The discussion of our financial condition and results of operations that follows provides information that will assist the reader in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our consolidated financial statements. This discussion should be read in conjunction with our consolidated financial statements and the related notes that appear elsewhere in this document.
Premium in force at December 31, 2017 was $940.8 million. There were 524,450 policies in-force at December 31, 2017. The NBIC acquisition added approximately $330 million of in force premium and nearly 200,000 policies in force at December 31, 2017.
A 62% increase in policy count from December 31, 2016 to December 31, 2017.
Gross premiums written of $625.6 million and total revenue of $406.6 million.
Cash, cash equivalents and investments of $720.7 million, with total assets of $1.8 billion.
The following table summarizes our results of operations for the periods indicated (in thousands, except per share amounts):
Gross premiums written. Gross premiums written represent, with respect to a period, the sum of direct premiums written (premiums from voluntary policies written during the period, net of any midterm cancellations and renewals of voluntary policies and policies assumed from Citizens’) and assumed premiums written (premiums from state fair plan polices and policies that we assumed from Citizens, net of opt-outs), in each case prior to ceding premiums to reinsurers.
Other revenue. Other revenue includes rental income due under non-cancelable leases for space at the Company’s commercial property in Clearwater, Florida that we acquired in April 2013, and all policy and pay-plan fees. Our regulators have approved a policy fee on each policy written for certain states; these fees are not subject to refund, and the Company recognizes the income immediately when collected. The Company also charges pay-plan fees to policyholders that pay its premiums in more than one installment and record the fees as income when collected. In addition, the Company records revenue earned from its restoration subsidiary for non-insurance construction as services performed using the percentage of completion method. The revenue generated from non-insurance contracts is not material in nature, non-insurance construction revenue declined in 2017 and is expected to be minimal in 2018.
Policy acquisition costs. Policy acquisition costs consist of the following items: (i) commissions paid to outside agents at the time of policy issuance, (ii) policy administration fees paid to a third-party administrator at the time of policy issuance, (iii) premium taxes and (iv) inspection fees. We recognize policy acquisition costs ratably over the term of the underlying policy. Until renewed, policies assumed from Citizens have no associated policy acquisition costs. We recognize these costs ratably over the term of the unearned premium acquired in the transaction. We also earn ceding commission on our quota share reinsurance contracts, which is presented as a reduction of policy acquisition costs. Ceding commission income is deferred and earned over the contract period. The amount and rate of ceding commission earned on the net quota share contract can slide within a prescribed minimum and maximum, depending on loss performance and how future losses develop.
Provision for income taxes. Provision for income taxes consists of federal and state corporate level income taxes, which have historically resulted in a statutory blended tax rate of approximately 38.575%. Due to the enactment of the Tax Act, we expect our future expected statutory blended tax rate to be approximately 25.4%.
Gross premiums earned increased slightly to $643.3 million for the year ended December 31, 2017 as compared to $640.5 million for the year ended December 31, 2016. A reduction of gross earned premium by Heritage P&C was offset by increases for a full year of Zephyr premium earned, additional earned premium on the Sawgrass polices and the additional earned premium for one month associated with the NBIC acquisition.
Ceded premiums increased to $263.7 million for the year ended December 31, 2017 as compared to $228.8 million for the year ended December 31, 2016. Approximately $24 million of the increase related to ceded premium associated with NBIC and approximately $11 million of the increase related to catastrophe excess of loss reinsurance for Heritage P&C and Zephyr. As described in Note 9, Reinsurance, to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K, NBIC’s reinsurance program includes extensive quota share reinsurance designed to mitigate the adverse impact of winter storms, in addition to its catastrophe excess of loss reinsurance program. The quota share reinsurance program for NBIC includes one month of ceding commission income of $8.6 million, which is presented as a reduction of policy acquisition costs in our audited financial statements.
Our catastrophe excess of loss reinsurance programs renews each year on June 1. The cost for catastrophe reinsurance for the 2017 hurricane season for Heritage P&C and Zephyr is approximately $223.0 million compared to $247.0 million for the 2016 season. The reduction in premium in force described previously resulted in a reduction in the amount of catastrophe reinsurance purchased from approximately $3.1 billion in the 2016 season to approximately $2.6 billion for the 2017 season. As described in Note 9 to our audited consolidated financial statements included elsewhere in this Form 10-K, the Company’s retention for the 2017 hurricane season is $20.0 million compared to $40.0 million for the 2016 season for a first event.
Net investment income, inclusive of realized investment gains, increased to $11.9 million for the year ended December 31, 2017 as compared to $10.9 million for the year ended December 31, 2016. The increase in net investment income is primarily due to the increase in cash and invested assets during 2017 over the prior year. The increase resulted primarily from invested proceeds associated with the Secured Notes and Convertible Notes, coupled with the additional investment income from Zephyr in 2017 due to the timing of the acquisition in 2016. A portion of the proceeds from the Secured Notes and Convertible Notes were expended during the fourth quarter of 2017 for the acquisition of NBIC Holdings.
The Company’s losses incurred for the years ended December 31, 2017 reflects a prior year development of $12.6 million, associated with management’s best estimate of the actuarial loss and LAE reserves with consideration given to Company specific historical loss experience. The Company recorded approximately $6.5 million of adverse development in 2017 for Hurricane Hermine and Matthew. The remaining $6.1 million of prior year development was primarily due to management strengthening of personal lines losses associated with Florida litigated claims, one-way attorney fees and Assignment of Benefits abuse in the Florida market.
Policy acquisition costs decreased slightly to $83.9 million for the year ended December 31, 2017 as compared to $84.4 million for the year ended December 31, 2016. The Company recorded ceding commission income of $8.6 million related to NBIC as a reduction in policy acquisition expense offset by an increase attributable to having a full twelve months of policy acquisition costs related to Zephyr in 2017 compared to nine months in 2016 due to timing of that acquisition, as well as the favorable impact of assumed premiums from Citizens for the year ended December 31, 2016 which did not recur in 2017.
General and administrative expenses increased to $71.7 million for the year ended December 31, 2017 as compared to $58.9 million for the year ended December 31, 2016. A significant portion of the increase relates to general and administrative costs associated with mergers and acquisitions. The year ended December 31, 2017 includes expenses incurred by NBIC and Zephyr for one and twelve months, respectively, whereas the year ended December 31, 2016 included no general and administrative expenses incurred by NBIC and only nine months of general and administrative expenses incurred by Zephyr. Additionally, we incurred legal, transactional, and accounting costs associated with the NBIC acquisition as well as amortization of intangible assets associated with the NBIC and Zephyr acquisitions. A smaller portion of the increase relates to costs, including systems associated with infrastructure and expansion.
For the year ended December 31, 2017, the fair value of the conversion option liability coupled with the net loss on debt extinguishment amounted to approximately $42.2 million and is presented on the statement of operations as a charge to non-operating expense. For tax purposes, any financial gain or loss associated with the change in the value of the conversion option liability is neither includible or deductible when computing taxable income.
Our gross expense ratio increased to 24.2% for the year ended December 31, 2017 compared to 22.4% for the year ended December 31, 2016. The increase relates to a combination of the favorable effect of Citizens take-out activity on the 2016 ratio, transaction costs associated with the NBIC acquisition in 2017 and fixed personnel and other costs which were diluted in 2016 due to higher gross earned premium. Assumptions from Citizens had a favorable impact on the 2016 expense ratio because assumed policies have no acquisition costs until the policies renew onto Heritage policy forms.
Other revenue increased to $16 million for the year ended December 31, 2016 from $9.6 million for the year ended December 31, 2015. The increase in other revenue between the comparable periods is primarily attributable to the policy fees and pay plan fees generated by our growing portfolio of policies, including the renewal of policies previously assumed from Citizens, coupled with policy fee and pay plan income associated with Zephyr. Revenue earned from non-insurance claims generated by our restoration subsidiary also contributed to the increase.
Losses and loss adjustment expenses increased to $238.9 million for the year ended December 31, 2016 from $141.2 million for the year ended December 31, 2015. The increase in losses and loss adjustment expenses resulted primarily from non-catastrophe unfavorable development on prior year loss reserves, an increase in our non-catastrophe loss ratio, the impact of Hurricanes Hermine and Matthew and growth of our business. Losses and loss adjustment expenses for the year ended December 31, 2016 includes losses paid of $157.6 million and a $56.4 million increase in unpaid losses and loss adjustment expenses, which includes the addition of $36.8 million of IBNR reserves. As of December 31, 2016, we reported $140.1 million in unpaid losses and loss adjustment expenses, which included $83.6 million attributable to IBNR, or 59.7% of total reserves for unpaid losses and loss adjustment expenses.
Policy acquisition costs increased to $84.4 million for the year ended December 31, 2016 from $57.2 million for the year ended December 31, 2015. Approximately $9 million of the increase is attributable to the inclusion of policy acquisition costs, including amortization of certain intangibles associated with the acquisition of Zephyr. The remainder of the increase relates to the renewal of policies assumed from Citizens as well as new voluntary policies written during 2016, which have associated commissions and administration fees paid to outside agents and administrators at the time of policy issuance, premium taxes and inspection fees, none of which are associated with policies assumed from Citizens prior to their renewal. The impact of amortization of certain intangible costs associated with the Zephyr transaction increased the policy acquisition ratio by approximately 1% from 2015.
Provision for income taxes was $22.5 million and $57.8 million for the years ended December 31, 2016 and 2015, respectively. Our effective tax rates for the years ended December 31, 2016 and 2015 were 40% and 38.5%, respectively. The increase in the effective tax rate is primarily a result of permanent items as more fully described in Note 12 - Income Taxes to our consolidated financial statements included elsewhere in this Form 10-K. The tax rate is further impacted overall due to the magnitude of pre-tax income which amplifies the impact of effective tax rate items due to lower income levels compared to the prior year.
Our net loss ratio increased to 58.0% for the year ended December 31, 2016 from 37.5% for the year ended December 31, 2015, primarily as a result of the items discussed above combined with the increase in the ceded premium ratio.
Our gross expense ratio increased to 22.4% for the year ended December 31, 2016 from 19.7% for the year ended December 31, 2015, primarily due to the larger Citizens take-out activity favorably impacting the prior year acquisition costs, coupled with an increase in the general and administration expense ratio. Amortization of intangibles associated with the Zephyr transaction added 1.1% to the gross expense ratio.
The net increases (decreases) in cash and cash equivalents are summarized in the following table:
Net cash provided by operating activities for December 31, 2017 was $7.6 million as compared to net cash provided of $67.1 million during the year ended December 31, 2016. The decrease resulted primarily from cash used to pay catastrophe claims related to Hurricanes Matthew and Irma and payment of reinsurance premiums.
Net cash provided by financing activities for the year ended December 31, 2017 was $47.6 million, as compared to $43.8 million for the year ended December 31, 2016. In August 2017, the Company entered into a debt arrangement providing net proceeds in the amount of $106 million. This was partially offset by payment of dividends to shareholders for $8.2 million and purchase of treasury stock for $61.6 million.
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.
We estimate the fair value of our investments using the closing prices on the last business day of the reporting period, obtained from active markets. For securities for which quoted prices in active markets are unavailable, we use observable inputs such as quoted prices in inactive markets, quoted prices in active markets for similar instruments, benchmark interest rates, broker quotes and other
The carrying amounts for the following financial instruments approximate their fair values at December 31, 2017 and December 31, 2016 because of their short-term nature: cash and cash equivalents, accrued investment income, premiums receivable, reinsurance payable, and accounts payable and accrued expenses.
Stock-Based Compensation. We recognize compensation expense under ASC 718 for stock-based payments based on the fair value of the awards. The Company grants stock options at exercise prices equal to the fair market value of the Company’s stock on the dates the options are granted. The options 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. If a participant’s employment relationship ends, the participant’s vested awards will remain exercisable for the shorter of a period of 30 days or the period ending on the latest date on which such award could have been exercisable. The fair value of each option grant is separately estimated for each grant date. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the award and each vesting date. The Company estimates the fair value of all stock option awards as of the date of the grant by applying the Black-Scholes-Merton multiple-option pricing valuation model. The application of this valuation model involves assumptions that are judgmental and highly sensitive in the determination of compensation expense. The fair value of restricted stock awards are estimated by the market price at the date of grant and amortized on a straight-line basis to expense over the period of vesting. We recorded $4.8 million, $4.8 million and $2.6 million of stock-based compensation in 2017, 2016 and 2015, respectively.
Income taxes. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which we expect to recover or settle those temporary differences. The effect on deferred taxes and liabilities attributable to a change in tax rates is recognized in income in the period that includes the enactment date.
Deferred tax assets are recognized to the extent that there is sufficient positive evidence, as allowed under the Accounting Standard Codification Topic 740 ("ASC 740"), Income Taxes, to support the recoverability of those deferred tax assets. The Company establishes a valuation allowance to the extent that there is insufficient evidence to support the recoverability of the deferred tax asset under ASC 740. In making such a determination, management considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies, and results of recent
operations. If it is determined that the deferred tax assets would be realizable in the future in excess of their net recorded amount, an adjustment would be made to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
Our insurance business is seasonal; hurricanes typically occur during the period from June 1 through November 30 and winter storms generally impact the first and fourth quarters each year. With our catastrophe reinsurance program effective on June 1 each year, any variation in the cost of our reinsurance, whether due to changes to reinsurance rates or changes in the total insured value of our policy base will occur and be reflected in our financial results beginning June 1 of each year, subject to certain adjustments.
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2017, 2016 and 2015
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2017, 2016 and 2015
Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016 and 2015
We have audited the accompanying consolidated balance sheets of Heritage Insurance Holdings, Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of operations and comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
Our insurance subsidiaries are Heritage Property & Casualty Insurance Company (“Heritage P&C”), Zephyr Insurance Company (“Zephyr”), Narragansett Bay Insurance Company (“NBIC”) and Pawtucket Insurance Company (“PIC”). Our other subsidiaries include: Heritage MGA, LLC (“MGA”), the managing general agent that manages substantially all aspects of our insurance subsidiaries’ business; Contractors’ Alliance Network, LLC, our vendor network manager, which includes BRC Restoration Specialists, Inc., our restoration service; Skye Lane Properties, LLC, our property management subsidiary; First Access Insurance Group, LLC, our retail agency; Osprey Re Ltd, our reinsurance subsidiary that may provide a portion of the reinsurance protection purchased by our insurance subsidiaries; Heritage Insurance Claims, LLC, an inactive subsidiary reserved for future development; Zephyr Acquisition Company (“ZAC”); NBIC Holdings, Inc., NBIC Service Company which provides services to NBIC and Westwind Underwriters, Inc., an inactive subsidiary of NBIC Holdings, Inc.
The Company estimates the fair value of its investments using the closing prices on the last business day of the reporting period, obtained from active markets such as the NYSE and NASDAQ. For securities for which quoted prices in active markets are unavailable, the Company uses observable inputs such as quoted prices in inactive markets, quoted prices in active markets for similar instruments, benchmark interest rates, broker quotes and other relevant inputs. The Company does not have any investments in its portfolio which require the use of unobservable inputs. The Company’s estimate of fair value reflects the interest rate environment that existed as of the close of business on December 31, 2017. Changes in interest rates after December 31, 2017 may affect the fair value of the Company’s investments.
Premiums receivable represents amounts due from our policyholders for billed premiums and related policy fees. We perform a policy-level evaluation to determine the extent to which the balance of premiums receivable exceeds the balance of unearned premiums. We then age any resulting exposure based on the last date the policy was billed to the policyholder, and we establish an allowance for credit losses for any amounts outstanding for more than 90 days. When we receive payments on amounts previously charged off, we reduce 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 no allowance for the years ended December 31, 2017 and 2016, respectively. Bad debt expense (recovery) related to uncollectible premiums was $0, $250,000 and $(250,000) for the years ended December 31, 2017, 2016 and 2015, respectively.
Our insurance affiliates may charge policyholders a policy fee on each policy written; these fees are not subject to refund, and the Company recognizes the income immediately when collected. 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 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 years assessments. There were no assessments during the periods presented.
To determine the carrying values of the debt and derivative components at issuance, the Company measures the fair value of a similar liability, including any embedded features other than the conversion option, and assigns such value to the liability or equity component. The liability component’s fair value is then subtracted from the initial proceeds to determine the carrying value of the debt
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which we expect to recover or settle those temporary differences. The effect on deferred taxes and liabilities attributable to a change in tax rates is recognized in income in the period that includes the enactment date.
In February 2018, the FASB issued ASU 2018-03, Recognition and Measurement of Financial Assets and Financial Liabilities, Technical Corrections and Improvements to Financial Instruments (Topic 825-10). The amendment clarifies that an entity measuring an equity security using the measurement alternative may change its measurement approach to a fair value method in accordance with Topic 820. In addition, the amendment clarifies that the prospective transition approach for equity securities without a readily determinable fair value in the amendments in Update 2016-01 is meant only for instances in which the measurement alternative is applied, an insurance entity subject to the guidance in Topic 944 and should apply a prospective transition method when applying the amendments related to equity securities without a readily determinable fair value. The Company should apply the selected prospective transition method consistently to the entire population of equity securities for which the measurement alternative is elected. The guidance is effective for the interim period beginning after June 15, 2018. Early adoption is permitted for fiscal years beginning after December 15, 2017. This new guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): The amendment allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act (“Tax Act”). In addition, under ASU 2018-02, an entity will be required to provide certain disclosures regarding stranded tax effects. The new guidance is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. This new guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.
In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 is a new accounting standard that will make eight targeted changes to how cash receipts and cash payments are presented and classified in the statement of cash flows. This updated guidance is effective on January 1, 2018, and will require adoption on a retrospective basis with early adoption permitted. The Company has not experienced any transactions that are within the scope of this guidance and accordingly will evaluate the effect of this guidance further if and when any such transactions occur.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses Measurement of Credit Losses on Financial Instruments. The estimate of expected credit losses should consider historical information, current information, as well as reasonable and supportable forecasts, including estimates of prepayments. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset in order to present the net carrying value at the amount expected to be collected on the financial asset on the consolidated balance sheet. The guidance also amends the current accounting for other-than-temporary impairment model by requiring an estimate of the expected credit loss only when the fair value is below the amortized cost of the asset. The length of time the fair value of an available-for-sale debt security has been below the amortized cost will no longer impact the determination of whether a potential credit loss exists. The available-for-sale debt security model will also require the use of a valuation allowance as compared to the current practice of writing down the asset. The standard is effective for the Company in the first quarter of 2020 with early adoption permitted in the first quarter of 2019. The Company does not expect the adoption of this standard will have a material impact on the Company’s Consolidated Financial Statements.
In February 2016, the FASB issued ASU 2016-02, Lease Accounting, which amends the accounting treatment for leases. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Lessees (for capital and operating leases) and lessors (for sales-type leases, direct financing leases, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of ASU 2016-02 may have on its consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU, which will significantly change the income statement impact of equity investments held by an entity, and the recognition of changes in fair value of financial liabilities when the fair value option is elected. The guidance requires equity investments to be measured at fair value with changes in fair value recognized through net income (other than those accounted for under the equity method of accounting or those that result in consolidation of the investee) and an assessment of a valuation allowance on deferred tax assets related to unrealized losses of available-for-sale debt securities in combination with other deferred tax assets. The standard is effective for the Company in the first quarter of 2018.
In May 2014, the FASB issued ASU Topic 2014-09, Revenue from Contracts with Customers. This guidance is not applicable to insurance contracts. The ASU 2014-09 creates a new topic, Topic 606, to provide guidance on revenue recognition for entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets. The updated guidance requires an entity to recognize revenue as performance obligations are met, in order to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration the entity is entitled to receive for those goods or services. The standard is effective for the Company in the first quarter of 2018 with early adoption permitted. The Company has determined that this pronouncement is not applicable to its insurance contracts and will not be material to the Company’s Consolidated Financial Statements.
On November 30, 2017, the Company completed the acquisition of all the outstanding capital stock of NBIC Holdings, Inc., the parent company of Narragansett Bay Insurance Company, a leading specialty underwriter of personal residential insurance products and services in several states in the northeastern United States. The acquisition resulted in NBIC becoming a wholly-owned subsidiary of the Company (the “Acquisition”). The Company completed the NBIC Acquisition pursuant to the previously disclosed Agreement and Plan of Merger, dated as of August 8, 2017, by and among the Company, Gator Acquisition Merger Sub, Inc., NBIC and PBRA, LLC, in its capacity as Stockholder Representative (the “Merger Agreement”). The completion of the NBIC acquisition represents a significant advancement in executing our geographic diversification strategy by leveraging our combined platform to accelerate growth along the Eastern region.
The transaction was accounted for using the acquisition method of accounting, which requires, assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. Goodwill is not deductible for tax purposes, but is subject to annual impairment tests using a fair-value based approach.
The table below presents the Company’s the fair values of NBIC’s tangible and intangible assets acquired and liabilities assumed. The operations of NBIC are included in our audited consolidated statement of operations and comprehensive income effective November 30, 2017.
The following unaudited pro forma results of operations assume that the NBIC acquisition occurred at the beginning of the periods presented. The pro forma amounts include certain adjustments, including depreciation and amortization expense and income taxes. The pro forma amounts for the twelve month period below exclude acquisition-related charges. Accordingly, these unaudited pro forma results are presented for informational purposes only and are not necessarily indicative of what have been if the acquisitions had occurred as of January 1, 2016, nor are they indicative of future results of operations.
The following table summarizes the results of the acquired NBIC operations since the acquisition date that have been included within our consolidated statement of operations.
On March 21, 2016, the Company acquired 100% of the outstanding stock of ZAC and its wholly-owned subsidiary, Zephyr, in exchange for approximately $110.3 million, net of cash acquired. Zephyr is a specialty property insurance provider that offers policies for residential customers in Hawaii that only cover the peril of windstorm-hurricane events. The purchase consideration for this acquisition has been allocated to the estimated fair market value of the net assets acquired, including approximately $76.5 million in investments, $31.8 million in identifiable intangibles assets and a residual amount of goodwill of approximately $38.4 million offsets by $43.2 million in assumed liabilities. This acquisition furthers the Company’s strategic push to diversify business operations and achieve potential reinsurance synergies while expanding growth opportunities outside of Florida.
On July 31, 2015, the Company acquired BRC Restoration Specialists, Inc., a Florida based provider of restoration services and emergency and recovery assistance for a purchase price in aggregate of $8 million in cash and common stock. The Company issued 79,850 shares of its common stock to BRC at a fair value of $2.0 million as part of the purchase price and paid in cash $6.0 million. For the purchase price allocation, the Company utilized a third party to calculate the valuation. The purchase consideration for the BRC acquisition has been allocated to the estimated fair market value of the net assets acquired, including approximately $2.2 million in identifiable intangibles assets (brand, customer relations and non-compete), and a residual amount of goodwill of approximately $5.7 million.
The following table details the difference between cost or adjusted/amortized cost and estimated fair value, by major investment category, at December 31, 2017 and December 31, 2016:
the Company recovers its amortized cost basis. All the issuers of the equity securities it owns had near-term prospects that indicated the Company could recover its cost basis, and the Company also has the ability and the intent to hold these securities until the value equals or exceeds its cost.
The following table presents an aging of the Company’s unrealized investment losses by investment class as of December 31, 2017 and December 31, 2016:
As of December 31, 2017, and 2016 goodwill was $152.5 million and $46.5 million, respectively, and intangible assets were $101.6 million and $26.5 million, respectively. The Company has recorded $1.3 million relating to insurance licenses classified as an indefinite lived intangible.
Excludes insurance license valued at $175,000 and classified as an indefinite lived intangible which is subject to annual impairment testing and not amortized.
The following table sets forth the computation of basic and diluted EPS for the periods indicated:
The following table presents information about the Company’s assets measured at fair value on a recurring basis. The Company assesses the levels for the investments at each measurement date, and transfers between levels are recognized on the actual date of the event or change in circumstances that caused the transfer in accordance with the Company’s accounting policy regarding the recognitions of transfers between levels of the fair value hierarchy. For the years ended December 31, 2017 and 2016, there were no transfers in or out of Level 1, 2, and 3.
The Company anticipates that its DPAC costs will be fully recoverable in the near term. The table below depicts the activity with regard to DPAC for the years ended December 31, 2017 and 2016:
The reinsurance program, which is segmented into layers of coverage, protects the Company for excess property catastrophe losses and loss adjustment expenses. The Company’s 2017-2018 reinsurance program incorporates the mandatory coverage required by law to be placed with FHCF, which is available only for Florida catastrophe risk. For the 2017 hurricane season, the Company maintained the prior year selected participation percentage in the FHCF at 45%. The Company also purchased private reinsurance below and alongside the FHCF layer, as well as aggregate reinsurance coverage. The Company is not utilizing its captive, Osprey, for any catastrophe risk for the 2017 hurricane season. The Company has a primary retention of the first $20 million of losses and loss adjustment expenses. Additionally, the December 1, 2016 treaty between Heritage P&C and Osprey was commuted effective June 1, 2017.
2017-1 Notes: During March 2017, Heritage P&C entered into catastrophe reinsurance agreements with Citrus Re. The agreements provide for three-years of coverage from catastrophic losses caused by named storms, including hurricanes, beginning on June 1, 2017. Heritage P&C pays a periodic premium to Citrus Re during this three-year risk period. Citrus Re issued principal-at-risk variable notes due March 2020 to fund the reinsurance trust account and its obligations to Heritage P&C under the reinsurance agreements. The notes provide $125 million of coverage for a layer above the FHCF. The limit of coverage is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
Shared Layers above retention. Immediately above the retention, the Company has purchased $372 million of reinsurance from third party reinsurers. This coverage includes the following layers: Top and Aggregate layer, Underlying layer, Layer 1, Layer 2 and a private sliver alongside those layers. Through the payment of a reinsurance reinstatement premium, Heritage P&C and Zephyr are able to reinstate $352 million of this reinsurance one time. There is $20 million of shared coverage subject to a seasonal aggregate of $68 million.
NBIC’s property catastrophe program protects NBIC from the aggregation of losses in a single occurrence. Reinstatement provisions (one reinstatement at 100% of premium) on the first three layers and a portion of the fourth layer provides protection for NBIC from a second catastrophic event. The program is 81.25% placed, with the remaining 18.75% of catastrophe protection coming from NBIC’s gross quota share contract. NBIC’s net retention of $20 million is further reduced with a net quota share reinsurance contract described below.
Section 1: $20 million excess $21.5 million in the aggregate for all catastrophe losses excluding named tropical storms.
NBIC’s net lines quota share is proportional reinsurance for which certain of our other reinsurance inures to the quota share (property catastrophe excess of loss and reinstatement premium protection and the second layer of the general excess of loss.) An occurrence limit of $20 million for catastrophe losses is in effect on the quota share, subject to certain aggregate loss limits that vary
The Company’s Retention. If a first catastrophic event strikes Florida, the Company had a primary retention of the first $40 million of losses and loss adjustment expenses, of which Osprey was responsible for $20 million. If a first catastrophic event strikes Hawaii, the Company had a primary retention of the first $30 million of losses and loss adjustment expenses, of which Osprey was responsible for $15 million. If a second event strikes Florida, Heritage P&C’s primary retention decreases to $15 million and the remainder of the losses are ceded to third parties. If a second event strikes Hawaii, Zephyr’s primary retention decreases to $5 million. In the second event only for a loss exceeding $190 million, there was an additional Company co-participation of 5.4% subject to a maximum co-participation of $11.6 million. Heritage P&C and Zephyr each had a $5 million primary retention for events beyond the second catastrophic event. Osprey had no primary retention beyond the first catastrophic event in Florida or Hawaii. Additionally, Osprey was responsible for payment of up to $5.3 million of reinstatement premium, depending on the amount of losses incurred.
FHCF Layer. The Company’s FHCF program provided coverage for Florida events only and includes an estimated maximum provisional limit of 45% of $1.5 billion, more than its retention of $460 million. The limit and retention of the FHCF coverage was subject to upward or downward adjustment based on, among other things, submitted exposures to FHCF by all participants. The Company had purchased coverage alongside from third party reinsurers and through reinsurance agreements with Citrus Re. To the extent the FHCF coverage was adjusted, this private reinsurance with third party reinsurers and Citrus Re would adjust to fill in any gaps in coverage up to the reinsurers’ aggregate limits for this layer. The FHCF coverage cannot be reinstated once exhausted, but it did provide coverage for multiple events.
Layers alongside the FHCF. The Florida reinsurance program includes third party layers alongside the FHCF. These include 2015 C and 2015 B series catastrophe bonds, which cover Florida only for the 2016 season, and 2016 D and 2016 E catastrophe bond series issued by Citrus Re, which total $377.5 million of coverage, as discussed below, as well as a traditional reinsurance layer providing $200 million of coverage. Through a reinstatement, the Company can reinstate the full amount of the $200 million of reinsurance one time. These 2016 catastrophe bonds and the traditional reinsurance layer provide coverage for both Florida and Hawaii catastrophe losses.
2016 Class D and E Notes: During February 2016, Heritage P&C and Zephyr entered into two catastrophe reinsurance agreements with Citrus Re. The agreements provided for three years of coverage from catastrophic losses caused by named storms, including hurricanes, beginning on June 1, 2016. Heritage P&C and Zephyr paid a periodic premium to Citrus Re during this three-year risk period. Citrus Re issued an aggregate of $250 million of principal-at-risk variable notes due February 2019 to fund the reinsurance trust account and its obligations to Heritage P&C and Zephyr under the reinsurance agreements. The Class D notes provided $150 million of coverage and the Class E notes provided $100 million of coverage. The Class D and Class E notes provided reinsurance coverage for a sliver of the catastrophe coverage that had previously been provided by the FHCF. The limit of coverage is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C and Zephyr. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
2015 Class B and C Notes: During April 2015, Heritage P&C entered into catastrophe reinsurance agreements with Citrus Re. The 2015 notes do not provide coverage for Zephyr for the 2016 hurricane season. The agreements provided for three years of coverage from catastrophic losses caused by named storms, including hurricanes, beginning on June 1, 2015. Heritage P&C paid a periodic premium to Citrus Re during this three-year risk period. Citrus Re issued principal-at-risk variable notes due April 2018 to fund the reinsurance trust account and its obligations to Heritage P&C under the reinsurance agreements. The Class B notes provide $97.5 million of coverage, and the Class C notes provide $30 million of coverage. The Class B and Class C notes provide reinsurance coverage for a sliver of the catastrophe coverage that had previously been provided by the FHCF. The limit of coverage is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
2014 Class A Notes: Coverage immediately below and above the 2015 Class A notes is provided by the 2014 reinsurance agreements entered into with Citrus Re. The first contract with Citrus Re provides $150 million of coverage immediately below 2015 Class A, and the second contract provides an additional $50 million of coverage which sits immediately above 2015 Class A. During April 2014, Heritage P&C entered into two catastrophe reinsurance agreements with Citrus Re. The 2014 notes do not provide coverage for Zephyr for the 2016 hurricane season. The agreements provided for three years of coverage from catastrophe losses caused by certain named storms, including hurricanes, beginning on June 1, 2014. The limit of coverage of $200 million is fully collateralized by a reinsurance trust account for the benefit of Heritage P&C. Heritage P&C paid a periodic premium to Citrus Re during this three-year risk period. Citrus Re issued $200 million of principal-at-risk variable notes due April 2017 to fund the reinsurance trust account and its obligations to Heritage P&C under the reinsurance agreements. The maturity date of the notes may be extended up to two additional years to satisfy claims for catastrophic events occurring during the three-year term of the reinsurance agreements.
Aggregate Coverage. In addition to what is described above, much of the reinsurance is structured in a way to provide aggregate coverage. $682 million of limit was structured on this basis. To the extent that this coverage is not fully exhausted in the first catastrophic event, it provided coverage commencing at its reduced retention for second and subsequent events where underlying coverage has been previously exhausted. $460 million had a reinstatement, which is prepaid.
For a first catastrophic event striking Florida, our reinsurance program provided coverage for $1.9 billion of losses and loss adjustment expenses, including our retention, and we were responsible for all losses and loss adjustment expenses in excess of such amount. For a first catastrophic event striking Hawaii, our reinsurance program provided coverage for $1.1 billion of losses and loss adjustment expenses, including our retention, and we are responsible for all losses and loss adjustment expenses in excess of such amount. For 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. $860 million of limit purchased in 2016 includes a reinstatement, with $825 million being prepaid. In total, we have purchased $3 billion of potential reinsurance coverage, including our retention, for multiple catastrophic events. Our ability to access this coverage, however, was subject to the severity and frequency of such events.
The Company’s Retention. For the first catastrophic event, the Company had a primary retention of the first $35 million of losses and loss adjustment expenses, of which Osprey was responsible for $20 million. For a second event, Heritage P&C’s primary retention decreased to $5 million and Osprey is responsible for $10 million. To the extent that there is reinsurance coverage remaining, Heritage P&C has a $5 million primary retention for events beyond the second catastrophic event. Osprey had no primary retention beyond the second catastrophic event.
The Secured Notes contain customary restrictive covenants relating to merger, modification of the indenture, subordination, issuance of debt securities and sale of assets, the most significant of which include limitations with respect to certain designated subsidiaries on the incurrence of additional indebtedness or guarantees secured by any security interest on any shares of their capital stock. The Secured Notes covenants also limit the Company’s ability to sell or otherwise dispose of any shares of capital stock of such designated subsidiaries. The Secured Notes do not have the benefit of any sinking funds. They also contain customary limitations and lien provisions as well as customary events of default provisions, which if breached, could result in the accelerated maturity of the Secured Notes. The Company was in compliance with the Senior Notes covenants for the year ended December 31, 2017.
Upon the occurrence of a fundamental change (as defined in the Indenture) (but not, at the Company’s election, a public acquirer change of control (as defined in the Indenture)), holders of the Convertible Notes may require the Company to repurchase for cash all or a portion of their Convertible Notes at a fundamental change repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date .
Except as described below, the Company may not redeem the Convertible Notes prior to August 5, 2022. If the NBIC Acquisition had not been consummated for any reason by June 8, 2018, or if the acquisition agreement relating to the NBIC
The Company records the fair value of these derivatives on its balance sheet at fair value with changes in the values of these derivatives reflected in the consolidated statement of operations. The embedded derivatives are valued using the Convertible Lattice model at issuance and at the end of each quarter and marked to fair value with corresponding adjustment as “gain or loss” on change in fair values included in Other Non-Operating expense in the consolidated statements of operations.
On December 1, 2017, the Company held a Special Meeting of Stockholders, at which the Company’s stockholders approved, as required by Rule 312 of the New York Stock Exchange Listed Company Manual, the issuance of the Company’s common stock upon conversion of the Convertible Notes. Pursuant to the approval, the Company has the ability to settle the conversion option in shares of common stock, cash or a combination thereof. Upon conversion of the Convertible Notes, the Company intends to pay cash in respect of only the principal amount of the Convertible Notes being converted or (if lower) the conversion value thereof, and to settle any amounts in excess thereof in cash, shares of common stock or a combination thereof, at the Company’s election.
The valuation of the embedded derivatives within the convertible note was completed with the following assumptions:
The following table summarizes the derivative liability activity for the year ended December 31, 2017:
Based on the reacquisition of the Convertible Notes by the Company, through Heritage P&C, the Company should derecognize the related debt and conversion option liability.
On October 30, 2017, the Company and its subsidiary, Skye Lane Properties LLC (“Skye Lane”), jointly obtained a commercial real estate mortgage loan in the amount of $12.7 million which is secured by a first mortgage on the real property owned by Skye Lane. The term of the loan shall end on October 30, 2027. The loan shall bear interest at an initial interest rate equal to 4.95% per annum. On October 30, 2022, the interest rate shall adjust to an interest rate equal to the annualized interest rate of United States 5-year Treasury Notes as reported by the Federal Reserve on a weekly average basis plus 3.10%. The loan is payable monthly of principal and interest based upon a 25-year amortization. As of December 31, 2017, the Company paid $54,000 for interest expense and $43,000 for principal.
The income tax (benefit) expense differs from the amounts computed by applying the U.S. federal income tax rate of 35% to pretax income as a result of the following (in thousands):
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. However, due to the timing of the enactment of the Tax Act and its proximity to December 31, 2017, the SEC issued SAB 118 which provides a framework for companies to account for uncertainties in applying the provisions of the Tax Act. SAB 118 allows companies to record a provisional amount in situations where a company does not have the necessary information available but can make a reasonable estimate. In situations where companies cannot make a reasonable estimate due to various factors, including lack of information, a provisional amount is not recorded. Instead, companies will continue to apply current
accounting guidance based on the provision of the tax laws that were in effect immediately prior to the Tax Act being enacted. The measurement period, as defined in SAB 118 for the Tax Act, begins on the enactment date of the Tax Act and ends when a company has obtained, prepared and analyzed the information that was needed in order to complete the accounting requirements under current accounting guidance. However, under no circumstances will the measurement period extend beyond one year from the enactment date of the Tax Act.
The Company has completed its accounting for the impact of the effective tax rate change from 35% to 21%. As a result, the Company recorded a $21.3 million benefit to operations for the reduction in the deferred tax liability as of December 22, 2017.
As of December 31, 2017, the Company has net operating loss carryforwards for federal and state income tax purposes of $13.1 million and $76.2 million, respectively. The losses will expire between 2026 and 2037. In addition, the Company has a $300 thousand capital loss carryforward which will expire in 2018.
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 $6.5 million and $7 million for the years ended December 31, 2017 and 2016, respectively. We had non-deductible goodwill for $144.4 million and $38.4 million for the years ended December 31, 2017 and 2016, 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.
The Company’s insurance subsidiaries are required to file with state insurance regulatory authorities an “Annual Statement” which reports, among other items, net income and surplus as regards policyholders, which is called stockholder’s equity under GAAP. Combined results of the Company’s insurance subsidiaries reported statutory net income of $50.6 million and $567,000 for the years ended December 31, 2017 and 2016, respectively. The Company’s insurance subsidiaries must maintain capital and surplus ratios or balances as determined by the regulatory authority of the states in which they are domiciled. Heritage P&C is required to maintain capital and surplus equal to the greater of $15 million or 10% of their respective liabilities. Zephyr is required to maintain a deposit of $750,000 in a federally insured financial institution. NBIC is required to maintain capital and surplus of $3.0 million. The combined statutory surplus for Heritage P&C, Zephyr, and NBIC was $376.3 million at December 31, 2017. The combined statutory surplus for Heritage P&C and Zephyr was $276.1 million at December 31, 2016. State laws also require the Company’s insurance subsidiaries to adhere to prescribed premium-to-capital surplus ratios, with which the Company’s insurance affiliates are complying. At December 31, 2017, our insurance subsidiaries met the financial and regulatory requirements of the states in which they do business.
The legislatures of the states of domicile of our insurance affiliates have adopted the National Association of Insurance Commissioners (“NAIC”) recommendations with regard to expansion of the regulation of insurers to include non-insurance entity affiliates. Specifically, the new law permits the state insurance regulators to examine affiliated entities within an insurance holding company system in order to ascertain the financial condition of the insurer. The law also provides for certain disclosures regarding enterprise risk, which are satisfied by the provision of related information filed with the SEC.
The NAIC published risk-based capital guidelines for insurance companies that are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policy holders. Most states, including Florida, Hawaii, and Rhode Island, have enacted the NAIC guidelines as statutory requirements, and insurers having less statutory surplus than required will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy. State insurance regulatory authorities could require an insurer to cease operations in the event the insurer fails to maintain the required statutory capital.
Company Action Level-If RBC is between 150%-200%, the insurer must prepare a report to the regulator outlining a comprehensive financial plan that identifies conditions that contributed to the insurer’s financial condition and proposes corrective actions.
At December 31, 2017, the ratio of adjusted capital to authorized control level risk based capital for each of our insurance company subsidiaries was above 300%.
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 laws provide calculations to determine the
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, 2017 and 2016.
For the year ended December 31, 2017, the Company recognized employee bonus compensation expense of approximately $6.9 million, which the Company paid out in cash approximately $0.9 million during 2017. For the year of December 31, 2016, the Company recognized employee bonus compensation expense of approximately $4.4, which the Company paid out in cash of approximately $0.8 million for 2016. For the year ended December 31, 2015, the Company recognized employee bonus compensation
In January 2017, the Company entered into a consulting agreement with Mrs. Shannon Lucas, the wife of the 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 providing written notice. Additionally, she serves as a director of Heritage P&C with an annual compensation of $75,000. For the year ended December 31, 2017, the Company paid consulting fees to Ms. Lucas of approximately $440,000.
All the Company personnel are employed by one of our insurance company subsidiaries.
As of December 31, 2017, all unvested shares have been forfeited. At December 31, 2017 and 2016, there were 1,125,243 and 170,814 shares available for grant under the Plan, respectively.
On September 24, 2014, the Company granted options to purchase 359,000 shares to certain employees and directors. No stock options were granted in the years ending December 31, 2015 and 2016. These options were awarded with the strike price set at the fair market value at the grant date, and vested on March 15, 2015 with an expiration date of September 24, 2017. The fair value of each option grant, which was $2.70 per option granted in 2014, was estimated on the date of grant using the Black-Scholes option-pricing model. The fair value of options vested during the year ended December 31, 2014 was $2.5 million.
On December 2, 2014, the Company granted options to purchase 1,326,923 shares to certain employees and directors. The employee options were awarded with the strike price set at the fair market value at the grant date, and vested at 50 percent upon grant and 50 percent on April 30, 2015 with an expiration date of December 2, 2017. The directors’ options were awarded with the strike price set at the fair market value at the grant date, and vest quarterly commencing on January 1, 2015 with an expiration date of December 2, 2017. The fair value of each option grant, which ranged from $3.07 to $3.54 per option granted in 2014, was estimated on the date of grant using the Black-Scholes option-pricing model. The fair value of options that vested as of December 31, 2015 was $2.7 million.
No compensation expense was recognized for stock options granted above during the years December 31, 2017 and 2016. The Company has recognized $1.9 million of compensation expense during the year ended December 31, 2015.