We lease office space in Fenton, Missouri and Kapolei, Hawaii. The leases account for approximately 47,000 square feet of office space. These leases expire within thirty-one months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $84,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
We invest funds in the participant loss layer for several of the ART programs. We receive investment income and generate realized gains or losses, and incur an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents both investment income and realized gains or losses that we remit back to ART participants. The related investment income and realized gains or losses are included in our “Net investment income” and "Net realized (losses) gains on investments" lines, respectively, on our Consolidated Statements of Income.
By offering insurance products to all sizes of risks, we believe we have hedged against the possibility that there will be a reduction in demand for the products we offer. We believe that we will continue to have opportunities to grow and profit with both traditional and ART customers based on our assumptions regarding future economic and competitive conditions. We generally incur low start-up costs when we enter new product niches, typically less than $0.5 million incurred over several quarters. We believe our flexible processes and scalable systems, along with controlled increase of businesses, allow us to manage costs and match them with the revenue flow.
The change in our rate structure from period to period. The rates we file and quote are impacted by several factors including: the cost and extent of the reinsurance we purchase; our operating efficiencies; our average loss costs, which reflect the effectiveness of our underwriting; our underwriting profit expectations; and our claims adjusting processes. The difference between our rates and the rates of our competitors is a primary factor impacting the revenue growth of our established product lines.
The workers’ compensation line of business has also lagged the P/C insurance industry as a whole despite improved performance in 2014 and 2015. The industry expects deterioration in this line of business as competition has put pressure on rate levels, which have decelerated in recent periods and have mostly offset exposure growth, and loss cost trends have continued to increase and outpace inflation. Additionally, according to A.M Best, the workers’ compensation line of business is estimated to have the largest reserve deficiency amongst all lines in the P/C industry in 2015. The outlook for the workers’ compensation line of business is that of continuing negative trends including, but not limited to, downward pressure on pricing due to competition, increasing claims costs and unfavorable development on prior years’ loss and LAE reserves.
Our pricing model, which is continually monitored and adjusted based on specific market conditions, and bottom line orientation, have resulted in disciplined and consistent risk assessment and pricing adequacy of new and renewal business.
The P/C insurance industry had its third consecutive year of relatively low catastrophe losses in 2015. For weather-related events such as hurricanes, tornados, and hailstorms, we conduct an analysis at least annually pursuant to which we input our in-force exposures (vehicle values in all states and property limits in Hawaii) into an independent catastrophe model that predicts our probable maximum loss at various statistical confidence levels. Our estimated probable maximum loss is impacted by changes in our in-force exposures as well as changes in the assumptions inherent in the catastrophe model. Hurricane and other weather-related events have not had a material adverse impact on our past or current results.
Our transportation insurance business, in particular, is also affected by loss cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs. We routinely obtain independent data for vehicle repair inflation, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs and adjust our pricing routines to project more accurately the future costs associated with insurance claims. We would expect a negative impact on our future results if we fail to account adequately for and project for these inflationary trends. Increased litigation of claims may also negatively impact our profitability.
As described below, the average revenue dollar per personal lines policy is significantly lower than typical commercial policies. Profitability in the specialty personal lines component is dependent on proper pricing and the efficiency of underwriting and policy administration. We have continued to monitor rate levels and have adjusted them during 2015, as warranted. We continuously strive to improve our underwriting and policy issuance functions to keep this cost element as low as possible by utilizing current technological advances.
We derive our revenues primarily from premiums from our insurance policies and income from our investment portfolio. Our underwriting approach is to price our products to achieve an underwriting profit even if it requires us to forgo volume. As with all P/C insurance companies, the impact of price changes is reflected in our financial results over time. Price changes on our in-force policies occur as they are renewed, which generally takes twelve months for our entire book of business and up to an additional twelve months to earn a full year of premium at the average renewal rate. Insurance rates charged on renewing policies reflected an approximate average increase of 5% in 2015 and 7% in 2014.
for a traditional insurance quote versus an ART insurance quote. We use a cost plus pricing approach that projects future losses based upon the insured’s historic losses and other factors. Operating expenses, premium taxes and a profit margin are then added to the projected loss component to achieve the total premium to be quoted. The lower the projected losses, expenses and taxes, the lower the total quoted premiums regardless of whether it is a traditional or ART program quotation. Quoted premiums are computed in accordance with our approved insurance department filings in each state.
Other operating and general expenses consist primarily of personnel expenses (including salaries, benefits and certain costs associated with awards under our equity compensation plans, such as stock compensation expense) and other general operating expenses. Our personnel expenses are primarily fixed in nature and do not vary with the amount of premiums written. Interest expenses associated with outstanding debt and “Expense on amounts withheld” are disclosed separately from operating and general expenses. We invest funds in the participant loss layer for several of our ART programs. We receive investment income and generate gains or losses and incur an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents investment income and net realized gains that we remit back to ART participants. The related investment income and net realized gains are included in the “Net investment income” and "Net realized (losses) gains on investments" lines on our Consolidated Statements of Income.
Our net income for 2015 was $20.8 million ($1.05 per share diluted) compared to $11.0 million ($0.56 per share diluted) in 2014. The increase in net income during the current year reflects an improvement in the loss and LAE ratio to 80.6% compared to 83.8% last year. The 2015 loss and LAE ratio, while improved compared to the prior year, was elevated due to the impact of prior year development, including reserve strengthening, on the commercial auto liability line of business related to the 2012 and 2013 accident years. The 2014 loss and LAE ratio was also primarily attributable to unfavorable development from prior years’ loss reserves including $20.0 million of reserve strengthening recorded in the second quarter of 2014, primarily for accident years 2011, 2012 and 2013. The majority of such strengthening was concentrated in our commercial auto liability lines of business. Also contributing to the improvement in net income over the prior year was increased net investment income due primarily to higher average investment balances in the current year compared to last year. Additionally, 2014 net income was adversely impacted by after-tax transaction expenses related to the Great American tender offer. Partially offsetting these increases to net income was after-tax net realized losses of $2.1 million ($0.11 per share diluted) in 2015 compared to after-tax net realized gains of $4.4 million ($0.22 per share diluted) in 2014. Such losses in 2015 were attributable to other-than-temporary impairment charges primarily from securities related to the energy and financial services sectors. The declines in these sectors and equity markets in general also impacted our other invested assets which produced net realized losses during 2015 compared to net realized gains in the prior year.
Our net income from operations for 2015 was $23.0 million ($1.16 per share diluted) compared to $8.0 million ($0.41 per share diluted) in 2014. The primary drivers for the period-over-period fluctuations are the same as those discussed above for the change in net income for the respective periods.
We operate our business as one segment, property and casualty insurance. We manage this segment through a product management structure. The following table sets forth an analysis of gross premiums written by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Gross premiums written includes both direct premium and assumed premium. During 2015, our gross premiums written increased $38.1 million, or 5.5%, compared to 2014, primarily attributable to growth in our ART component. Gross premiums written in our ART component increased $38.3 million, or 10.2%, during 2015 compared to 2014 and was primarily due to growth within our national account ART product's workers' compensation line of business. Additionally, our ART business achieved average rate increases on renewed business of approximately 5% and benefited from increased exposures and high renewal retention amongst our group ART programs. Partially offsetting such growth was the loss of several insureds resulting from rate actions taken within our group captive and national account ART products, as well as the loss of one national account insured to aggressive competition. Gross premiums written in our transportation component decreased $8.0 million, or 3.3%, due primarily to lower renewals from rate actions taken on underperforming accounts within our traditional trucking, tow and waste operations products. These decreases were partially offset by average rate increases of approximately 6% on renewed business, as well as new business written on our expanded limits coverage offered to trucking customers and our traditional crane and heavy haul insurance products. The other component, which is comprised of premium from assigned risk policies that we receive from involuntary state insurance plans from the states in which our insurance company subsidiaries operate and over which we have no control, increased $7.1 million, or 55.9%, compared to 2014.
Our ART programs, which focus on specialty or niche businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to companies with similar risk profiles and to specified classes of business of our agent partners.
2015 compared to 2014. We operate our business as one segment, property and casualty insurance. We manage this segment through a product management structure. The following table shows premiums earned for the years ended December 31, 2015 and 2014 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
During 2015, our premiums earned increased $28.5 million, or 5.1%, to $585.8 million compared to $557.3 million for the year ended December 31, 2014. The increase is primarily attributable to our ART component, which grew $20.3 million, or 6.8%. Our ART component growth was due to the addition of one large insured to our national account ART product, as well as rate and exposure increases on renewed business in our group ART programs. Growth in our transportation component of $4.5 million, or 2.3%, was primarily due to rate increases on renewed business, as well as new business premium from several of our recently introduced traditional program offerings including our home delivery, ambulance and crane and heavy haul insurance products. Partially offsetting this component's growth has been rate actions and non-renewals of underperforming accounts within our traditional trucking and tow products. The decrease in our specialty personal lines component was primarily due to the continued impact of our decision to stop selling our commercial vehicle product during the third quarter of 2013. The slight increase in our Hawaii and Alaska component was due primarily to rate increases on renewed business, high renewal retention and new business premium. The growth in the other component is due to an increase in premiums from assigned risk policies that we receive from
involuntary state insurance plans from the states in which our insurance company subsidiaries operate and over which we have no control.
2014 compared to 2013. The following table shows premiums earned for the years ended December 31, 2014 and 2013 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
disciplines to our new business opportunities. We believe that the current rate level increases we are obtaining on renewal business, along with improved pricing on new business, are at levels that consider industry loss cost trends.
Excluding development from prior year claims, the 2015 accident year loss and LAE ratio of 78.1% is equal to the loss and LAE ratio for the 2014 accident year as developed through December 31, 2015. While these results do include severity on the commercial auto liability line of business which do not meet our expectations, both periods show improvement from recent accident years and reflect the cumulative impact of rate increases on renewed business since 2013, as well as improved pricing discipline applied to new business. We continue to be diligent in monitoring and maintaining our disciplined underwriting criteria and risk selection among all lines of business and will continue to pursue rate increases and take rate actions on or non-renew underperforming accounts. In addition to our stringent underwriting criteria, we continuously seek to enhance our claims management and risk management tools to improve pricing and risk selection, as well as focusing on being disciplined and well managed in our reserving practices.
The underwriting expense ratio for the years ended December 31, 2015 and 2014 of 19.8% and 20.1%, respectively, is indicative of our effective management of operating costs over an increased earned premiums base.
The underwriting expense ratio for the year ended December 31, 2014 decreased 0.6 percentage points to 20.1% compared to 20.7% for the same period in 2013, which was primarily attributable to a lower cost structure in our mix of business written and leveraging our operating costs over increased premiums earned.
2015 compared to 2014. Net investment income increased $4.2 million, or 11.9%, to $39.7 million in 2015 compared to 2014. The increase in net investment income is primarily due to higher average invested assets.
2014 compared to 2013. In 2014, we had pre-tax net realized gains of $6.8 million compared to $6.5 million for 2013. The pre-tax net realized gains for the year ended December 31, 2014 were primarily generated from the sales or redemptions of securities of $5.4 million, as well as net gains associated with other invested assets of $3.3 million. Offsetting these gains were other-than-temporary impairment charges of $2.0 million primarily concentrated within the energy and financial services sectors. The pre-tax net realized gains for the year ended December 31, 2013 were primarily generated from net realized gains from the sales or redemptions of securities of $5.2 million, as well as net gains associated with other invested assets of $1.5 million. Offsetting these gains were other-than-temporary impairment charges of $0.2 million.
2015 compared to 2014. Commissions and other underwriting expenses for the year ended December 31, 2015 were relatively flat, decreasing $0.4 million, or 0.4%, to $94.1 million from $94.4 million in the comparable period in 2014. As a percentage of premiums earned, commissions and other underwriting expenses decreased to 16.1% for the year ended December 31, 2015 as compared to 16.9% for the same period in 2014. Such decrease is attributable to changes in the business mix written and an increase in earned premiums over relatively flat other underwriting expenses during 2015 as compared to 2014.
2015 compared to 2014. Other operating and general expenses increased $4.6 million, or 22.0%, to $25.6 million during the year ended December 31, 2015 compared to $21.0 million for the same period in 2014. Such growth is due primarily to growth in our employee headcount and related personnel expenses, as well as an increased investment in information technology to support business decisions and sustain continued growth. As a percentage of premiums earned, such expenses were 4.4% and 3.8% for both years ended December 31, 2015 and 2014, respectively.
2014 compared to 2013. For the year ended December 31, 2014, the expense on amounts withheld increased $1.4 million, or 26.8%, compared to the same period in 2013, primarily due to growth experienced in our ART programs participant loss layer.
2015 compared to 2014. Interest expense for the year ended December 31, 2015 was relatively flat, decreasing $21 thousand, or 9.5%, to $199 thousand from $220 thousand in the comparable period in 2014.
2015 compared to 2014. The 2015 effective tax rate (ETR) was 24.2%, increasing 17.9 percentage points from a rate of 6.3% in 2014. Such increase is attributed to the $15.7 million increase in income before taxes compared to the prior year, resulting in tax-exempt income having a less favorable impact on the current year ETR.
2014 compared to 2013. The 2014 effective tax rate was 6.3%, decreasing 12.7 percentage points from a rate of 19.0% in 2013. The decrease in our ETR can be attributed to the $9.9 million decrease in income before taxes while tax-exempt income remained stable.
Fixed maturity investments are generally invested in securities with intermediate-term maturities. At December 31, 2015, the weighted average maturity of our fixed maturity investments was approximately 5.9 years. At December 31, 2015, 91.2% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB-) by nationally recognized rating agencies. Investment grade securities generally bear lower degrees of risk and corresponding lower yields than those that are unrated or non-investment grade. Although we cannot provide any assurances, we believe that, in normal market conditions, our high quality investment portfolio should generate a stable and predictable investment return.
The National Association of Insurance Commissioners ("NAIC") assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for MBS based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2015, 98.9% (based on statutory carrying value of $166.9 million) of our MBS had an NAIC designation of 1 or 2.
Certain European countries, including the so-called "peripheral countries" (Greece, Portugal, Ireland, Italy and Spain) have been experiencing varying degrees of financial stress over the past few years and there remains uncertainty as to future developments and the impact on global financial markets. At December 31, 2015, less than 5% of our investments consisted of European debt and we owned no sovereign debt issued by the peripheral countries.
At December 31, 2015, $53.0 million, or 5.0%, of our fixed maturity portfolio and $5.0 million, or 6.1%, of our equity portfolio consisted of investments issued by energy and commodity related entities, with unrealized loss exposure to these entities totaling $4.9 million and $0.5 million, respectively. Investment-grade rated fixed maturities represented 80.2% of that total.
The table below summarizes the unrealized gains and losses on fixed maturities and equity securities by dollar amount:
Pricing services use a variety of observable inputs to estimate the fair value of fixed maturities that do not trade on a daily basis. These inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data and measures of volatility. Included in the pricing of mortgage-backed securities are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Inputs from brokers and independent financial institutions include, but are not limited to, yields or spreads of comparable investments which have recent trading activity, credit quality, duration, credit enhancements, collateral value and estimated cash flows based on inputs including delinquency rates, estimated defaults and losses and estimates of the rate of future prepayments. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by our internal and affiliated investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, our internal investment professionals, who report to the Chief Investment Officer, compare the valuation received to independent third party pricing sources and consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. If we believe that significant discrepancies exist, we will perform additional procedures, which may include specific inquiry of the pricing source, to resolve the discrepancies.
Net cash used in investing activities was $107.2 million, $61.5 million and $49.2 million for the years ended December 31, 2015, 2014 and 2013, respectively. The $45.7 million increase in cash used in investing activities during 2015, as compared to 2014, was primarily driven by securities purchases exceeding sales, maturities and redemptions. Purchases of and proceeds from the redemption of fixed maturity securities were $276.2 million and $168.2 million, respectively, for the year ended December 31, 2015, compared to $199.4 million and $143.1 million, respectively, for 2014. The increase in purchases of fixed maturity securities was concentrated in other debt obligations and was primarily driven by reinvesting funds in excess of cash requirements. The $12.3 million increase in cash used in investing activities during 2014, as compared to 2013, was primarily driven by investing net operating cash to purchase fixed maturity and equity securities which outpaced the proceeds from sales and redemptions of such securities. Proceeds from sales and redemptions of fixed maturity securities decreased amid the low interest rate environment, which led to a shift in asset allocation from callable U.S. government agency bonds into longer duration state and local government bonds, residential mortgage-backed securities and corporate obligations.
On November 19, 2012, we replaced our $50.0 million credit agreement with a $100.0 million unsecured credit agreement (the “Credit Agreement”) that terminates in November 2017, which includes a sublimit of $10.0 million for letters of credit. We have the ability to increase the line of credit to $125.0 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a LIBOR rate plus an applicable margin ranging from 0.75% to 1.00% based on our A.M. Best insurance group rating, or (2) a rate per annum equal to the greater of (a) the administrative agent’s prime rate, (b) 0.50% in excess of the federal funds effective rate, or (c) 1.00% in excess of the one-month LIBOR rate. At December 31, 2015, we had $12.0 million outstanding under the Credit Agreement. Based on our A.M. Best insurance group rating of “A” at December 31, 2015, the interest rate on this debt is equal to the six-month LIBOR (0.524% at December 31, 2015) rate plus 87.5 basis points, with interest payments due quarterly.
We believe that funds generated from operations, including dividends from insurance subsidiaries, parent company cash and funds available under our Credit Agreement will provide sufficient resources to meet our liquidity requirements for at least the next 12 months. However, if these funds are insufficient to meet fixed charges in any period, we would be required to generate cash through additional borrowings, sale of assets, sale of portfolio securities or similar transactions. If we were required to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated. If we find it necessary to borrow additional funds under our Credit Agreement in order to meet liquidity needs, we would incur additional interest expense, which could have a negative impact on our earnings. Since our ability to meet our obligations in the long-term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our long-
term operating needs. We are not aware of any trends or uncertainties affecting our liquidity, including any significant future reliance on short-term financing arrangements.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. At December 31, 2015 and 2014, we had $1.0 billion and $883.1 million, respectively, of gross loss and LAE reserves, representing management’s best estimate of the ultimate loss. Management records, on a monthly and quarterly basis, its best estimate of loss reserves.
closure rates and statistics related to closed and open claim percentages;
When establishing and reviewing reserves, we analyze historic data and estimate the impact of various sources of loss development factors, such as our historic loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages and changes and trends in general economic conditions, including the effects of inflation. As of December 31, 2015, management has not made any key assumptions that are inconsistent with historical loss reserve development patterns. A change in any of these aforementioned factors from the assumptions implicit in our estimate can cause our actual loss experience to be better or worse than our reserves and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves. Currently established reserves may not prove adequate in light of subsequent actual occurrences. To the extent that reserves are inadequate and are increased or “strengthened,” the amount of such increase is treated as a charge to income in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a benefit to income in the period that redundancy is recognized.
The estimated cumulative unfavorable impact that this 1% change would have on net income is shown below:
Our investments are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation risks. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. We evaluate whether impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security's issuer and uses its best judgment in evaluating the cause and amount of decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations that we use in the impairment evaluation process include, but are not limited to:
We closely monitor each investment that has a fair value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. During the years ended December 31, 2015, 2014 and 2013, we recorded other-than-temporary impairment charges of $7.8 million, $2.0 million and $0.2 million, respectively, in earnings. The impairment charges during 2015 were elevated due to market turmoil and consist of $5.8 million on equity securities and $2.0 million on fixed maturity securities and were primarily within the energy and financial services sectors. The impairment charges on equity securities were due to the uncertainty surrounding the timing and extent of ultimate recovery, while the impairment charges on fixed maturity securities occurred as management is uncertain of full principle repayment. The impairment charges during 2014 and 2013 were primarily related to equity securities and were not concentrated in any one sector. While it is not possible to accurately predict if or when a specific security will become impaired, given the inherent uncertainty in the market, charges for other-than-temporary impairment could be material to net income in subsequent quarters. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Investments.”
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.
Management has evaluated the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015, based on the control criteria established in a report entitled Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on such evaluation, we have concluded that the Company’s internal control over financial reporting is effective as of December 31, 2015.
We have audited National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). National Interstate Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2015 and 2014 and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2015 of National Interstate Corporation and subsidiaries and our report dated March 9, 2016 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2015. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
The Company has five property and casualty insurance subsidiaries: National Interstate Insurance Company (“NIIC”), Vanliner Insurance Company (“VIC”), National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”), Triumphe Casualty Company (“TCC”), and Hudson Indemnity, Ltd. (“HIL”) and six active agency and service subsidiaries. The Company writes its insurance policies on a direct basis through NIIC, VIC, NIIC-HI and TCC. NIIC and VIC are licensed in all 50 states and the District of Columbia. NIIC-HI is licensed in Ohio, Hawaii, Michigan and New Jersey. TCC holds licenses for multiple lines of authority, including auto-related lines, in 43 states and the District of Columbia. HIL is domiciled in the Cayman Islands and provides reinsurance for NIIC, VIC, NIIC-HI and TCC, primarily for the Company’s alternative risk transfer (“ART”) component. Insurance products are marketed through multiple distribution channels including independent agents and brokers, program administrators, affiliated agencies and agent internet initiatives. The Company uses its six active agency and service subsidiaries to sell and service the Company’s insurance business. Approximately 15.2% of the Company’s premiums are written in the state of California, and an additional 37.2%, collectively, in the states of Texas, New York, Florida, Missouri, New Jersey, North Carolina, Pennsylvania, and Illinois.
The accompanying consolidated financial statements of the Company and its subsidiaries have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) which differ in some respects from statutory accounting principles (“SAP”) permitted by state regulatory agencies (see Note 14 - “Statutory Accounting Principles”).
For each program in the Company’s ART business, a portion of the risk and premium is ceded to a captive reinsurer that is either “rented” or owned by the program participants (the insureds). HIL, the Company’s consolidated subsidiary, is “rented” to program participants to facilitate the transfer of risk to the participants and the respective program’s results are recorded solely in HIL’s financial statements. Captive reinsurance facilities owned and managed directly by the member-owned program participants are not consolidated since they are not variable interest entities.
The Company classifies its fixed maturity and equity securities as available-for-sale, which are recorded at fair value, with unrealized gains and losses (net of tax) on such securities reported as accumulated other comprehensive income, a separate component of shareholders’ equity. The Company accounts for its other invested assets, which are limited partnership investments, under the equity method with changes in value reported as a component of net realized gains or losses on investments. Earnings from limited partnerships are generally reported on a one month to one quarter lag and are invested in debt and equity securities that are listed and traded on exchanges, as well as private equity investments. Cash contributions made to and distributions received from limited partnerships are recorded in the period in which the transaction occurs.
Net investment income is adjusted for amortization of premiums to the earliest of the call date or maturity date and accretion of discounts to maturity. Realized gains and losses credited or charged to income are determined by the specific identification method. Estimated fair values for investments are determined based on published market quotations or where not available, based on other observable market data, broker quotations or other independent sources. When a decline in fair value is deemed to be other-than-
Policy acquisition costs, principally commissions, premium taxes and assessments, directly related to the production of new business, are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs are limited based upon recoverability without any consideration for anticipated investment income and are charged to operations ratably over the terms of the related policies. The Company accelerates the amortization of these costs for premium deficiencies. The amount of deferred policy acquisition costs amortized during both years ended December 31, 2015 and 2014 was $85.0 million, and for December 31, 2013 was $82.2 million. There were no premium deficiencies for the years ended December 31, 2015, 2014 or 2013.
Property and equipment are reported at cost, less accumulated depreciation and amortization, and include capitalized software developed or acquired for internal use. Property and equipment are depreciated or amortized over the estimated useful lives on a straight-line basis. The useful lives range from three to five years for computer equipment; 20 to 40 years for buildings and improvements; three years for capitalized software; and five to seven years for all other property and equipment. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts and the resulting gain or loss is included in operations. Repairs and maintenance are charged to operations when incurred. The Company recorded depreciation expense of $5.0 million, $5.2 million and $5.1 million for the years ended December 31, 2015, 2014 and 2013, respectively.
The Company recognized certain intangible assets as part of the Vanliner acquisition in 2010 based on their fair value as required by ASC 805. These intangible assets consist of acquired state insurance licenses, with an indefinite life, and an acquired relationship asset relating to renewal rights, trade names, customer relationships and distribution networks. Intangible assets with definite lives are amortized over their estimated useful life, which is five years for the acquired relationship asset. The Company recorded amortization expense of $0.1 million for the year ended December 31, 2015 and $0.3 million for both the years ended December 31, 2014 and 2013 relating to this intangible asset, which became fully amortized in 2015. All identifiable intangible assets are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Indefinite-lived intangible assets are subject to annual impairment testing, which was performed during the fourth quarter of 2015. Based upon this review, no impairment losses were recognized in 2015.
The Company recognizes liabilities for estimated assessments for reported insolvencies of other insurers and other charges from regulatory organizations. Management accrues for these liabilities as assessments are imposed or when it is probable an assessment has occurred and the amount of the assessment can be reasonably estimated.
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09") to clarify the principles for recognizing revenue. This standard is intended to help reduce diversity in practice and enhance comparability between entities related to revenue recognition. While insurance contracts are not within the scope of this updated guidance, the Company's fee income related to claim and loss prevention services will be subject to this updated guidance. In July 2015, the FASB deferred the effective date of the updated guidance by one year. The updated guidance is effective for the quarter ending March 31, 2018. The Company is in the process of assessing the impact the adoption of this guidance will have on its consolidated financial statements and related disclosures.
In February 2015, the FASB issued ASU No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis ("ASU 2015-02"). The FASB issued ASU 2015-02 to simplify consolidation accounting by reducing the number of consolidation models and to provide more useful information to stakeholders. The ASU affects reporting entities that are required to evaluate whether they should consolidate certain entities. The main provisions affect limited partnerships and similar legal entities as
variable interest entities or voting interest entities; the evaluation of fees paid to a decision maker as a variable interest; the effect of fee arrangements on the primary beneficiary determination; and a scope exception for certain investment funds. The updated guidance is effective for annual and interim periods beginning after December 15, 2015. The adoption of this guidance is not expected to have a material effect on the Company's results of operations or financial position.
The Company must determine the appropriate level in the fair value hierarchy for each applicable measurement. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value.
The following table presents the Company’s investment portfolio, categorized by the level within the fair value hierarchy in which the fair value measurements fell as of December 31, 2015:
The Company uses the end of the reporting period as its policy for determining transfers into and out of each level. During the year ended December 31, 2015, the Company transferred four nonredeemable preferred stocks, one common stock and one redeemable preferred stock, with total fair values of $1.2 million, $0.9 million, and $0.2 million, respectively, from Level 1 to Level 2 due to decreases in trading activity. Conversely, during the same period, the Company transferred four nonredeemable preferred stocks, one common stock and one redeemable preferred stock, with total fair values of $1.5 million, $19 thousand, and $0.2 million, respectively, from Level 2 to Level 1 due to increases in trading activity.
During the year ended December 31, 2014, the Company transferred seven nonredeemable preferred stocks with a total fair value of $5.9 million, from Level 1 to Level 2, due to decreases in trading activity. Conversely, during the same period, the Company transferred seven nonredeemable preferred stocks, with a total fair value of $6.1 million, from Level 2 to Level 1 due to increases in trading activity. During the year ended December 31, 2013, the Company transferred eight nonredeemable preferred stocks, two common stocks, and one redeemable preferred stock, with total fair values of $3.8 million, $1.7 million, and $1.0 million, respectively, from Level 2 to Level 1, due to increases in trading activity.
The following tables present a reconciliation of the beginning and ending balances for all investments measured at fair value on a recurring basis using Level 3 inputs for the years ending December 31, 2015, 2014 and 2013. The transfers in and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
At December 31, 2015 the Company had 29 securities with a fair value of $30.1 million that are included in Level 3, which represents approximately 3.0% of its total investments reported at fair value. The significant unobservable inputs used by the brokers and pricing services in establishing fair values of the Company’s Level 3 securities are primarily spreads to U.S. Treasury rates and discounts to comparable securities. The specifics of such spreads and discounts were not reasonably obtainable or made available to the Company. Significant increases (decreases) on spreads to U.S. Treasury rates and discount spreads to comparable securities would result in lower (higher) fair value measurements. Generally, a change in the assumption used for determining a spread is accompanied by market factors that warrant an adjustment for the credit risk and liquidity premium of the security. As the total fair value of Level 3 securities is approximately 8.0% of the Company’s shareholders’ equity at December 31, 2015, reasonable changes in unobservable inputs would not have a material impact on the Company’s financial position.
The non-credit portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative non-credit charges taken for securities still owned were $3.3 million at both December 31, 2015 and 2014.
with sinking funds are categorized based on their average maturity. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The average life of mortgage-backed securities is 3.8 years in the Company’s investment portfolio.
Amortized cost and fair value of the fixed maturities in the Company’s investment portfolio were as follows:
Pre-tax net realized losses on investments were $3.3 million for the year ended December 31, 2015, as compared to net realized gains of $6.8 million and $6.5 million for the years ended December 31, 2014 and 2013, respectively. The net realized losses in 2015 were driven by $7.8 million in other-than-temporary impairment charges on both equity and fixed maturity securities, which were concentrated within the energy and financial services sectors, as compared to $2.0 million and $0.2 million for the years ended December 31, 2014 and 2013, respectively. The other-than-temporary impairment charges for the years ended December 31, 2015, 2014 and 2013, occurred on securities where management is uncertain of the timing and the extent of ultimate recovery. In addition, other invested assets produced net losses of $1.7 million as these investments were impacted by turmoil in the energy sector during 2015, as compared to net gains of $3.3 million and $1.5 million for the years ended December 31, 2014 and 2013, respectively.
The following table summarizes investment income earned and investment expenses incurred:
On November 19, 2012, the Company replaced its $50.0 million credit agreement with a $100.0 million unsecured credit agreement (the “Credit Agreement”) that terminates in November 2017, which includes a sublimit of $10.0 million for letters of credit. The Company has the ability to increase the line of credit to $125.0 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a LIBOR rate plus an applicable margin ranging from 0.750% to 1.000% based on the Company’s A.M. Best insurance group rating, or (2) a rate per annum equal to the greater of (a) the administrative agent’s prime rate, (b) 0.5% in excess of the federal funds effective rate, or (c) 1.0% in excess of the one-month LIBOR rate. Based on the Company’s A.M. Best insurance group rating of “A” at December 31, 2015, the interest rate on this debt is equal to the six-month LIBOR (0.524% at December 31, 2015) rate plus 87.5 basis points, with interest payments due quarterly. Commitment fees on the average daily unused portion of the Credit Agreement also vary with the Company’s A.M. Best insurance group rating and range from 0.075% to 0.125%, or 0.100% at December 31, 2015.
The Credit Agreement requires the Company to maintain specified financial covenants measured on a quarterly basis, including minimum consolidated net worth and a maximum debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants customary for facilities of this type, including negative covenants that limit or restrict the Company’s ability to, among other things, pay dividends, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2015, the Company was in compliance with all covenants.
Federal income taxes paid, net of refunds, for 2015, 2014 and 2013 were $6.2 million, $2.5 million and $16.2 million, respectively. At December 31, 2015 and December 31, 2014, income tax recoverables were $1.4 million and $0.9 million, respectively, and are included in the "Prepaid expense and other assets" line-item on the Company's Consolidated Balance Sheets.
The Company grants options and other share awards to officers and key employees of the Company under the LTIP. At December 31, 2015, there were 745,389 of the Company’s common shares reserved for issuance under the LTIP, of which 180,000 common shares are for outstanding options. Options and restricted shares vest pursuant to the terms of a written grant agreement. Options must be exercised no later than the tenth anniversary of the date of grant. Restricted share awards generally cliff vest three years from the date of grant. As set forth in the LTIP, the Compensation Committee of the Board of Directors may accelerate vesting and exercisability of options. Treasury shares are used to fulfill the options exercised and other awards granted.
The Company recognized share-based compensation expense, inclusive of options forfeited, of $0.8 million for the year ended December 31, 2015 and $0.6 million for both years ended December 31, 2014 and 2013. Related income tax benefits were approximately $0.2 million for each of the years ended December 31, 2015, 2014 and 2013. At December 31, 2015, there was $0.3 million and $0.8 million of unrecognized compensation expense related to nonvested options and restricted share awards, respectively. These amounts are both expected to be recognized over a weighted average of 1.5 years. The Company has included share-based compensation expense within the “Other operating and general expenses” line-item in the Consolidated Statements of Income.
A summary of option activity in the LTIP is as follows:
The intrinsic value of options exercised was $0.9 million, $1.1 million and $0.6 million for the years ended December 31, 2015, 2014 and 2013, respectively. The total fair value of options vested during the years ended December 31, 2015, 2014, and 2013 was $0.2 million, $0.3 million, and $0.4 million, respectively. The Company has not granted options since 2012.
The Company granted 18,885 restricted shares (fair value of $23.00 per share) in 2014. There were 12,543 restricted shares (fair value $32.33 per share) granted in 2013. The fair value of shares vested was $0.4 million for the year ended December 31, 2015 and $0.3 million for each of the years ended December 31, 2014 and 2013.
The Company maintains a retirement savings plan under Section 401(k) of the Internal Revenue Code of 1986, as amended, covering substantially all full-time employees (the “Plan”). Contributions to the profit sharing portion of the Plan are made at the discretion of the Company and are based on a percentage of employees’ earnings after their eligibility date. Profit sharing expense for the year ended December 31, 2015 was $0.1 million and was $1.0 million for both of the years ended December 31, 2014 and 2013. Effective August 2015, the Plan provides for employer matching of participant contributions for 100% on the first 3% and
50% on the next 3% of the employee’s qualifying salary. For the year ended December 31, 2015, matching contributions made by the Company for the Plan were $0.6 million. There were no matching contributions made by the Company to the Plan for the years ended December 31, 2014 and 2013. Profit sharing distributions and employee and employer matching contributions are invested at the direction of the employee in a number of investment options available under the Plan, offered by an unaffiliated investment manager. Participants in the Plan may choose to invest in the Company’s common shares as an investment option. The Company does not provide other postretirement and postemployment benefits.
The Company’s principal insurance subsidiary, NIIC, is involved in the assumption of reinsurance. NIIC is a party to a reinsurance agreement, and NIIA, a wholly-owned subsidiary of the Company, is a party to an underwriting management agreement with Great American. As of December 31, 2015, Great American owned 51.1% of the outstanding shares of the Company. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks underwritten pursuant to the reinsurance agreement. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. The Company was also previously involved in the cession of premium through reinsurance agreements with Great American to reduce exposure in certain of its property and casualty insurance programs. Effective November 1, 2014, Great American no longer participates in such reinsurance agreements and settlement activity in 2015 was not material.
The Company is not substantially dependent on any individual reinsurance agreements, including the expired reinsurance agreements with Great American. The Company does not depend on these specific reinsurers to a material extent, as other reinsurers could be obtained for those treaties or the business could be retained.
During 2015, Virginia, Washington, and Connecticut recreational vehicle risks previously written through Great American were transitioned to TCC, resulting in a decline in assumed premiums written and earned from Great American.
to meet their obligations for losses assumed. To minimize its exposure to significant losses from reinsurer insolvencies, the Company seeks to do business with only reinsurers rated “Excellent” or better by A.M. Best Company and regularly evaluates the financial condition of its reinsurers. If a reinsurer is not rated by A.M. Best Company or their rating falls below "A-", the contract with them generally requires that they secure outstanding obligations with cash, a trust or a letter of credit that the Company deems acceptable.
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid losses and LAE, on a net of reinsurance basis, for the dates indicated, to the gross amounts reported in the Company’s Consolidated Balance Sheets:
and other regulatory bodies may make inquiries and conduct examinations or investigations concerning the Company’s compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.
As a direct writer of insurance, the Company receives assessments by state funds to cover losses to policyholders of insolvent or rehabilitated companies and other authorized fees. These mandatory assessments may be partially recovered through a reduction in future premium taxes in some states over several years. At December 31, 2015 and 2014, the liability for such assessments was $5.0 million and $4.6 million, respectively, and will be paid over several years as assessed by the various state funds.
a purchase price of $30.00 per share in cash. As of March 7, 2016, Great American beneficially owned 10,200,000, or approximately 51.0%, of the outstanding shares of Common Stock.