurance Holdings, Inc. (the “Company”) as of December 31, 2020 and 2019, the related statements of operations, comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes and schedules (collectively referred to as the “financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO framework”).
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
We verified the consistency of the estimation process between the current year and those used in prior years and assessed the reasonableness of management’s selection of its estimate for unpaid losses and LAE;
General and administration includes $14.1 million, $15.4 million and $18.1 million of ceding commission income for the reporting years 2020, 2019 and 2018, respectively.
Our primary products are personal and commercial residential insurance, which we currently offer in Alabama, California, Connecticut, Delaware, Florida, Georgia, Hawaii, Maryland, Massachusetts, Mississippi, New Jersey, New York, North Carolina, Rhode Island, South Carolina, and Virginia. We conduct our operations under a single reporting segment.
The preparation of consolidated financial statements in conformity with United States Generally Accepted Accounting Principles (“U.S. GAAP”) requires us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and accompanying notes. We evaluate our estimates on an ongoing basis when updated information related to such estimates becomes available. We base our estimates on historical experience and information available to us at the time these estimates are made. Actual results could differ materially from these estimates.
The Company excludes from cash and cash equivalents negative cash balances that the Company has with an individual financial institution. The liability presents outstanding checks not yet presented to the financial institution and is reported in accounts payable and other liabilities.
As of December 31, 2020, and 2019, restricted cash was $5.4 million and $14.7 million, respectively. As of December 31, 2020 and 2019, Heritage P&C held approximately $0 and $9.0 million relating to a reinsurance agreement with an entity that issued catastrophe (“CAT”) bonds, as Heritage P&C is contractually required to deposit certain installments of reinsurance premiums into a trust account and $5.4 million and $5.7 million in restricted cash relating to individual regulatory state deposits, respectively. The Company earned interest income of $33,400 and $28,969 on its restricted cash deposits.
The Company classifies all of its investments in debt securities as available-for-sale and reports them at fair value. Subsequent to its acquisition of debt securities available-for-sale, the Company records changes in value through the date of disposition as unrealized holding gains and losses, net of tax effects, and includes them as a component of other comprehensive income. Refer to Note 2 “Investments” to our consolidated statements included in this Annual Report on Form 10-K, for further information.
Net realized investment gains and losses are included as a component of pre-tax revenues based upon specific identification of the investments sold on the trade date. Included in net realized and unrealized gains (losses) are credit impairment losses on invested assets other than those investments accounted for using the equity method of accounting described in the “Allowance for Credit Losses” and “Impairment of Other Investments” section discussed below.
The Company makes investments in limited partnerships (“LPs”), Limited Liability Companies (“LLCs”), and a Real Estate Investment Trust (“REIT”), which are deemed to be VIEs. The Company determines at the inception of each arrangement whether an entity in which it has made an investment or in which it has other variable interests is considered a variable interest entity ("VIE"). The Company consolidates VIEs when it is determined to be the primary beneficiary. The Company is the primary beneficiary of a VIE when it has the power to direct activities that most significantly affect the economic performance of the VIE and has the obligation to absorb the majority of their losses or benefits. If the Company is not the primary beneficiary in a VIE, it will account for the investment or other variable interests in a VIE in accordance with applicable GAAP. For the year ended December 31, 2020 and 2019, the Company was not the primary beneficiary to any of its other investments and therefore considered the other investments as non-consolidated VIEs.
The Company has elected to measure its REIT investment in which it does not exercise significant influence over the investees and without readily determinable fair value at cost, less impairment, adjusted up or down for any observable price changes from orderly transactions for the identical or a similar investment of the same issuer. The carrying value of its investment is written down, to fair value when a qualitative assessment indicates that the fair value is less than the carrying value. In making the determination as to whether an individual investment is impaired, the Company assesses such qualitative factors as the current and expected financial conditions of each relevant entity, the market conditions of the industry in which the entity operates and the entity’s anticipated ability to generate sufficient cash flows.
We earn ceding commission on our gross and net quota share reinsurance contracts. Our accounting policy is to allocate ceding commission between policy acquisition costs and general and administrative expenses for financial reporting purposes. Ceding commission is allocated between policy acquisition costs and general and administrative expenses based upon the proportion these costs bear to production of new business. For the years ended December 31, 2020 and 2019, we earned ceding commission income of $57.1 million and $62.4 million of which $43.0 million and $47.0 million was allocable to policy acquisition costs.
At each reporting date, the Company determines whether it has a premium deficiency. A premium deficiency would result if the sum of the Company’s expected losses, deferred policy acquisition costs, and policy maintenance costs (such as costs to store records and costs incurred to collect premiums and pay commissions) exceeded the Company’s related unearned premiums plus investment income. Should the Company determine that a premium deficiency exists, the Company would write off the unrecoverable portion of deferred policy acquisition cost.
The Company remains liable for claims payments if any reinsurer is unable to meet its obligations under the reinsurance agreements. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities or economics characteristics of the reinsurers to minimize its exposure to significant loses from reinsurers insolvencies. The Company contracts with a diverse population of reinsurers to secure its annual reinsurance coverage, for which the excess of loss treaties generally become effective June 1st each year.
(iii) the low interest rate environment and (iv) the stressed global economy, including the impact of COVID-19. Reinsurance recoverables are reported on the consolidated balance sheets net of the CECL allowance.
The application of the purchase method of accounting for business combinations requires the use of significant estimates and assumptions in determining the fair value of assets acquired and liabilities assumed in order to properly allocate the fair value of the acquired business. The estimates of the fair value of the assets acquired and liabilities assumed are based upon assumptions believed to be reasonable using established valuation techniques that consider a number of factors and when appropriate, valuations performed by independent third-party appraisers. Assets acquired, and liabilities assumed in connection with business combinations are recorded based on their respective fair values at the date of acquisition.
Our insurance affiliates may charge policyholders a policy fee on each policy written; to the extent these fees are not subject to refund, and the Company recognizes the income immediately when collected, which coincide with related service obligations. The Company also charges pay-plan fees to policyholders that pay its premiums in more than one installment and records the fees as income when collected. Other income also includes rental income due under non-cancelable leases for space at the Company’s commercial property.
Guaranty fund and other insurance-related assessments imposed upon the Company’s insurance company affiliates are recorded as policy acquisition costs in the period the regulatory agency imposes the assessment. To recover guaranty or other insurance-related assessments, the Company in turn submits a plan for recoupment to the Insurance Commissioner for approval and upon approval, begins collecting a policy surcharge that will allow it to collect the prior year’s assessments. There were no assessments during the periods presented.
Beginning December 1, 2017, the conversion option of the Convertibles Notes qualified for the equity classification and was no longer accounted for as a separate derivative instrument liability in accordance with applicable U.S. GAAP guidance. The Company separately accounts for the liability and equity components of Convertible Notes that can be settled in cash by allocating the proceeds from issuance between the liability component and the embedded conversion option, or equity component, in accordance with accounting for convertible debt instruments that may be settled in cash (including partial cash settlement) upon conversion. The Company recognizes the accretion of the resulting discount using the effective interest method as part of interest expense in its consolidated statements of operations.
The Company has reacquired convertible senior notes over a series of transactions. In accordance with ASC 470 “Debt”, the Company evaluated the accounting treatment to determine if the repurchase of the Convertible Notes constituted a debt extinguishment. ASC 405-20-40-1 provides implementation guidance in order to determine if the Company is legally released from being the primary obligor under the liability, either judicially or by the creditor. Based on the reacquisition of the Convertible Notes, the Company derecognized the related debt and conversion option liability. Upon extinguishment, the Company performed a discounted cash flow (“DCF”) analysis for each transaction based on its date and principal amount, leveraging market debt yield data as of each trade date to estimate the costs of the debt.
In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments . This standard changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. The Company adopted this standard on January 1, 2020, and based on the composition of our reinsurance recoverables, investment portfolio and other financial assets, current economic conditions and historical credit loss activity, the adoption of this standard did not have a material impact on the Company’s consolidated financial statements and related disclosures.
Although there are several other new accounting pronouncements issued by the FASB, the Company does not believe any of these accounting pronouncements had or will have a material impact on its consolidated financial statements.
Includes securities at December 31, 2019 with a carrying amount of $20.2 million that were pledged as collateral for the advance agreement entered into with a financial institution in 2018. The Company is permitted to withdraw or exchange any portion of the pledged collateral over the minimum requirement at any time.
The table below summarizes the Company’s fixed maturity securities at December 31, 2020 and 2019 by contractual maturity periods. Actual results may differ as issuers may have the right to call or prepay obligations, with or without penalties, prior to the contractual maturity of those obligations.
The following table presents net realized gains (losses) on the Company’s debt securities available-for-sale as of December 31, 2020, 2019 and 2018, respectively:
The Company’s unrealized losses on corporate bonds have not been recognized because the bonds are of high credit quality with investment grade ratings of A- or higher, the Company does not intend to sell and it is unlikely the Company will be required to sell the securities prior to their anticipated recovery, and the decline in fair value is deemed due to changes in interest rates and other market conditions. The bond issuers continue to make timely principal and interest payments on the bonds. After taking into account these and other factors previously described, the Company believes these unrealized losses generally were caused by a decrease in market interest rates since the time the securities were purchased.
The Company makes passive investments in limited partnerships (“LPs”), Limited Liability Companies (“LLCs”), and a Real Estate Investment Trust (“REIT”). These investments are accounted for using the equity method, with income reported in net realized and unrealized gains and losses or the measurement alternative method, which is reported at cost less impairment (if any), plus or minus changes from observable price changes.
The Class A preferred units in the amounts of $7.5 million and $9.9 million are measured at amortized cost under the guidance of ASC 320 and are subject to a fixed principal and interest payment schedule with maturity dates of February 1, 2023 and April 1, 2024, respectively.
The following table summarizes the carrying value and maximum loss exposure of the Company’s non-consolidated VIEs at December 31, 2020 and 2019:
Our intangible assets resulted primarily from the acquisitions of Zephyr Acquisition Company and NBIC Holdings, Inc. and consist of brand, agent relationships, renewal rights, customer relations, trade names, non-competes and insurance licenses. Finite-lived intangibles assets are amortized over their useful lives from one to fifteen years.
Amortization expense of intangible assets was $6.4 million, $8.2 million and $24.8 million for the years ended December 31, 2020, 2019 and 2018, respectively.
The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. Accordingly, when market observable data are not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded at fair value on the consolidated balance sheets are categorized based on the level of judgment associated with inputs used to measure their fair value and the level of market price observability, as follows:
Level 2 - Valuations based on observable inputs, such as quoted prices similar assets or liabilities at the measurement date; quoted prices in the markets that are not active; or other inputs that are observable, either directly or indirectly.
Level 3 - Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.
For the Company’s investments in U.S. government securities that do not have prices in active markets, agency securities, state and municipal governments, and corporate bonds, the Company obtains the fair values from its third-party valuation service and evaluates the relevant inputs, assumptions, methodologies and conclusions associated with such valuations. The valuation service calculates prices for the Company’s investments in the aforementioned security types on a month-end basis by using several matrix-pricing methodologies that incorporate inputs from various sources. The model the valuation service uses to price U.S. government securities and securities of states and municipalities incorporates inputs from active market makers and inter-dealer brokers. To price corporate bonds and agency securities, the valuation service calculates non-call yield spreads on all issuers, uses option-adjusted yield spreads to account for any early redemption features, then adds final spreads to the U.S. Treasury curve as of quarter end. The inputs the valuation service uses in their calculations are not quoted prices in active markets, but are observable inputs, and therefore represent Level 2 inputs.
Assets and liabilities that are measured at fair value on a non-recurring basis include intangible assets and goodwill which are recognized at fair value during the period in which an acquisition is completed, from updated estimates and assumptions during the measurement period, or when they are considered to be impaired. These non-recurring fair value measurements, primarily for intangible assets acquired, were based on Level 3 unobservable inputs. For the years ended December 31, 2020 and 2019, these non-recurring fair values inputs consisted of brand, agent relationships, renewal rights, customer relations, trade names, non-compete and goodwill. To evaluate such assets for a potential impairment, we determine the fair value of the goodwill and intangible assets using a combination of a discounted cash flow approach and market approaches, which contain significant unobservable inputs and therefore are considered a Level 3 fair value measurement. The unobservable inputs in the analysis generally include future cash flow projections and a discount rate.
There were no non-recurring fair value adjustments to intangible assets and goodwill during 2020, 2019 and 2018. The measurement period may be up to one year from the acquisition date. We record any measurement period adjustments to the fair value of assets acquired and liabilities assumed, with the corresponding offset to goodwill, the carrying amount for cash and cash equivalents approximates fair value due to the short term maturity of these investments.
Property and equipment, net consists of the following at December 31, 2020 and 2019 (in thousands):
Depreciation expense for the years ended December 31, 2020, 2019 and 2018 was $1.6 million, $2.2 million, $2.3 million, respectively. The Company’s real estate consists of 15 acres of land, 5 buildings with a gross area of 191,200 square feet and a parking garage.
The Company defers certain costs in connection with written policies, called deferred policy acquisition costs (“DPAC”), which are amortized over the effective period of the related insurance policies.
The majority of our program was placed on a cascading basis which provides greater horizontal protection in a multiple small events scenario and features additional coverage enhancements.
We are responsible for all losses and loss adjustment expenses in excess of our reinsurance program. For second or subsequent catastrophic events, our total available coverage depends on the magnitude of the first event, as we may have coverage remaining from layers that were not previously fully exhausted. An aggregate of $2.6 billion of limit purchased in 2020 includes reinstatement through the purchase of reinstatement premium protection. In total, we have purchased $2.6 billion of potential reinsurance coverage, including our retention, for multiple catastrophic events. The amount of coverage, however, will be subject to the severity and frequency of such events.
The Company's estimated net cost for the 2020-2021 catastrophe reinsurance programs is approximately $272.1 million.
Our Net Quota Share coverage is proportional reinsurance, which applies to business underwritten by NBIC, for which certain of our other reinsurance (property catastrophe excess of loss and the second layer of the general excess of loss) inures to the quota share program. An occurrence limit of $20.0 million for catastrophe losses is in effect on the quota share program, subject to certain aggregate loss limits that vary by reinsurer. The amount and rate of ceding commissions slide, within a prescribed minimum and maximum, depending on loss performance. The Net Quota Share program was renewed on December 31, 2020 ceding 56% of the net premiums and losses and 3% of the prior year quota share is in run off.
For a discussion of 2019-2020 Reinsurance Program please Refer to Part II, Item 8, “Financial Statements and Supplementary Data” further “Note 12. Reinsurance” in our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the SEC on March 10, 2020.
The following is information about incurred and paid claims development as of December 31, 2020, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities plus expected development on reported claims included within the net incurred claims amounts.
Average Annual Percentage Payout of Incurred Claims by Age, Net of Reinsurance as of December 31, 2020 (Unaudited)
Interest accrues from August 16, 2018 and is payable semi-annually in arrears, on February 1 and August 1 of each year, beginning in 2019.
As of December 31, 2019, the Company had $21.3 million of the Convertible Notes outstanding, net of debt issuance and debt discount costs which totaled approximately, $2.1 million. For the year ended December 31, 2019, the Company made interest payments of approximately $1.5 million on the Convertible Notes.
Term Loan Facility: The principal amount of the Term Loan Facility amortizes in quarterly installments, beginning with the close of the fiscal quarter ending March 31, 2019, in an amount equal to $1.9 million per quarter, with the remaining balance payable at maturity. As of December 31, 2020 and 2019, the aggregate principal outstanding on the term loan totaled $60.0 million and $69.4 million, respectively. For the year ended December 31, 2020 and 2019, the Company made interest payments of approximately $2.6 million and $4.0 million on the term loan, respectively.
Revolving Credit Facility: The Revolving Credit Facility allows for borrowings of up to $50.0 million inclusive of a $5.0 million sublimit for the issuance of letters of credit and a $10.0 million sublimit for swingline loans. As of December 31, 2020, and 2019, the Company had $10.0 million of borrowings and a letters of credit outstanding under the Revolving Credit Facility. For the year ended December 31, 2020 and 2019, the Company made interest payments of $403,000 and $565,000 under the credit facility, respectively.
As of December 31, 2020, the Company’s effective interest rate for the Term Loan and for the Revolving Credit Facility was 3.475%. The Company monitors the rates prior to the reset date which allows it to establish if the payment is monthly or quarterly payment based on the most beneficial rate used to calculate the interest payment.
On April 27, 2020, the Company amended its Credit Agreement by entering into the Second Amendment to Credit Agreement (the “Second Amendment”) with the lenders to the Credit Agreement, and Regions Bank, as administrative agent and collateral agent. The Second Amendment modified the negative covenants in the Credit Agreement to permit the Company to make acquisitions and investments if, after giving effect to the acquisition or investment, either (1) the Company has an aggregate of $25.0 million in cash and availability under the revolving credit facility or (2) the consolidated leverage ratio under the Credit Agreement is at least a quarter turn less than the required ratio for the trailing four quarters. The amendment gives the Company more flexibility to make acquisitions and investments in the future. All other material terms of the Credit Agreement remain unchanged.
On June 1, 2020, the Company amended the Credit Agreement by entering into the Third Amendment to Credit Agreement (the “Third Amendment”) with the lenders party to the Credit Agreement, and Regions Bank, as administrative agent and collateral agent. The Third Amendment modified the Credit Agreement to increase the letter of credit sublimit from $5 million to $40 million and to make related modifications to certain of the negative covenants in the Credit Agreement.
The Tax Act was signed into law on December 22, 2017 and contains several key provisions that impact the Company's business, including the reduction of the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018, the reduction in
the amount of executive compensation that could qualify as a tax deduction, and a change in how property and casualty taxpayers discount loss reserves. Under current accounting guidance, the effects of changes in tax rates and laws are recognized in the period in which the new legislation is enacted.
In assessing the net carrying amount of deferred tax assets, we consider whether it is more likely than not that we will not realize some portion or all of the deferred tax assets. The ultimate realization of deferred tax assets depends upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. The remaining goodwill from asset purchases that is deductible for tax purposes over the future years totaled $6.0 million for the years ended December 31, 2020 and 2019, respectively. We had non-deductible goodwill of $144.4 million for the years ended December 31, 2020 and 2019, respectively.
State laws and regulations, as well as national regulatory agency requirements, govern the operations of all insurers such as our insurance subsidiaries. The various laws and regulations require that insurers maintain minimum amounts of statutory surplus and risk-based capital; restrict insurers’ ability to pay dividends; restrict the allowable investment types and investment mixes and subject the Company’s insurers to assessments.
State laws for Florida, Hawaii, and Rhode Island permit an insurer to pay dividends or make distributions out of that part of statutory surplus derived from net operating profit and net realized capital gains. The applicable laws pertain to the state of domicile of each insurance company affiliate and provide calculations to determine the amount of dividends or distributions that can be made without the prior approval of the insurance regulatory authority and the amount of dividends or distributions that would require prior approval of the insurance regulatory authority. In the state of Florida, a dividend may be taken without regulatory approval if the dividend is equal to or less than the greater of 10% of the insurer’s surplus or the insurer’s net income. In the state of Rhode Island, a dividend may be taken without regulatory approval if the dividend is equal to or less than the lesser of 10% of the insurer’s surplus or the insurer’s net income excluding realized capital gains. The state of Hawaii restricts dividends without regulatory approval to the smaller of prior years’ net income or 10% of prior year’s surplus. Heritage P&C and NBIC have not paid dividends in any of the last three years. Zephyr paid dividends of $13.7 million and $6.9 million for the years ended December 31, 2020 and 2019.
Statutory risk-based capital requirements may further restrict our insurance subsidiaries ability to pay dividends or make distributions if the amount of the intended dividend or distribution would cause statutory surplus to fall below minimum risk-based capital requirements.
State insurance laws limits an insurer’s investment in equity instruments and also restricts investments in medium to low quality debt instruments. The Company’s insurance affiliates were in compliance with all investment restrictions at December 31, 2020 and 2019.
The Company’s reinsurance subsidiary, Osprey, which was incorporated on April 23, 2013, is licensed as a Class 3a Insurer under The Bermuda Insurance Act 1978 and related regulations. Osprey is required to maintain statutory capital and surplus of at least $1.0 million and maintain liquid resources or have access to liquid resources equal to its maximum obligation for which it is responsible under the terms of any reinsurance arrangement to which it is a party. Osprey maintains sufficient collateral to comply with regulatory requirements as of December 31, 2020. Bermuda’s standard for financial statement reporting is U.S. GAAP.
In July 2020, the Company entered into a ten year, non-cancellable operating lease agreement for approximately 88,600 square feet of office space located in Tampa, Florida. The Company anticipates relocating from the Clearwater Corporate office to the new location during the second half of 2021.
At December 31, 2020, the Company recognized employee bonus compensation expense in aggregate of $6.4 million of which $2.9 million was carried over into 2021, of which $2.1 million relates to the consolidated severance payment due, as disclosed in Part IV, Item 6. Exhibit 10.5 Separation agreement dated December 1, 2020. At December 31, 2019, the Company recognized employee bonus compensation expense of approximately $7.6 million, which the Company paid out in cash of approximately $6.0 million for 2019, the remainder was paid in 2020.
In January 2018, the Company entered into a consulting agreement with Mrs. Shannon Lucas, the wife of the Former Chairman and CEO, in which she agreed to provide consulting services related to the Company’s catastrophe reinsurance and risk management program at a rate of $400 per hour. The consulting agreement has no specific term and either party may terminate the agreement upon
In July 2020, the Board of Directors appointed Mark Berset to the Board of Directors of the Company. Mr. Berset is also the Chief Executive Officer of Comegys Insurance Agency, Inc. (“Comegys”), an independent insurance agency that writes policies for Company. The Company pays commission to Comegys based upon standard industry rates consistent with those provided to the Company’s other insurance agencies. There are no arrangements or understandings between Mr. Berset and any other persons with respect to his appointment as a director. For the years ended December 31, 2020 and 2019, the Company paid agency commission to Comegy of approximately $1.0 million and $589,800, respectively.
The Company provides a 401(k) plan for substantially all employees. The Company provides a matching contribution of 100% on the first 3% of employees’ contribution and 50% on the next 2% of the employees’ contribution to the plan. The maximum match is 4%. For the years ended December 31, 2020 and 2019, the contributions made to the plan on behalf of the participating employees were approximately $1.2 million and $1.0 million, respectively.
The Company provides for its employees a partially self-insured healthcare plan and benefits. For years ended December 31, 2020 and 2019, incurred medical premium and related costs amounted to an aggregate of $4.1 million and $3.8 million, respectively. An additional liability of approximately $1.4 million and $418,000 was recorded for unpaid claims as of December 31, 2020 and 2019, respectively. A stop loss reinsurance policy caps the maximum loss that could be incurred by the Company under the self-insured plan. The Company’s stop loss coverage per employee is $125,000 for which any excess cost would be covered by the reinsurer subject to an aggregate limit for losses in excess of $1.5 million which would provide up to $1.0 million of coverage. Any excess of the $1.5 million retention and the $1.0 million of aggregate coverage would be borne by the Company. The aggregate stop loss commences once our expenses exceed 120% of the annual aggregate expected claims.
The total amount of authorized capital stock consists of 50,000,000 shares of common stock and 5,000,000 shares of preferred stock. As of December 31, 2020, the Company had 27,748,606 shares of common stock outstanding, 9,279,839, treasury shares of common stock and 100,267 shares of unvested restricted common stock issued reflecting total paid-in capital of $331.9 million as of such date.
For the year ended December 31, 2020, we recorded quarterly cash dividends of approximately $6.8 million as follows:
In 2020, the Company awarded 10,000 and 5,000 shares of restricted stock with at a fair value of $10.60 per share and $10.83 per share, respectively. The 2020 restricted stock grants vest over a 2 year and 12 month, period commencing from the date of grant, respectively. No restricted stock was granted during the year ended December 31, 2019. In 2018, the Company granted 155,801 restricted shares vesting over three to five years, to the Company’s executives and other key employees.
The Plan authorizes the Company to grant stock options at exercise prices equal to the fair market value of the Company’s stock on the dates the options are granted. Any options granted would typically have a maximum term of ten years from the date of grant and vest primarily in equal annual installments over a range of one to five-year periods following the date of grant for employee options. The Company has not granted any stock options since 2015 and all unexercised stock options have since been forfeited.
At December 31, 2020 and 2019 there was approximately $1.1 million and $5.6 million, representing unrecognized expense related to the non-vested stock, which is expected to be recognized over the remaining restriction periods as described in the table below.
Additional information regarding our outstanding non-vested restricted stock at December 31, 2020 is as follows:
On March 3, 2021, the Company announced that its Board of Directors declared a $0.06 per share quarterly dividend payable on April 6, 2021 to stockholders of record as of March 15, 2021.