Combined ratio is calculated as the sum of losses and loss adjustment expenses and all operating expenses less interest expense divided by net premiums earned.
The lower premiums in Automobile was due to our decision to select specific types and amounts of premiums to be underwritten with consideration and focus on profitability. Automobile was not profitable throughout the year 2017 and we announced in December 2017 that we were taking the appropriate steps, including the completion of all required regulatory filings and approvals, to withdraw from Automobile. The increase in gross premiums written in the homeowners non-Florida was due to the expansion of our operations outside of Florida, allowing us to leverage personnel and diversify insurance risk. The increase in homeowners Florida reflects our strategy to grow market share in a controlled manner with a renewed focus on risk profile and profitability.
Ceded premiums earned decreased $34.3 million, or 11.3%, to $269.7 million for the year ended December 31, 2017, as compared to $304.1 million for the year ended December 31, 2016. The decrease in ceded premiums earned was driven by the expiration of the 30% and 10% Florida-only property quota share treaties, which ended on July 1, 2016 and 2017, respectively. The effect of these expirations was partially offset by the new 10% Florida-only property quota share treaty, which became effective on July 1, 2017.
Net investment income increased $1.2 million, or 13.1%, to $10.3 million for the year ended December 31, 2017, as compared to $9.1 million for the year ended December 31, 2016. The increase in net investment income was primarily due to the growth in our fixed income portfolio including a re-allocation of $30 million of equity investments into fixed income securities. The increase was also due to the improvement in the yield on our fixed income portfolio as a result of portfolio repositioning during the first quarter of 2017, particularly the sale of tax-free municipal bonds, the proceeds of which were reinvested in taxable municipal and corporate fixed income securities with higher coupon rates. A portion of the increase in net investment income will be offset by higher federal income taxes, given that a lower percentage of our investment income originates from tax-free securities.
Direct written policy fees increased by $0.6 million, or 3.3%, to $17.2 million for the year ended December 31, 2017, as compared to $16.6 million for the year ended December 31, 2016. The increase in direct written policy fees is correlated to the increase in gross premiums earned in Homeowners, offset by the decrease in gross premiums earned in Automobile, as compared to the prior year.
Other income increased $4.8 million, or 27.4%, to $22.2 million for the year ended December 31, 2017, as compared to $17.4 million for the year ended December 31, 2016. Other income included the following for the periods presented:
The increase in other income was due to the improvement in brokerage revenue and partnership income, partially offset by the decline in commission income. The improvement in brokerage revenue was due to the increase in the amount of our homeowners reinsurance placed, the type of reinsurance purchased and the commissions paid on these reinsurance agreements for the year ended December 31, 2017, as compared to the year ended December 31, 2016. The improvement in partnership income from our 33% investment in SECCC, was driven by the increased claims adjustment services provided by SECCC to its customers, primarily related to Hurricanes Irma and Harvey for the year ended December 31, 2017, as compared to the prior year. The decline in commission income was primarily due to the lower premiums in Automobile for the year ended December 31, 2017, as compared to the year ended December 31, 2016.
Total revenue for the year ended December 31, 2016 of $307.5 million increased $64.1 million, or 26.3%, compared to revenue of $243.5 million in 2015.
Direct written policy fees increased by $6.9 million, or 70.6%, to $16.6 million for the year ended December 31, 2016, as compared to $9.7 million in 2015. The increase in direct written policy fees is correlated to the increase in gross premiums earned in Homeowners and Automobile compared to the prior year.
The increase in commission income is primarily a result of the premium growth in Automobile, which increases the fees we receive for managing that business. Additionally, the increase in brokerage revenue is driven by the increase in our homeowners reinsurance program, the type of reinsurance purchased, and the commissions paid on these reinsurance agreements in calendar year 2016 as compared to calendar year 2015.
The following table sets forth commissions and other underwriting expenses for the periods presented:
Based on RBC requirements, the extent of regulatory intervention and action increases as the ratio of an insurer’s statutory surplus to its ACL, as calculated under the NAIC’s requirements, decreases. The first action level, the Company Action Level, requires an insurer to submit a plan of corrective actions to the insurance regulators if statutory surplus falls below 200.0% of the ACL amount. The second action level, the Regulatory Action Level, requires an insurer to submit a plan containing corrective actions and permits the insurance regulators to perform an examination or other analysis and issue a corrective order if statutory surplus falls below 150.0% of the ACL amount. The third action level, ACL, allows the regulators to rehabilitate or liquidate an insurer in addition to the aforementioned actions if statutory surplus falls below the ACL amount. The fourth action level is the Mandatory Control Level, which requires the regulators to rehabilitate or liquidate the insurer if statutory surplus falls below 70.0% of the ACL amount. FNIC’s ratio of statutory surplus to its ACL was 301.9% and 307.5% as of December 31, 2017 and 2016, respectively. MNIC’s ratio of statutory surplus to its ACL was 1,070.1% and 2,419.8% as of December 31, 2017 and 2016, respectively.
Net cash used in investing activities was $31.7 million for the year ended December 31, 2017, as compared to $33.2 million for the year ended December 31, 2016, representing net growth in our investment portfolio each year. The change was due to the higher purchases of debt and equity investment securities of $375.5 million for the year ended December 31, 2017, as compared to $342.1 million the year ended December 31, 2016, and the lower proceeds from sales of debt and equity investment securities of $306.7 million for the year ended December 31, 2017, as compared to $311.1 million for the prior year. The changes were offset by the maturities and redemptions of debt securities of $38.0 million for the year ended December 31, 2017, as compared to $81.8 million for the year ended December 31, 2016.
Net cash used in investing activities was $33.2 million for the year ended December 31, 2016, as compared to net cash used in investing activities of $63.6 million for the year ended December 31, 2015. The change was due to the decline in the net purchases of investment securities for the year ended December 31, 2016, as compared to prior year.
(2) Long-term debt payments on notes payable, excludes deferred financing costs.
We believe our most critical accounting estimates inherent in the preparation of our financial statements are: (i) fair value measurements of our investments; (ii) accounting for investments; (iii) premium and unearned premium calculation; (iv) reinsurance contracts; (v) the amount and recoverability of deferred acquisition costs; (vi) reserve for loss and losses adjustment expenses; and, (vii) income taxes. The accounting estimates that result require the use of assumptions about certain matters that are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, our financial condition, results of operations, and cash flows would be affected.
We recognize premiums as revenue on a pro-rata basis over the term of an insurance policy. Assumed reinsurance premiums written and earned are based on reports received from ceding companies for pro-rata treaty contracts and are generally recorded as written based on contract terms for excess-of-loss and quota share contracts. Premiums are earned ratably over the terms of the related coverage.
Ceded premiums written are recorded in accordance with applicable terms of the various reinsurance contracts and ceded premiums earned are charged against revenue over the period of the various reinsurance contracts. This also generally applies to reinstatement premiums paid to a reinsurer, which arise when contractually-specified ceded loss triggers have been breached. Ceded commissions reduce commissions, brokerage and other underwriting expenses and ceded losses incurred reduce net loss and LAE incurred over the applicable periods of the various reinsurance contracts with third party reinsurers. If premiums or commissions are subject to adjustment (for example, retrospectively-rated or experience-rated), the estimated ultimate premium or commission is recognized over the period of the contract.
Bornhuetter-Ferguson Method: The results from the Expected Loss Ratio Method are essentially blended with either the Reported Loss Development Method or the Paid Development Method.
The primary actuarial assumptions used by insurance companies include the following:
Rate of loss cost inflation (or deflation) represents management’s expectation of the inflation associated with the costs we may incur in the future to settle claims. Expected loss cost inflation is particularly important for longer-tailed classes.
Refer to Note 1. Organization, Consolidation and Basis of Preparation and Note 6. Loss and Loss Adjustment Reserves, in the Notes to Consolidated Financial Statements set forth in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report, for additional information regarding our loss and LAE.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 13, 2018 expressed an unqualified opinion thereon.
Federated National Holding Company (“FNHC,” the “Company,” “we,” “us,” or "our") is an insurance holding company that controls substantially all aspects of the insurance underwriting, distribution and claims processes through our subsidiaries and contractual relationships with independent agents and general agents. We, through our wholly owned subsidiaries, are authorized to underwrite, and/or place homeowners multi-peril (“homeowners”), personal automobile, commercial general liability, federal flood and other lines of insurance in Florida and other states. We market, distribute and service our own and third-party insurers’ products and other services through a network of independent and general agents.
The Company organized MNIC to obtain its certificate of authority to write homeowners property and casualty insurance in Florida from the Florida Office of Insurance Regulation (the “Florida OIR”). The Company’s joint venture partners are Crosswinds Investor Monarch LP (“Crosswinds Investor”), a wholly-owned subsidiary of Crosswinds Holdings Inc. (“Crosswinds Holdings”), a private equity firm and asset manager, and Transatlantic Reinsurance Company (“TransRe”), an international property and casualty reinsurance company. The Company and Crosswinds Investor each invested $14.0 million for a 42.4% membership interest in Monarch Delaware Holdings LLC ("Monarch Delaware") (each holding 50.0% of the voting interests in Monarch Delaware). TransRe invested $5.0 million for a 15.2% non-voting membership interest in Monarch Delaware and advanced an additional $5.0 million in debt evidenced by a six-year promissory note bearing an annual interest rate of 6% and payable by Monarch National Holding Company (“Monarch Holding”).
On February 21, 2018, FNIC closed on the transaction contemplated by the purchase and sale agreement with Crosswinds Investor and TransRe. Refer to Note 17. Subsequent Events, in these notes to consolidated financial statements, for additional information regarding the transaction.
The Company identifies a VIE as an entity that does not have sufficient equity to finance its own activities without additional financial support or where the equity investors lack certain characteristics of a controlling financial interest. The Company assesses its contractual, ownership or other interests in a VIE to determine if the Company’s interest participates in the variability the VIE was designed to absorb and pass onto variable interest holders. The Company performs an ongoing qualitative assessment of its variable interests in a VIE to determine whether the Company has a controlling financial interest and would therefore be considered the primary beneficiary of the VIE. If the Company determines it is the primary beneficiary of a VIE, the Company consolidates the assets and liabilities of the VIE in its consolidated financial statements.
In connection with the investment in Monarch Delaware, the Company has determined that the Company possesses the power to direct the activities of the VIE that most significantly impact its economic performance and the Company is the primary beneficiary of the VIE. As such, the Company consolidates Monarch Delaware in its consolidated financial statements. Refer to Note 14. Variable Interest Entity, in these notes to consolidated financial statements, for additional information regarding the VIE.
The revisions to correct the errors primarily relate to: (1) up-front recognition of direct written policy fees across all our lines of business and fee income generated through the Company’s personal automobile business, (2) the over-amortization of deferred acquisition costs and (3) the accounting for certain limits in our automobile reinsurance agreements, related to ceded premiums and other items. The Company has also included certain other adjustments that have been corrected.
Direct written policy fees and other fee income: The Company re-evaluated the accounting treatment for up-front recognition of direct written policy fees across all lines of business and fee income generated through the Company’s personal automobile business. As a result of the re-evaluation, the Company concluded that the direct written policy fees and fee income should be recognized over the life of the underlying policies, net of cancellations, and not be recognized
up-front. Additionally, with this change, the timing of revenue recognition of direct written policy fees and fee income will be consistent with the timing of recognition of the related insurance costs, including commissions and other acquisition related expenses. This correction resulted in an after-tax net loss impact of $0.7 million and $1.4 million for the years ended December 31, 2016 and 2015, respectively.
Deferred acquisition costs: The Company corrected an error in the calculation of deferred acquisition costs related to the over-amortization of the costs, resulting in an overstatement of expenses. Consistent with above, the timing of expense recognition will be consistent with the timing of the recognition of the related premiums and policy fees and the underlying policy term. This correction resulted in an impact to commissions and other underwriting expenses for all periods presented. This correction resulted in an after-tax net income impact of $0.5 million and $0.7 million for the years ended December 31, 2016 and 2015, respectively.
Automobile reinsurance agreements: The Company corrected errors on the accounting for certain terms in its reinsurance coverage related to the automobile line of business. This correction was related to limits on the amount of premiums that could be ceded and other terms. The primary impact of the correction resulted in a lower inception-to-date quota share percentage on the reinsurance treaties impacted, which resulted in an overstatement of ceded premiums earned, ceded loss and LAE and ceded commissions. This correction resulted in an after-tax net loss impact of $0.4 million for the year ended December 31, 2016.
Income taxes: The Company corrected errors in its tax provision related to tax deductions on executive compensation, which resulted in an after-tax net loss of $0.4 million and $0.2 million for the years ended December 31, 2016 and 2015, respectively. Additionally, a portion of the revisions includes a $2.2 million deferred tax adjustment which is part of the retained earnings beginning balance adjustment, as the item related to periods in 2014 and prior. This error was previously recorded as an out-of-period adjustment and disclosed in the 2016 financial statements.
Homeowners quota share agreements: As previously disclosed and corrected in the Company’s Quarterly Report for the period ended September 30, 2015, the Company re-evaluated the accounting treatment for quota share reinsurance contracts with retrospective rating provisions and other adjustments. As part of these revisions, the Company recorded these adjustments in the appropriate period. These adjustments resulted in an impact to revenue, loss and LAE, commissions and other underwriting expenses and general and administrative expenses, which had an after-tax net loss impact of $0.8 million for the year ended December 31, 2015.
The following table includes the effects of the adjustments on the retained earnings beginning balance as of January 1, 2015, which represents the cumulative impact of the revisions to periods prior to 2015.
The Company prepares the accompanying consolidated financial statements in accordance with U.S. GAAP, which requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results may materially differ from those estimates.
Held-to-maturity investments are recorded at the amortized cost, reflecting the ability and intent to hold the securities to maturity. All other securities are classified as available-for-sale and recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to available-for-sale, are excluded from income and reflected in other comprehensive income, and the cumulative effect is reported as a separate component of shareholders’ equity until realized. If a decline in fair value is deemed to be other-than-temporary, the investment is written down to its fair value and the amount of the write-down is recorded as an other-than-temporary impairment (“OTTI”) loss on the statement of operations. Any portion of such decline related to debt securities that is believed to arise from factors other than credit is recorded as a component of other comprehensive income rather than against income.
Cash and cash equivalents consist of all deposit or deposit in transit balances with a bank that are available for withdrawal. The Company considers all highly liquid investments with an original maturity of three months or less at the date of the purchase to be cash equivalents.
Deferred acquisition costs represent those costs that are incremental and directly related to the successful acquisition of new or renewal of existing insurance contracts. The Company defers incremental costs that result directly from, and are essential to, the acquisition or renewal of an insurance contract. Such deferred acquisition costs generally include agent or broker commissions, referral fees, premium taxes, medical and inspection fees that would not have been incurred if the insurance contract had not been acquired or renewed. Each cost is analyzed to assess whether it is fully deferrable.
Other income represents brokerage, commission related income from the Company’s agency operations, partnership income as well as fees generated from the personal automobile line of business. Brokerage income is recognized over the term of the reinsurance period, typically one year. Commission income from its agency operations are recognized up-front upon policy inception. The partnership income is the Company’s share of its equity method investment. The fees associated with the personal automobile line of business are recognized ratably over the related policy term, generally six months.
The Company has a 33% partnership interest in Southeast Catastrophe Consulting Company, LLC (“SECCC”), based in Mobile, Alabama. The Company has an agreement in which SECCC provides claims adjusting services for FNIC and MNIC, primarily in the event of catastrophes, such as Hurricane Irma and Matthew. We use the equity method of accounting for this investment as we do not have the ability to exercise significant influence nor control operating or financial decisions. In applying the equity method, the Company recorded its initial investment at cost, and subsequently increases or decreases the carrying amount of the investment by its proportionate share of the net earnings or losses. Any dividends or distributions received are recorded as a decrease in the carrying value of the investment. The Company’s proportionate share of net income (loss) is reported as other income in the consolidated statements of operations.
The reserves for loss and LAE represent management’s best estimate of the ultimate cost of all reported and unreported losses incurred through the balance sheet date. Such liabilities are determined based upon the Company’s assessment of claims pending and the development of prior years’ loss liability, including liabilities based upon individual case estimates for reported loss and LAE and estimates of such amounts that are incurred but not yet reported (“IBNR”). Changes in the estimated liability are charged or credited to operations as the losses and LAE are settled.
The Company records long-term debt, net in the consolidated balance sheets at carrying value.
The Company applies the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss, capital loss and tax-credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income or expense in the period that includes the enactment date. The Company will establish a valuation allowance if management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. Significant judgment is required in determining whether valuation allowances should be established and the amount of such allowances.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). ASU 2014-09 requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The update replaces all general and most industry specific revenue recognition guidance (excluding insurance) currently prescribed by U.S. GAAP. The core principle is that an entity recognizes revenue to reflect the transfer of a promised good or service to customers in an amount that reflects that consideration to which the entity expects to be entitled in exchange for that good or service. The update also provides clarification on when an entity is a principal or an agent in a transaction. The guidance may be applied using one of the two following methods: (1) retrospectively to each prior reporting period presented, or (2) retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application. The FASB issued additional updated clarifying certain implementation guidance within ASU 2014-09, subsequent to the initial issuance to provide guidance to improve the operability and understandability of the implementation guidance included in ASU 2014-09. The Company adopted this update and the other related revenue standard clarifications and technical guidance effective January 1, 2018, using the modified retrospective approach. The Company completed the analysis of its non-insurance revenues and has concluded that the implementation did not have any impact on the Company’s consolidated financial condition or results of operations.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The update will supersede the current lease guidance in Topic 840, Leases and lessees will be required to recognize for all leases, with the exception of short-term leases, a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis. Concurrently, lessees will be required to recognize a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The update is effective for interim and annual reporting periods beginning after December 15, 2018, with early adoption permitted. The guidance is required to be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative periods presented in the financial statements. The guidance is required to be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative periods presented in the financial statements. All of the Company’s leases are classified as operating leases under current lease accounting guidance. The Company expects to elect all of the standard’s available practical expedients upon adoption. The update requires the Company to add the operating leases to the Company’s consolidated balance sheets. The Company does not expect this standard will have a material impact on the Company’s consolidated financial position or results of operations.
The classification of assets and liabilities in the fair value hierarchy is based upon the lowest level input that is significant to the fair value inputs consisted of the following:
The Company’s held-to-maturity debt securities are reported on the consolidated balance sheets at amortized cost and disclosed at fair value in Note 4. Investments in these notes to consolidated financial statements. The fair values of these securities are classified within Level 1 and Level 2 of the fair value hierarchy and consist of United States government obligations and authorities, corporate securities and international securities. The fair value of the securities classified as Level 1 was $4.0 million as of December 31, 2017 and 2016. The fair value of the securities classified as Level 2 was $1.3 million and $1.6 million as of December 31, 2017 and 2016, respectively.
The Company has engaged a nationally recognized third party pricing service to provide the fair values of securities in Level 2. The Company reviews the third party pricing methodologies on a quarterly basis and tests for significant differences between the market price used to value the securities and the recent sales activities.
United States Government Obligations and Authorities: In determining the fair value for United States government securities in Level 1, the Company uses quoted prices (unadjusted) in active markets for identical or similar assets. In determining the fair value for United States government securities in Level 2, the Company uses the market approach utilizing primary valuation inputs including reported trades, dealer quotes for identical or similar assets in markets that are not active, benchmark yields, credit spreads, reference data and industry and economic events.
Corporate and International Securities: In determining the fair value for corporate securities the Company uses the market approach utilizing primary valuation inputs including reported trades, dealer quotes for identical or similar assets in markets that are not active, benchmark yields, credit spreads (for investment grade securities), observations of equity and credit default swap curves (for high-yield corporates), reference data and industry and economic events.
Equity Securities: In determining the fair value for equity securities in Level 1, the Company uses quoted prices (unadjusted) in active markets for identical or similar assets. In determining the fair value for equity securities in Level 2, the Company uses the market approach utilizing primary valuation inputs including reported trades, dealer quotes for identical or similar assets in markets that are not active, benchmark yields, credit spreads, reference data and industry and economic events.
There were no changes to the Company’s valuation methodology and the Company is not aware of any events or circumstances that would have a significant adverse effect on the carrying value of its assets and liabilities measured at fair value as of December 31, 2017 and 2016. There were no transfers between the fair value hierarchy levels during the years ended December 31, 2017, 2016 and 2015.
The difference between amortized cost or cost and estimated fair value and gross unrealized gains and losses, by major investment category, consisted of the following:
Net realized gains, by major investment category, consisted of the following:
As of December 31, 2017, the Company held a total of 866 debt and equity securities that were in an unrealized loss position, of which 73 securities were in an unrealized loss position continuously for 12 months or more. As of December 31, 2016, the Company held a total of 1,132 debt and equity securities that were in an unrealized loss position, of which 36 securities were in an unrealized loss position continuously for 12 months or more. The unrealized losses associated with these securities consisted primarily of losses related to corporate securities.
The Company holds its equity securities and some of its debt securities as available-for-sale and as such, these securities are recorded at fair value. The Company continually monitors the difference between cost and the estimated fair value of its investments, which involves uncertainty as to whether declines in value are temporary in nature. If the decline of a particular investment is deemed temporary, the Company records the decline as an unrealized loss in shareholders’ equity. If the decline is deemed to be other than temporary, the Company will write the security’s cost-basis or amortized cost-basis down to the fair value of the investment and recognizes an OTTI loss in the Company’s consolidated statement of operations. Additionally, any portion of such decline related
to debt securities that is believed to arise from factors other than credit will be recorded as a component of other comprehensive income rather than charged against income.
To the extent that an equity security in an unrealized loss position is not impaired based on the initial review described previously, the Company then evaluates such equity security by considering qualitative and quantitative factors. These factors include but are not limited to facts and circumstances specific to individual securities, asset classes, the financial condition of the issuer, changes in dividend payment, the length of time fair value had been less than cost, the severity of the decline in fair value below cost, industry outlook and the Company’s ability and intent to hold each position until its forecasted recovery.
The determination that unrealized losses on such securities were other-than-temporary was primarily based on the duration of the decline in the fair value of such securities relative to their cost as of the balance sheet date. OTTI losses were $0, $0.3 million and $0.4 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Reinsurance is used to mitigate the exposure to losses, manage capacity and protect capital resources. The Company reinsures (cedes) a portion of written premiums on an excess of loss or a quota share basis in order to limit the Company’s loss exposure. To the extent that reinsuring companies are unable to meet their obligations assumed under these reinsurance agreements, the Company remain primarily liable to its policyholders.
FNIC’s 2016-2017 reinsurance programs, costing $179.5 million, included $125.6 million for the private reinsurance for FNIC’s Florida exposure, including prepaid automatic premium reinstatement protection on all layers, along with $53.9 million payable to the Florida Hurricane Catastrophe Fund (“FHCF”). The combination of private and FHCF reinsurance treaties afforded FNIC with $2.2 billion of aggregate coverage with a maximum single event coverage totaling $1.6 billion, exclusive of retentions. FNIC maintained its FHCF participation at 75% for the 2016 hurricane season. FNIC’s single event pre-tax retention for a catastrophic event in Florida was $18.5 million. In addition, FNIC purchased separate underlying reinsurance layers in Louisiana, Texas, South Carolina and Alabama to cover losses and LAE outside of Florida for each catastrophic event from $8.0 million to $18.5 million. Depending on the characteristics of the catastrophic event, and the states involved, FNIC’s single event pre-tax retention could have been as low as $8.0 million. The maximum pre-tax retention was $18.5 million.
FNIC’s 2017-2018 reinsurance programs costing $173.9 million, including $124.0 million for the private reinsurance for FNIC’s Florida exposure including prepaid automatic premium reinstatement protection on all layers, along with $49.9 million payable to the FHCF. The combination of private and FHCF reinsurance treaties will afford FNIC with $2.2 billion of aggregate coverage with a maximum single event coverage totaling $1.5 billion, exclusive of retentions. FNIC maintained its FHCF participation at 75% for the 2017 hurricane season. FNIC’s single event pre-tax retention for a catastrophic event in Florida is $18.0 million, down slightly from the 2016-2017 reinsurance programs.
MNIC’s 2017-2018 reinsurance program costing $5.0 million, including $3.2 million for the private reinsurance for MNIC’s Florida exposure including prepaid automatic premium reinstatement protection on all layers, along with $1.8 million payable to the FHCF. The combination of private and FHCF reinsurance treaties affords MNIC with $109.0 million of aggregate coverage with a maximum single event coverage of $64.9 million, exclusive of retentions. MNIC maintained its FHCF participation at 75% for the 2017 hurricane season.
MNIC’s private market excess of loss treaties became effective July 1, 2017, and all private layers have prepaid automatic reinstatement protection, which affords MNIC additional coverage for subsequent events, and have a cascading feature such that substantially all layers attach at $3.4 million for MNIC’s Florida exposure. These treaties are with reinsurers that currently have an A.M. Best or Standard & Poor’s rating of “A-” or better, or have fully collateralized their maximum potential obligations in dedicated trusts.
In addition to the excess of loss coverages described above, our reinsurance program also includes property quota-share treaties. One such treaty for 30% became effective July 1, 2014, and another for 10% became effective July 1, 2015 with each running for two years. The combined treaties provided up to a 40% quota-share reinsurance on all non-catastrophe homeowners property insurance claims in Florida, and 40% quota share coverage on the first $100 million of covered catastrophe losses for the homeowners property insurance program in Florida per occurrence; $200 million any one contract year. The treaties embodied an experience account and
On July 1, 2016, the 30% property quota-share treaty expired on a cut-off basis, which means as of that date we retained an incremental 30% of the underlying unearned premiums and losses. On July 1, 2017, the 10% property quota-share treaty expired on a cut-off basis, which means as of that date we retained an incremental 10% of the underlying unearned premiums and losses. The reinsurers remain liable for 30% and 10% of the paid losses occurring during the terms of the treaties, until each treaty is commuted.
Certain reinsurance agreements require FNIC and MNIC to secure the credit, regulatory and business risk. Fully funded trust agreements securing these risks for FNIC were $2.6 million as of December 31, 2017 and 2016. Fully funded trust agreements securing these risks for MNIC were $0.3 million as of December 31, 2017 and 2016.
Amounts recoverable from reinsurers are recognized in a manner consistent with the claims liabilities associated with the reinsurance placement and presented on the consolidated balance sheet as reinsurance recoverables. Reinsurance recoverable, net consisted of the following:
Net premiums written and net premiums earned consisted of the following:
Reflects loss development from prior accident years impacting pre-tax net income. Excludes losses ceded under retrospective reinsurance treaties to the extent there is an offsetting experience account adjustment.
Reflects losses ceded under retrospective reinsurance treaties to the extent there is an offsetting experience account adjustment, such that there is no impact on pre-tax net income.
Various actuarial methods are utilized to determine the reserves that are booked to our financial statements. Weightings of tests and methods at a detailed level may change from evaluation to evaluation based on a number of observations, measures and time elements. On an overall basis, changes to methods and/or assumptions underlying reserve estimations and selections as of December 31, 2017 and 2016, were not considered material.
IBNR reserves are established for the quarter and year-end based on a quarterly reserve analysis by our actuarial staff. Various standard actuarial tests are applied to subsets of the business at a line of business and coverage basis. Included in the analyses are the following:
The 2027 Notes and 2022 Notes are senior unsecured obligations of the Company and will rank equally with all of the Company’s other future senior unsecured indebtedness. The Indenture, as supplemented by Supplemental Indenture No. 1 and Supplemental Indenture No. 2, includes customary covenants and events of default. Among other things, the covenants: (a) restrict the ability of the Company and its subsidiaries to incur additional indebtedness or make restricted payments under certain circumstances; (b) limit the Company and its subsidiaries from creating, incurring or assuming liens other than permitted liens as defined in the indenture; (c) require the Company to maintain certain levels of reinsurance coverage while the notes remain outstanding; and (d) maintain certain financial covenants.
The Company’s estimated annual aggregate amount of debt maturities includes the following:
The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21%. SAB No. 118 provides guidance on accounting for the tax effects of the Tax Act and a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under the FASB’s Accounting Standard Codification (“ASC”) 740 - Income Taxes (“ASC 740”). In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act. In connection with the Company’s analysis of the impact of the Tax Act, the Company recorded a discrete provisional net tax expense of $0.3 million for the year ended December 31, 2017. This estimated net expense primarily consists of the U.S. federal rate reduction from 35% to 21% applied to the net deferred tax asset.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense in the consolidated statements of operations and statements of comprehensive income (loss). For the years ended December 31, 2017, 2016 and 2015, the Company did not recognize any expense for accrued interest and penalties related to unrecognized tax benefits. For the years ended December 31, 2017, 2016 and 2015, the Company recognized income tax expense related to an uncertain tax position of $0, $0.4 million and $0.2 million, respectively.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s net deferred tax asset (liability) include the following:
On March 2, 2017, the Company filed a complaint in Broward County, Florida court to enforce the terms of the restrictive covenants set forth in the Amended and Restated Non-Competition, Non-Disclosure and Non-Solicitation Agreement dated August 5, 2013, as amended, entered into between Peter J. Prygelski, III and our company during Mr. Prygelski’s employment with us and set forth in the separation agreement he entered into in connection with his separation from our company. We believe that he accepted employment with a competitor in contravention of these restrictive covenants and therefore we are seeking injunctive relief, declaratory relief and damages. Prygelski has also filed an arbitration seeking declaratory relief as to his obligations under the above-referenced agreements and to recover the remainder of his severance and health insurance premium reimbursements. Because we are seeking monetary relief, we have filed a counterclaim in the arbitration seeking damages and recovery of separation payments. The litigation seeking injunctive relief and the companion arbitration related to damages are ongoing. The final hearing on the arbitration is scheduled for May 14, 2018. There can be no assurances as to the outcome of this matter.
The Company operates in a regulatory environment where certain entities and organizations have the authority to require us to participate in assessments. Currently these entities and organizations include: Florida Insurance Guaranty Association (“FIGA”), Citizens Property Insurance Corporation (“Citizens”), FHCF, Florida Joint Underwriters Insurance Association (“JUA”), Georgia Insurers Insolvency Pool (“GIIP”), Special Insurance Fraud Fund (“SIIF”), Fair Access to Insurance Requirements Plan (“FAIRP”), Georgia Automobile Insurance Plan (“GAIP”), Property Insurance Association of Louisiana (“PIAL”), Louisiana Automobile Insurance Plan (“LAIP”), South Carolina Property & Casualty Insurance Guaranty Association (“SCPCIGA”), Texas Property and Casualty Insurance Guaranty Association (“TPCIGA”), Texas Windstorm Insurance Association (“TWIA”), Texas Automobile Insurance Plan Association (“TAIPA”), Alabama Insurance Guaranty Association (“AIGA”), and Alabama Insurance Underwriters Association (“AIUA”). As a direct premium writer in Florida, we are required to participate in certain insurer solvency associations under Florida law, administered by FIGA.
In November 2016, the Company’s Board of Directors authorized a program, which program may be modified, suspended or terminated by the Company at any time without notice, to repurchase shares of common stock of FNHC, at such times and at prices as management determines advisable, up to an aggregate of $10.0 million through March 1, 2017.
During the year ended December 31, 2017, the Company repurchased 654,250 shares of its common stock at a total cost of $10.6 million, which is an average price per share of $16.23. The remaining availability for future repurchases of the Company’s common stock from the March 2017 Board of Directors’ authorization was $0.8 million as of December 31, 2017.
In December 2017, the Company’s Board of Directors authorized an additional share repurchase program under which the Company may repurchase up to $10.0 million of its outstanding shares of common stock through December 31, 2018. Together with the $0.8 million remaining as of December 31, 2017 from the Company’s previous stock repurchase authorization, the Company has available to it an aggregate of $10.8 million for future repurchases of its common stock.
In April 2012, the Company’s Board of Directors adopted, and in September 2012 the Company’s shareholders approved, the Company’s 2012 Stock Incentive Plan (the “2012 Plan”). The 2012 Plan permits the issuance of up to 1,000,000 shares of the Company’s common stock, subject to adjustment as provided for in the 2012 Plan, in connection with the grant of a variety of equity incentive awards, such as stock options and restricted stocks. Officers, directors, executive management and all other employees of the Company and its subsidiaries are eligible to participate in the 2012 Plan. Awards may be granted singly, in combination, or in tandem. The 2012 Plan will expire on April 5, 2022.
The intrinsic value of options exercised represents the difference between the stock option exercise price and the weighted average closing stock price of FNHC common stock on the exercise dates, as reported on the NASDAQ Global Market.
The unamortized share-based compensation expense is $4.3 million for the year ended December 31, 2017, which will be recognized over the remaining weighted average vesting period of approximately 1.35 years.
The Company recognizes share-based compensation expense for all restricted stock awards (“RSAs”) held by the Company’s directors, executives and other key employees. The accounting charge is measured at the grant date as the fair value of FNHC common stock and expensed as non-cash compensation over the vesting term using the straight-line basis for service awards and the accelerated basis for performance-based awards with graded vesting. Certain cliff vesting awards contain performance criteria which are tied to the achievement of certain market conditions. This value is recognized as expense over the service period using the straight-line recognition method.
During the years ended December 31, 2017 and 2016, the Board of Directors granted 106,454 and 128,472 RSAs, respectively, vesting over three or five years, to the Company’s directors, executives and other key employees.
The Company’s total contributions to the 401(K) Plan were $0.8 million, $0.9 million and $0.6 million for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company recorded claims adjustment service fees and other expenses to SECCC, our 33% owned subsidiary, of $17.0 million, $3.1 million and $0.1 million for the years ended December 31, 2017, 2016 and 2015, respectively. Additionally, the Company recognized partnership income (loss), which is recognized in other income in the consolidated statements of operations, of 2.0 million, $0.2 million and greater than $(0.1) million for the years ended December 31, 2017, 2016 and 2015, respectively.
In March 2017, the Company’s Board of Directors declared a dividend of $0.08 per common share, paid in June 2017, totaling $1.1 million.
In September 2017, the Company’s Board of Directors declared a dividend of $0.08 per common share, paid in December 2017, totaling $1.1 million.
In November 2017, the Company’s Board of Directors declared a dividend of $0.08 per common share, paid in March 2018, totaling $1.0 million.
We believe FNU, through the Monarch MGA Agreement, directs the activities which most significantly impact the Monarch Entities’ insurance operating company, MNIC. MNIC’s activities directed by FNU through the Monarch MGA Agreement include underwriting and claims. As a result, MNIC is a VIE because the equity holders, as a group, lack the characteristics of a controlling financial interest.
In addition to having power to direct the activities which most significantly impact MNIC, FNHC has the obligation to absorb the losses and/or the right to receive benefits that potentially could be significant through its 42.4% indirect equity interests in MNIC through Monarch Delaware and Monarch Holding.
As a result, FNHC is the primary beneficiary of MNIC, resulting in Monarch Delaware, MNIC’s indirect parent company, consolidating into our financial statements.
The Company’s insurance companies are subject to regulations and standards of the Florida OIR. These standards require that insurance companies prepare statutory-basis financial statements in accordance with the National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures Manual. The Company did not use any prescribed or permitted statutory accounting practices that differed from the NAIC’s statutory accounting practices as of December 31, 2017.
Additionally, Florida Statutes require the Company’s insurance companies to maintain specified levels of statutory capital and restrict the timing and amount of dividends and other distributions that may be paid to the parent company. These standards require dividends to be paid only from statutory unassigned surplus. The maximum dividend that may be paid by the Company’s insurance companies to their parent company, without prior regulatory approval is limited to the lesser of statutory net income from operations of the
As of December 31, 2017 and 2016, on a combined statutory basis, the capital and surplus of the Company’s insurance companies was $188.0 million and $172.1 million, respectively. Combined statutory operational results of the Company’s insurance companies was a net loss of $19.6 million, net loss of $37.0 million and net income of $23.9 million for the years ended December 31, 2017, 2016 and 2015, respectively. Statutory capital and surplus exceeds amounts necessary to satisfy regulatory requirements.
The following tables include the revisions as discussed on Note 1. Organization, Consolidation and Basis of Presentation in these notes to consolidated financial statements, set forth under the “Revisions to Previously Issued Financial Statements” to the Company’s previously reported consolidated statements of operations (unaudited) for each of the quarterly periods ended March 31, 2016 to September 30, 2017.
The following tables summarize the impacts of the revisions on the Company’s previously reported consolidated statements of operations (unaudited) for each of the quarterly periods ended March 31, 2017 to September 30, 2017, the six months ended June 30, 2017, and the nine months ended September 30, 2017.
Certain prior period line items in the consolidated statements of comprehensive income, consolidated statements of changes in shareholders’ equity and consolidated statements of cash flows, were affected by the revisions of previously issued financial statements. All of the changes in the consolidated statements of cash flows were included in cash flows from operating activities and all of the changes in the consolidated statements of comprehensive income were isolated to the net income line, which has been addressed through the preceding disclosures.
On February 16, 2018, the Company announced that the Board of Directors declared a dividend of $0.08 per share, payable in June 2018.
On February 28, 2018, in connection with the Company’s review of its subsidiaries’ financial condition and capital resources as of the end of the 2017 fiscal year, the Company’s Board of Directors approved an infusion of $30.0 million of capital into FNIC, effective December 31, 2017 for statutory accounting purposes, to support FNIC’s book of business.
On March 1, 2018, FNIC and MNIC have each entered into a Reimbursement Contract (the “Contracts”) with the State Board of Administration of Florida (“SBA”) for the 2018-2019 hurricane season. The SBA is the agency that administers the FHCF. The Contracts will reimburse FNIC and MNIC for covered property losses under their respective homeowners insurance policies resulting from hurricanes that cause damage in the State of Florida, from June 1, 2018 through May 31, 2019.
On March 13, 2018, the Company announced that it has decided to undergo an orderly withdrawal from the commercial general liability line of business and will begin the appropriate steps to withdraw from the line of business, including obtaining all required regulatory approvals.
We have audited Federated National Holding Company and subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Federated National Holding Company and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.