The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 8 of this report. This discussion includes forward-looking statements that are subject to risks, uncertainties and other factors described in Item 1A of this report. These factors could cause our actual results in 2018 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements.
We actively market our insurance in 27 states through independent agencies, as well as through our wholly owned insurance agency subsidiary. We are also licensed in an additional 20 states, the District of Columbia and the U.S. Virgin Islands.
Two of the key financial measures that we use to evaluate our performance are return on average equity and growth in book value per share adjusted for dividends paid to shareholders. We calculate return on average equity by dividing annual net income by the average of annual shareholders’ equity. Our return on average equity was 10.5% in 2017, 17.1% in 2016 and 15.6% in 2015. We calculate book value per share by dividing ending shareholders’ equity by the number of common shares outstanding. Our book value per share was $22.10 at December 31, 2017, $23.72 at December 31, 2016 and $23.73 at December 31, 2015. We paid cash dividends of $4.30 per share in 2017, $3.97 per share in 2016 and $3.60 per share in 2015.
Investment income is an important element of our net income. Because the period of time between our receipt of premiums and the ultimate settlement of claims is often several years or longer, we are able to invest cash from premiums for significant periods of time. As a result, we are able to generate more investment income from our premiums as compared to insurance companies that operate in other lines of business that pay claims more quickly. From December 31, 2012 to December 31, 2017, our investment portfolio, including cash and cash equivalents, increased from $900.8 million to $1.2 billion and produced net investment income of $29.3 million in 2017, $28.1 million in 2016 and $27.9 million in 2015.
The use of reinsurance is an important component of our business strategy. We purchase reinsurance to protect us from the impact of large losses. Our reinsurance program for 2018 includes 19 reinsurers that provide coverage to us in excess of a certain specified loss amount, or retention level. Our 2018 reinsurance program provides us with reinsurance coverage for each loss occurrence up to $70.0 million, subject to applicable limitations, deductibles, retentions and aggregate limits. However, for any loss occurrence involving only one claimant, our reinsurance coverage is limited to $10.0 million for any single claimant, subject to applicable deductibles, retentions and aggregate limits. Losses in the layer between $2.0 million and $10.0 million are ceded to a multi-year reinsurance treaty with an aggregate annual deductible of approximately $5.1 million and an aggregate limit of coverage of approximately $27.3 million for 2018. As losses are incurred and recorded, we record amounts recoverable from reinsurers for the portion of the losses ceded to our reinsurers.
For example, for the five-year period ended December 31, 2017 we had recorded 78 severe claims, or an average of 16 severe claims per year for accident years 2013 through 2017. The number of severe claims reported in any one accident year in this five-year period ranged from a low of 12 in 2014 to a high of 21 in 2016. The average reported case severity for these claims ranged from $1.8 million for the 2015 accident year to $3.1 million for the 2014 accident year. For the five accident years, the case incurred for these severe claims accounted for an average of 7.8 percentage points of our overall loss and loss adjustment expense, or LAE, ratio, measured at December 31, 2017.
A key assumption used by management in establishing loss reserves is that average per claim case incurred loss and loss adjustment expenses will increase year over year. We believe this increase primarily reflects medical and wage inflation and utilization. However, changes in per average claim case incurred loss and loss adjustment expenses can also be affected by frequency of severe claims in the applicable accident years.
We review the estimate of EBUB premiums on a quarterly basis using historical data and applying various assumptions based on the current market and economic conditions, and we record an adjustment to premium, related losses, and expenses as warranted.
Impairment of Investment Securities. Impairment of an investment security results in a reduction of the carrying value of the security and the realization of a loss when the fair value of the security declines below our cost or amortized cost, as applicable, for the security, and the impairment is deemed to be other-than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of specific investments. We consider various factors in determining if a decline in the fair value of an individual security is other-than-temporary. Some of the factors we consider include:
Net Realized Gains (Losses) on Investments. Net realized losses on investments in 2017 totaled $0.6 million, compared to losses of $0.5 million in 2016. In 2017, net realized losses of $1.1 million resulted from the redemption of fixed maturity securities. These losses were partially offset by realized gains of $0.5 million on the sale of equity and fixed maturity securities classified as available-for-sale. In 2016, net realized losses of $0.9 million resulted from the sale of fixed maturity securities classified as available-for-sale. These losses were partially offset by realized gains of $0.3 million on the redemption of fixed maturity securities.
Net Investment Income. Net investment income in 2016 was $28.1 million, an increase of 0.7% from the $27.9 million reported in 2015. The pre-tax investment yield on our investment portfolio was 2.5% per annum for 2016 and 2015. The tax-equivalent yield on our investment portfolio was 3.2% per annum for 2016, compared to 3.3% per annum for 2015. The tax-equivalent yield is calculated using the effective interest rate and the appropriate marginal tax rate. Average invested assets, including cash and cash equivalents, increased 2.2%, from an average of $1,140.7 million for 2015 to an average of $1,165.4 million for 2016.
Net Realized Gains (Losses) on Investments. Net realized losses on investments in 2016 totaled $0.5 million, compared to losses of $2.5 million in 2015. In 2016, net realized losses of $0.9 million resulted from the sale of fixed maturity securities classified as available-for-sale. These losses were partially offset by realized gains of $0.3 million on the redemption of fixed maturity securities. In 2015, net realized losses of $2.7 million resulted from an other-than-temporary impairment of four fixed maturity securities. These losses were partially offset by realized gains of $0.2 million on the redemption of fixed maturity securities and other sales of securities.
The Company recorded favorable prior accident year loss and loss adjustment expense development of $34.8 million in calendar year 2017, $51.3 million in calendar year 2016 and $47.8 million in calendar year 2015. The table below sets forth the favorable development for accident years 2012 through 2016 and, collectively, all accident years prior to 2012.
Net cash provided by operating activities was $130.8 million in 2017, as compared to $114.2 million in 2016, and $92.9 million in 2015. Major components of cash provided by operating activities in 2017 were net premiums collected of $349.6 million investment income collected of $44.0 million and a decrease of $27.8 million in amounts held by others. These increases were offset in-part by claim payments of $188.1 million, $74.0 million of operating expenditures, federal taxes paid of $28.3 million and dividends to policyholders paid of $1.5 million.
Major components of cash used in financing activities in 2016 included cash used for dividends paid to shareholders of $76.1 million, offset by $1.0 million of tax benefit from share-based compensation and $0.8 million of proceeds from the exercise of stock options. Major components of cash used in financing activities in 2015 included $1.8 million of proceeds from the exercise of stock options and $2.2 million of tax benefit from share-based compensation, offset by cash used for dividends paid to shareholders of $68.6 million.
The Company has a line of credit agreement with Frost Bank for borrowings up to a maximum of $20.0 million. Under the agreement, advances may be made either in the form of loans or letters of credit. Borrowings under the agreement accrue at interest rates based upon prime rate or LIBOR and are unsecured. Under the agreement, the Company pays a fee of 0.25% on the unused portion of the loan in arrears quarterly, for a fee of $50,000 annually. At December 31, 2017, there were no outstanding borrowings. Unless renewed, the agreement will expire in December 2019.
AMERISAFE is a holding company that transacts business through its operating subsidiaries, including AIIC, SOCI and AIICTX. AMERISAFE’s primary assets are the capital stock of these insurance subsidiaries. The ability of AMERISAFE to fund its operations depends upon the surplus and earnings of its subsidiaries and their ability to pay dividends to AMERISAFE. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds. Based upon the prescribed calculation, the insurance subsidiaries could pay to AMERISAFE dividends of up to $65.5 million in 2018 without seeking regulatory approval. See “Business-Regulation-Dividend Limitations” in Item 1 of this report.
On February 22, 2018 the Company declared a regular quarterly cash dividend of $0.22 per share payable on March 23, 2018 to shareholders of record as of March 9, 2018.
As of December 31, 2017, our investment portfolio, including cash and cash equivalents, totaled $1.2 billion, an increase of 3.7% from December 31, 2016. The majority of our fixed maturity securities are classified as held-to-maturity, as defined by FASB ASC Topic 320, Investments-Debt and Equity Securities. As such, the reported value of those securities is equal to their amortized cost, and is not impacted by changing interest rates. The remainder of our fixed maturity securities and all of our equity securities are classified as available-for-sale and reported at fair value.
We follow FASB ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a fair value hierarchy and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. As disclosed in Note 18 of the financial statements, our securities available-for-sale are classified using Level 1, 2 and 3 inputs. We did not elect the fair value option prescribed under FASB ASC Topic 825, Financial Instruments, for any financial assets or financial liabilities in 2016 or 2017.
For our securities classified as available-for-sale, the securities are “marked to market” as of the end of each calendar quarter. As of that date, unrealized gains and losses are recorded in Other Comprehensive Income (Loss), except when such securities are deemed to be other-than-temporarily impaired. For our securities classified as held-to-maturity, unrealized gains and losses are not recorded in the financial statements until realized or until a decline in fair value, below amortized cost, is deemed to be other-than-temporary.
During 2017 and 2016, the Company had no impairment losses recognized for other-than-temporary declines in the fair value of our investments.
We manage risk on certain long-duration claims by settling these claims through the purchase of annuities from unaffiliated life insurance companies. In the event these companies are unable to meet their obligations under these annuity contracts, we could be liable to the claimants, but our reinsurers remain obligated to indemnify us for all or part of these obligations in accordance with the terms of our reinsurance contracts. As of December 31, 2017, the present value of these annuities was $95.9 million, as estimated by our annuity providers. Substantially all of the annuities are issued or guaranteed by life insurance companies that have an A.M. Best rating of “A” (Excellent) or better. For additional information, see Note 16 to our consolidated financial statements in Item 8 of this report.
We lease equipment and office space under noncancelable operating leases. Future minimum lease payments at December 31, 2017, were as follows:
Rental expense was $0.1 million in 2017, and $0.2 million in 2016 and 2015, respectively.
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the US federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
In May 2015, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2015-07, Fair Value Measurements (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). The amendments in this update change the disclosure requirements for investments in certain entities that calculate net asset value, or NAV, per share. Under current accounting standards entities are permitted to estimate the fair value of certain investments using the investment’s NAV as a practical expedient. The disclosure guidance also permits entities to disclose the investment at NAV in the fair value hierarchy table as either Level 2 or Level 3, based upon certain criteria. The measurement basis utilizing NAV is different than the measurement criteria of all other investments which utilize inputs to calculate fair value. Due to this inconsistency, the FASB issued this ASU which requires entities to remove investments measured at NAV from the fair value hierarchy table. Other than the change in presentation, the adoption of this new guidance in interim periods beginning in 2016 did not have an impact on our consolidated financial statements.
In March 2016, FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The new guidance requires that all tax effects related to share-based payments be made through the income statement at the time of settlement as opposed to recognizing excess tax benefits in additional paid-in capital. It also requires the cash flows resulting from share-based payments to be included as an operating activity. In addition to the changes, the guidance permits reporting entities to elect to estimate forfeitures related to share-based payments or recognize them as they occur.
The threshold to qualify for equity classification has also been revised to permit withholding up to the maximum statutory tax rates in the applicable jurisdictions. The adoption of this new guidance in the first quarter of 2017 did not have a material impact on our financial condition and results of operations.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. This guidance requires fair value measurement for equity investments (not including those that result in consolidation of the investee or use the equity method of accounting) and the recognition of changes in fair value to be presented as a component of net income. The guidance also revises the disclosure requirements related to fair value changes of liabilities presented in comprehensive income, eliminates disclosure related to the methods and assumptions underlying fair value for financial instruments measured at amortized cost, and simplifies impairment assessments for equity investments without readily determinable fair values. This standard is effective for us in the first quarter of 2018. Based on the equity investments currently held by the Company, there would not be a material impact on the Company's financial condition and results of operations if the new guidance were to be adopted in the current accounting period. The impact on the Company's results of operations and financial position at the date of adoption will be determined by the equity investments held by the Company and the economic conditions at that time.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). Under current guidance for lessees, leases are only included on the balance sheet if certain criteria, classifying the contract as a capital lease, are met. The new guidance requires a lessee to recognize a lease liability and a right of use asset for all leases extending beyond twelve months. The new guidance is effective for us in the first quarter of 2019. Upon adoption, leases will be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach. Adoption of the guidance is not expected to have a material effect on the Company’s consolidated financial statements as the Company does not have any significant leases.
Short-term investments include municipal securities, corporate bonds and certificates of deposit with an original maturity greater than 90 days but less than one year.
Other investments consisted of a limited partnership interest that was accounted for under the equity method, valued using the net asset value provided by the general partner of the limited partnership, which approximates the fair value of the interest. The limited partnership’s objective was to generate absolute returns by investing long and short in publicly-traded global securities. The investment in the limited partnership was fully redeemed during 2017. The Company has no unfunded commitments to the limited partnership.
The Company estimates the annual premiums to be paid by its policyholders when the Company issues the policies and records those amounts on the balance sheet as premiums receivable. The Company conducts premium audits on all of its voluntary business policyholders annually, upon the expiration of each policy, including when the policy is renewed. The purpose of these audits is to
The Company estimates EBUB premiums on a quarterly basis using historical data and applying various assumptions based on the current market and economic conditions, and records an adjustment to premium, related losses, and expenses as warranted.
The Company computes earnings per share (EPS) in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 260, Earnings Per Share. The Company applies the treasury stock method in computing basic and diluted earnings per share.
AMERISAFE redeemed an investment in a limited partnership hedge fund accounted for under the equity method in 2017.
The gross unrealized gains and losses on, and the cost or amortized cost and fair value of, those investments classified as available-for-sale at December 31, 2017 are summarized as follows:
At December 31, 2017, there were $18.7 million of held-to-maturity investments and $2.4 million of available-for-sale investments on deposit with regulatory agencies of states in which the Company does business.
In 2017, there were no impairment losses recognized for other-than-temporary declines in the fair value of our investments.
The Company cedes certain premiums and losses to various reinsurers under quota share and excess-of-loss treaties. These reinsurance arrangements provide for greater diversification of business, allow management to control exposure to potential losses arising from large risks, and provide additional capacity for growth. Ceded reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company remains liable to its policyholders for the portion reinsured to the extent that any reinsurer does not meet the obligations assumed under the reinsurance agreements. To minimize its exposure to significant losses from reinsurer insolvencies, the Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers on a continual basis. The effect of reinsurance on premiums written and earned in 2017, 2016 and 2015 was as follows:
Amounts recoverable from reinsurers consists of ceded case reserves, ceded incurred but not reported (“IBNR”) reserves, paid losses recoverable and experience-rated commissions recoverable. Ceded case and ceded IBNR reserves represent the portion of gross loss and loss adjustment expense liabilities that are recoverable under reinsurance agreements, but are not yet due from reinsurers. Paid losses recoverable are receivables currently due from reinsurers for ceded paid losses. The Company considers paid losses recoverable outstanding for more than 90 days to be past due. At December 31, 2017, there were no paid losses recoverable past due. Experience-rated commissions recoverable represents earned commission from certain reinsurance companies based on the financial results of the applicable risks ceded to the reinsurers, and these amounts declined during 2016 as a result of the December 2016 commutation of the 2011 through 2013 reinsurance agreements with Hannover and Tokio.
The Company generally secures large reinsurance recoverable balances with various forms of collateral, including funds withheld accounts, irrevocable letters of credit and secured trusts. At December 31, 2017, reinsurance recoverables from reinsurers that exceeded 1.5% of statutory surplus of the Company’s insurance subsidiaries are shown below (in thousands).
Subsidiary of Fairfax Financial is no longer rated by A.M. Best.
During 2017, 2016 and 2015, there was no valuation allowance on the Company’s deferred income tax assets and liabilities.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. There were no uncertain tax positions as of December 31, 2017, 2016 and 2015.
The Company has an agreement providing for a line of credit in the maximum amount of $20.0 million with Frost Bank. The agreement expires in December 2019. Under the agreement, advances may be made either in the form of loans or letters of credit. Borrowings under the agreement accrue at interest rates based upon prime rate or LIBOR. Under the agreement, the Company pays a fee of 0.25% on the unused portion of the loan in arrears quarterly, or a fee of $50,000 annually, assuming the line of credit is not used during the calendar year. The line of credit is unsecured. No borrowings or letters of credit were outstanding under the line of credit arrangement at December 31, 2017 or 2016.
The Company’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting principles prescribed or permitted by the insurance regulatory authorities of the states in which the subsidiaries are domiciled. Statutory-basis shareholders’ capital and surplus at December 31, 2017, 2016 and 2015 of the directly owned insurance subsidiary, AIIC, and the combined statutory-basis net income and realized investment gains for all AMERISAFE’s insurance subsidiaries for the three years in the period ended December 31, 2017, were as follows (in thousands):
Stock options granted under the 2005 Incentive Plan have an exercise price of not less than 100% of the fair value of the common stock on the date of grant. Stock option grants are exercisable, subject to vesting requirements determined by the Compensation Committee, for periods of up to ten years from the date of grant. Stock options generally expire 90 days after the cessation of an optionee’s service as an employee. However, in the case of an optionee’s death or disability, the unexercised portion of a stock option remains exercisable for up to one year after the optionee’s death or disability. Stock options granted under the 2005 Incentive Plan are not transferable, except by will or the laws of descent and distribution.
The Company recognized compensation expense of $56,000 in 2017 and $58,000 in 2016 and $138,000 in 2015, related to awards made under the 2005 Incentive Plan. There were no tax benefits realized for tax deductions from vesting of restricted stock in 2017. Tax benefits realized for tax deductions from vesting of restricted stock in 2016 and 2015 were $110,000 and $81,000, respectively.
The following table summarizes information about the restricted stock outstanding under the 2012 Incentive Plan at December 31, 2017:
The Company recognized compensation expense of $884,000, $849,000 and $599,000 in 2017, 2016 and 2015, respectively, related to share-based grants. The Company recognized compensation expense of $724,000, $334,000 and $220,000 in 2017 2016 and 2015, respectively, related to long-term incentive awards under the 2012 Incentive Plan. The long-term incentive award is a liability award.
The AMERISAFE Non-Employee Director Restricted Stock Plan (the “Restricted Stock Plan”) is administered by the Compensation Committee of the Board and provides for the automatic grant of restricted stock awards to non-employee directors of the Company. Awards to non-employee directors are generally subject to terms including non-transferability, immediate vesting upon death or total disability of a director, forfeiture of unvested shares upon termination of service by a director and acceleration of vesting upon a change of control of the Company. The maximum number of shares of common stock that may be issued pursuant to restricted stock awards under the Restricted Stock Plan is 100,000 shares, subject to the authority of the Board to adjust this amount in the event of a merger, consolidation, reorganization, stock split, combination of shares, recapitalization or similar transaction affecting the common stock. At December 31, 2017, there were 13,668 shares of common stock available for future awards under the Restricted Stock Plan.
Under the Restricted Stock Plan, each non-employee director is automatically granted a restricted stock award for a number of shares equal to $50,000 divided by the closing price of the Company’s common stock on the date of the annual meeting of shareholders at which the non-employee director is elected or is continuing as a member of the Board. Each restricted stock award vests on the date of the next annual meeting of shareholders following the date of grant, subject to the continued service of the non-employee director. Under the terms of the Restricted Stock Plan, the Company’s Board of Directors may increase the dollar amount of the annual award to an amount up to $75,000 without shareholder approval.
Rental expense was $0.1 million in 2017 and $0.2 million in 2016 and 2015.
Assets and liabilities measured at amortized cost as of December 31, 2017 and 2016 are as follows:
At December 31, 2017, the Company held one security measured at fair value on a nonrecurring basis due to a recognized impairment of $100,000. The security is valued using Level 2 inputs and had a value of $13,000 at December 31, 2017. The security was valued at fair value at the time of impairment and is currently being carried at the adjusted amortized cost. The fair value of the security is $34,000 at December 31, 2017.
The Company’s Board of Directors initiated a share repurchase program in February 2010. In October 2016, the Board reauthorized this program with a limit of $25.0 million with no expiration date. There were no shares repurchased under this program in 2017. Since the beginning of this plan, the Company has repurchased a total of 1,258,250 shares for $22.4 million, or an average price of $17.78, including commissions.
On February 22, 2018 the Company declared a regular quarterly cash dividend of $0.22 per share payable on March 23, 2018 to shareholders of record as of March 9, 2018. In 2017, the Company paid a quarterly cash dividend of $0.20 per share.
The Board intends to continue to consider the payment of a regular cash dividend each calendar quarter. On an annualized basis, the cash dividend is expected to be $0.88 per share.