Item 2. Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our consolidated financial statements and the related notes thereto included in Item 1 of Part I. Unless otherwise indicated, all references to “we,” “us,” “our,” “the Company,” or similar terms refer to Employers Holdings, Inc. (EHI), together with its subsidiaries. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this quarterly report and in our other reports filed with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K for the year ended
December 31, 2015
(Annual Report).
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements if accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. You should not place undue reliance on these statements, which speak only as of the date of this report. Forward-looking statements include those related to our expected financial position, business, financing plans, litigation, future premiums, revenues, earnings, pricing, investments, business relationships, strategic initiatives, expected losses, loss experience, loss reserves, acquisitions, competition, the impact of changes in interest rates, rate increases with respect to our business, and the insurance industry in general. Statements including words such as “expect,” “intend,” “plan,” “believe,” “estimate,” “may,” “anticipate,” “will,” or similar statements of a future or forward-looking nature identify forward-looking statements.
We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. All forward-looking statements address matters that involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results, depending on a number of factors. These risks and uncertainties include, but are not limited to, those described in our Annual Report and other documents that we have filed with the SEC.
Overview
We are a Nevada holding company. Through our insurance subsidiaries, we provide workers’ compensation insurance coverage to select, small businesses in low to medium hazard industries. Workers’ compensation insurance is provided under a statutory system wherein most employers are required to provide coverage for their employees’ medical, disability, vocational rehabilitation, and/or death benefit costs for work-related injuries or illnesses. We provide workers’ compensation insurance in
34
states and the District of Columbia, with a concentration in California, where over one-half of our business is generated. Our revenues are primarily comprised of net premiums earned, net investment income, and net realized gains on investments.
We target small businesses, as we believe that this market is traditionally characterized by fewer competitors, more attractive pricing, and stronger persistency when compared to the U.S. workers’ compensation insurance industry in general. We believe we are able to price our policies at levels that are competitive and profitable over the long term. Our underwriting approach is to consistently underwrite small business accounts at appropriate and competitive prices without sacrificing long-term profitability and stability for short-term top-line revenue growth.
Our strategy is to pursue profitable growth opportunities across market cycles and maximize total investment returns within the constraints of prudent portfolio management. We pursue profitable growth opportunities by focusing on disciplined underwriting and claims management, utilizing medical provider networks designed to produce superior medical and indemnity outcomes, establishing and maintaining strong, long-term relationships with independent insurance agencies, and developing important alternative distribution channels. We continue to execute a number of strategic initiatives, including: focusing on internal and customer facing business process excellence; emphasizing the settlement of open claims; diversifying our risk exposure across our geographic markets; utilizing a three-company pricing platform; utilizing territorial multipliers in California; and targeting profitable classes of business across all of our markets.
Results of Operations
A primary measure of our performance is our ability to increase our Adjusted stockholders' equity over the long term. The following table shows a reconciliation of our stockholders' equity on a GAAP basis to our Adjusted stockholders' equity and the number of common shares outstanding.
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|
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
|
|
(in millions, except share data)
|
GAAP stockholders' equity
|
|
$
|
850.1
|
|
|
$
|
760.8
|
|
Deferred reinsurance gain–LPT Agreement
|
|
177.8
|
|
|
189.5
|
|
Less: Accumulated other comprehensive income, net
|
|
117.6
|
|
|
83.6
|
|
Adjusted stockholders' equity
(1)
|
|
$
|
910.3
|
|
|
$
|
866.7
|
|
Common shares outstanding
|
|
32,109,976
|
|
|
32,216,480
|
|
|
|
(1)
|
Adjusted stockholders' equity is a non-GAAP measure that is defined as total stockholders' equity plus the Deferred reinsurance gain–LPT Agreement (Deferred Gain), less Accumulated other comprehensive income, net. We believe that Adjusted stockholders' equity is an important supplemental measure of our capital position.
|
Overall, net income was
$22.6 million
and
$71.2 million
for the three and
nine
months ended
September 30, 2016
, respectively, compared to
$24.5 million
and
$67.7 million
for the corresponding periods of
2015
. We recognized underwriting income before tax of
$11.3 million
and
$29.7 million
for the three and
nine
months ended
September 30, 2016
, respectively, compared to
$10.6 million
and
$24.9 million
for the corresponding periods of
2015
. Underwriting income or loss is determined by deducting losses and LAE, commission expense, and underwriting and other operating expenses from net premiums earned.
Our results of operations during the
nine
months ended
September 30, 2016
were impacted by: (1) favorable development in the estimated reserves ceded under the LPT Agreement that resulted in a $3.1 million cumulative adjustment to the Deferred Gain and reduced our losses and LAE by the same amount during the second quarter of 2016 (LPT Reserve Adjustment) and (2) an increase in the contingent commission receivable under the LPT Agreement that resulted in a $1.8 million cumulative adjustment, which reduced our losses and LAE by the same amount (LPT Contingent Commission Adjustment) during the second quarter of 2016. Collectively, these items increased net income by $4.9 million during the second quarter of 2016.
Our results of operations during the
nine
months ended
September 30, 2015
were impacted by: (1) favorable development in the estimated reserves ceded under the LPT Agreement that resulted in a $6.4 million LPT Reserve Adjustment during the nine months ended
September 30, 2015
; (2) an increase in the contingent commission receivable under the LPT Agreement that resulted in a $2.6 million LPT Contingent Commission Adjustment during the nine months ended
September 30, 2015
; and (3) a reallocation of $19.4 million of reserves from non-taxable periods prior to January 1, 2000 during the second quarter of 2015, which reduced our tax expenses by $3.8 million and reduced our effective tax rate by 4.6 percentage points for the nine months ended
September 30, 2015
. Collectively, these items increased net income by $12.8 million for the nine months ended
September 30, 2015
.
The comparative components of net income are set forth in the following table:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
September 30,
|
|
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
(in millions)
|
Gross premiums written
|
|
$
|
164.4
|
|
|
$
|
168.5
|
|
|
$
|
545.7
|
|
|
$
|
533.1
|
|
Net premiums written
|
|
$
|
163.0
|
|
|
$
|
166.5
|
|
|
$
|
540.4
|
|
|
$
|
526.7
|
|
|
|
|
|
|
|
|
|
|
Net premiums earned
|
|
$
|
173.3
|
|
|
$
|
179.0
|
|
|
$
|
522.8
|
|
|
$
|
508.6
|
|
Net investment income
|
|
17.9
|
|
|
18.5
|
|
|
54.1
|
|
|
53.8
|
|
Net realized gains on investments
|
|
1.6
|
|
|
2.0
|
|
|
9.1
|
|
|
5.1
|
|
Other income
|
|
—
|
|
|
—
|
|
|
0.6
|
|
|
0.1
|
|
Total revenues
|
|
192.8
|
|
|
199.5
|
|
|
586.6
|
|
|
567.6
|
|
|
|
|
|
|
|
|
|
|
Losses and LAE
|
|
109.0
|
|
|
115.8
|
|
|
328.0
|
|
|
323.5
|
|
Commission expense
|
|
21.3
|
|
|
21.0
|
|
|
63.5
|
|
|
62.6
|
|
Underwriting and other operating expenses
|
|
31.7
|
|
|
31.6
|
|
|
101.6
|
|
|
97.6
|
|
Interest expense
|
|
0.4
|
|
|
0.7
|
|
|
1.2
|
|
|
2.1
|
|
Income tax expense
|
|
7.8
|
|
|
5.9
|
|
|
21.1
|
|
|
14.1
|
|
Total expenses
|
|
170.2
|
|
|
175.0
|
|
|
515.4
|
|
|
499.9
|
|
Net income
|
|
$
|
22.6
|
|
|
$
|
24.5
|
|
|
$
|
71.2
|
|
|
$
|
67.7
|
|
Less amortization of the Deferred Gain related to losses
|
|
$
|
2.5
|
|
|
$
|
2.3
|
|
|
$
|
7.2
|
|
|
$
|
7.1
|
|
Less amortization of the Deferred Gain related to contingent commission
|
|
0.5
|
|
|
0.4
|
|
|
1.5
|
|
|
1.4
|
|
Less impact of LPT Reserve Adjustments
(1)
|
|
—
|
|
|
—
|
|
|
3.1
|
|
|
6.4
|
|
Less impact of LPT Contingent Commission Adjustments
(1)
|
|
—
|
|
|
—
|
|
|
1.8
|
|
|
2.6
|
|
Net income before impact of the LPT Agreement
(2)
|
|
$
|
19.6
|
|
|
$
|
21.8
|
|
|
$
|
57.6
|
|
|
$
|
50.2
|
|
|
|
(1)
|
Any adjustment to the contingent profit commission under the LPT Agreement results in a cumulative adjustment to the Deferred Gain, which is recognized in losses and LAE incurred in the Consolidated Statements of Comprehensive Income, such that the Deferred Gain reflects the balance that would have existed had the revised contingent profit commission been recognized at the inception of the LPT Agreement (LPT Contingent Commission Adjustments).
|
|
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(2)
|
We define net income before impact of the LPT Agreement as net income before the impact of: (a) amortization of Deferred Gain; (b) adjustments to LPT Agreement ceded reserves; and (c) adjustments to contingent commission receivable–LPT Agreement. Deferred Gain reflects the unamortized gain from our LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method. Amortization is determined by the proportion of actual reinsurance recoveries to total estimated recoveries over the life of the LPT Agreement, except for the contingent profit commission, which is amortized through June 30, 2024. The amortization is reflected in losses and LAE. We periodically reevaluate the remaining direct reserves subject to the LPT Agreement and the expected losses and LAE subject to the contingent profit commission under the LPT Agreement. Our reevaluation results in corresponding adjustments, if needed, to reserves, ceded reserves, contingent commission receivable, and the Deferred Gain, with the net effect being an increase or decrease to net income. Net income before impact of the LPT Agreement is not a measurement of financial performance under GAAP, but rather reflects a difference in accounting treatment between statutory and GAAP, and should not be considered in isolation or as an alternative to net income before income taxes or net income, or any other measure of performance derived in accordance with GAAP.
|
We present net income before impact of the LPT Agreement because we believe that it is an important supplemental measure of operating performance to be used by analysts, investors, and other interested parties in evaluating us. The LPT Agreement was a non-recurring transaction under which the Deferred Gain does not effect our ongoing operations, and, consequently, we believe this presentation is useful in providing a meaningful understanding of our operating performance. In addition, we believe this non-GAAP measure, as we have defined it, is helpful to our management in identifying trends in our performance because the LPT Agreement has limited significance on our current and ongoing operations.
Gross Premiums Written
Gross premiums written is the sum of both direct premiums written and assumed premiums written before the effect of ceded reinsurance. Gross premiums written decreased 2.4% for the
three
months ended
September 30, 2016
and
increased
2.4%
for the
nine
months ended
September 30, 2016
, compared to the same periods of
2015
. The year-over-year decrease in gross premiums written for the quarter was primarily due to a $5.0 million decrease in our final audit premiums in the third quarter of 2016, compared to the third quarter of 2015. The year-over-year increase in gross premiums written for the
nine
months ended
September 30, 2016
was primarily due to final audit premiums that were $18.9 million higher, partially offset by declines in
premium due to lower levels of renewal premiums, year-over-year. The declines in renewal premiums year-over-year were due to declines in the LA Area of California, partially offset by increases in states outside California, as well as territories outside of southern California. While overall renewal premiums were down slightly year-over-year, primarily driven by lower net rates, our policy unit retention rate increased for the three and
nine
months ended
September 30, 2016
, compared to the same periods of
2015
. Premiums from new business written increased for the three and
nine
months ended
September 30, 2016
, compared to the same periods of
2015
.
Net Premiums Earned
Net premiums earned are those portions of the premiums that apply to the expired portions of the policies in force. Net premiums earned are recognized as revenue. Net premiums earned
decreased
3.2%
for the
three
months ended
September 30, 2016
and
increased
2.8%
for the
nine
months ended
September 30, 2016
, compared to the same periods of
2015
. The year-over-year decrease in net premiums earned was primarily the result of $5.0 million decrease in our final audit premiums for the
three
months ended
September 30, 2016
, while the year-over-year increase for the
nine
months ended
September 30, 2016
was primarily due to final audit premiums that were $18.9 million higher, partially offset by declines in premium due to lower levels of renewal premiums. The declines in renewal premiums year-over-year were due to declines in the LA Area of California, partially offset by increases in states outside California, as well as territories outside of southern California.
Fifty-six percent
of our in-force premiums were generated in California and no other state represented a significant concentration of business as of
September 30, 2016
.
The following table shows the percentage change in our in-force premiums, policy count, average policy size, payroll exposure upon which our premiums are based, and net rate overall and for California:
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|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, 2016
|
|
Year-to-Date (Decrease) Increase
|
|
Year-Over-Year (Decrease) Increase
|
|
Overall
|
|
California
|
|
All Other States
|
|
Overall
|
|
California
|
|
All Other States
|
In-force premiums
|
(0.3
|
)%
|
|
(1.3
|
)%
|
|
1.1
|
%
|
|
(0.5
|
)%
|
|
(2.5
|
)%
|
|
2.3
|
%
|
In-force policy count
|
0.6
|
|
|
(3.5
|
)
|
|
5.0
|
|
|
—
|
|
|
(5.5
|
)
|
|
6.2
|
|
Average in-force policy size
|
(0.9
|
)
|
|
2.3
|
|
|
(3.8
|
)
|
|
(0.5
|
)
|
|
3.1
|
|
|
(3.7
|
)
|
In-force payroll exposure
|
1.2
|
|
|
1.2
|
|
|
1.2
|
|
|
1.7
|
|
|
0.8
|
|
|
2.2
|
|
Net rate
(1)
|
(1.4
|
)
|
|
(2.4
|
)
|
|
(0.2
|
)
|
|
(2.1
|
)
|
|
(3.3
|
)
|
|
—
|
|
|
|
(1)
|
Net rate, defined as total in-force premiums divided by total insured payroll exposure, is a function of a variety of factors, including rate changes, underwriting risk profiles and pricing, and changes in business mix related to economic and competitive pressures.
|
Our in-force premiums and policy count in the LA Area of California declined 13.2% and 13.9%, respectively, year-over-year as of
September 30, 2016
, while our in-force premiums and policy count in California outside of the LA Area increased 10.3% and 4.1%, respectively, during the same period. The declines in total in-force premiums were driven by lower net rate.
Our net rate (total in-force premiums divided by total insured payroll exposure) in California decreased
3.3%
year-over-year as of
September 30, 2016
. Net rate is a function of a variety of factors, including rate changes, underwriting risk profiles and pricing, and changes in business mix related to economic and competitive pressures.
Our in-force premiums and number of policies in-force for California and all other states combined were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
|
September 30, 2015
|
|
December 31, 2014
|
State
|
|
In-force
Premiums
|
|
Policies
In-force
|
|
In-force
Premiums
|
|
Policies
In-force
|
|
In-force
Premiums
|
|
Policies
In-force
|
|
In-force
Premiums
|
|
Policies
In-force
|
|
|
(dollars in millions)
|
California
|
|
$
|
347.8
|
|
|
42,550
|
|
|
$
|
352.2
|
|
|
44,080
|
|
|
$
|
356.8
|
|
|
45,021
|
|
|
$
|
370.8
|
|
|
47,093
|
|
Other
|
|
270.1
|
|
|
42,450
|
|
|
267.3
|
|
|
40,416
|
|
|
264.1
|
|
|
39,981
|
|
|
257.1
|
|
|
38,209
|
|
Total
|
|
$
|
617.9
|
|
|
85,000
|
|
|
$
|
619.5
|
|
|
84,496
|
|
|
$
|
620.9
|
|
|
85,002
|
|
|
$
|
627.9
|
|
|
85,302
|
|
Our alternative distribution channels that utilize partnerships and alliances generated
$151.3 million
and
$147.4 million
, or
24.5%
and
23.7%
, of our in-force premiums as of
September 30, 2016
and
2015
, respectively. We believe that the bundling of products and services through these relationships contributes to higher retention rates than business generated by our independent agents. These relationships also allow us to access new customers that we may not have access to through our independent agent distribution channel. We continue to actively seek new partnerships and alliances.
Net Investment Income and Net Realized Gains on Investments
We invest our holding company assets, statutory surplus, and the funds supporting our insurance liabilities, including unearned premiums and unpaid losses and LAE. We invest in fixed maturity securities, equity securities, and cash equivalents. Net investment
income includes interest and dividends earned on our invested assets and amortization of premiums and discounts on our fixed maturity securities, less bank service charges and custodial and portfolio management fees. We have established a high quality/short duration bias in our investment portfolio.
Net investment income
decreased
3.2%
for the three months ended
September 30, 2016
and
increased
0.6%
for the
nine
months ended
September 30, 2016
, compared to the same periods of
2015
. The average pre-tax book yield on invested assets was
3.1%
and
3.2%
at
September 30, 2016
and
2015
, respectively. The tax-equivalent yield on invested assets was
3.7%
and
3.8%
at
September 30, 2016
and
2015
, respectively. The decrease in investment income year-over-year for the quarter was primarily related to the decrease in pre-tax book yield. The slight increase in net investment income for the
nine
months ended
September 30, 2016
was primarily related to a slight change in the mix of invested assets in the investment portfolio.
Realized gains and losses on our investments are reported separately from our net investment income. Realized gains and losses on investments include the gain or loss on a security at the time of sale compared to its original or adjusted cost (equity securities) or amortized cost (fixed maturity securities). Realized losses are also recognized when securities are written down as a result of an other-than-temporary impairment.
Net realized gains on investments were
$1.6 million
and
$9.1 million
for the three and
nine
months ended
September 30, 2016
, respectively, compared to
$2.0 million
and
$5.1 million
for the corresponding periods of
2015
. The increase in net realized gains on investments year-over-year for the
nine
months ended
September 30, 2016
was the result of the sale of equity securities as part of a regular rebalancing of our equity investment portfolio and to meet cash needs at the holding company. For the
nine
months ended
September 30, 2016
, these gains were partially offset by
$5.3 million
in other-than-temporary impairments of certain equity securities due to our intent to sell certain securities and the downturn in the energy sector that occurred in the first quarter of 2016.
Additional information regarding our Investments is set forth under “—Liquidity and Capital Resources—Investments.”
Combined Ratio
The combined ratio, a key measurement of underwriting profitability, is the sum of the loss and LAE ratio, the commission expense ratio, and the underwriting and other operating expenses ratio. When the combined ratio is below 100%, we have recorded underwriting income, and conversely, when the combined ratio is greater than 100%, we have recorded an underwriting loss and cannot be profitable without investment income. Because we have only one operating segment, holding company expenses are included in our calculation of the combined ratio and increased the combined ratio by 1.4 and 1.6 percentage points for the three and
nine
months ended
September 30, 2016
, respectively, compared to 1.7 and 1.9 percentage points for the corresponding periods of
2015
.
The following table provides the calculation of our calendar period combined ratios.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
September 30,
|
|
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Loss and LAE ratio
|
|
62.9
|
%
|
|
64.7
|
%
|
|
62.7
|
%
|
|
63.6
|
%
|
Underwriting and other operating expenses ratio
|
|
18.3
|
|
|
17.7
|
|
|
19.5
|
|
|
19.2
|
|
Commission expense ratio
|
|
12.3
|
|
|
11.7
|
|
|
12.1
|
|
|
12.3
|
|
Combined ratio
|
|
93.5
|
%
|
|
94.1
|
%
|
|
94.3
|
%
|
|
95.1
|
%
|
Loss and LAE Ratio.
This is the ratio of losses and LAE to net premiums earned. Losses and LAE represents our largest expense item and includes claim payments made, amortization of the Deferred Gain, estimates for future claim payments and changes in those estimates for current and prior periods, and costs associated with investigating, defending, and adjusting claims. The quality of our financial reporting depends in large part on accurately predicting our losses and LAE, which are inherently uncertain as they are estimates of the ultimate cost of individual claims based on actuarial estimation techniques.
Our indemnity claims frequency (the number of claims expressed as a percentage of payroll) has decreased year-over-year; however, our loss experience indicates a slight upward movement in medical and indemnity costs per claim that is reflected in our current accident year loss estimate. We believe our current accident year loss and LAE estimate is adequate; however, given the long-tail nature of our business, ultimate losses will not be known with any certainty for many years.
Our loss and LAE ratio decreased
1.8
and
0.9
percentage points for the three and
nine
months ended
September 30, 2016
, compared to the same periods of
2015
, while the amount of our losses and LAE
decreased
5.9%
year-over-year for the quarter and increased
1.4%
for the
nine
months ended
September 30, 2016
. The decreases in the loss and LAE ratio were primarily due to decreases in the current accident year loss estimates.
Our current accident year loss estimates were
64.1%
and
65.6%
for the three and
nine
months ended
September 30, 2016
, compared to
66.3%
and
66.8%
for the three and
nine
months ended
September 30, 2015
, respectively. The decreases in our current accident year loss estimate reflects the impact of key business initiatives, including but not limited to: emphasizing the settlement of open
claims; diversifying our risk exposure across our markets; non-renewing underperforming business; and targeting profitable classes of business across all of our markets. In addition, we have increased rates in the LA Area in California limiting our growth in that territory, while we continue to grow in other territories within and outside of California. The current accident year loss estimate for the
nine
months ended
September 30, 2016
includes the impact of $6.5 million in large losses recognized in the second quarter of 2016, which increased the current accident year loss estimate for the
nine
months ended
September 30, 2016
.
Prior accident year favorable (unfavorable) loss development was
$(0.8) million
and
$1.5 million
for the three and
nine
months ended
September 30, 2016
, compared to
$0.1 million
and
$(1.3) million
for the three and
nine
months ended
September 30, 2015
, respectively. Prior accident year loss development was related to our Assigned Risk Business.
Excluding the impact from the LPT Agreement, losses and LAE would have been
$112.0 million
and
$118.5 million
, or
64.6%
and
66.2%
of net premiums earned, for the three months ended
September 30, 2016
and
2015
, respectively. For the
nine
months ended
September 30, 2016
and
2015
, losses and LAE, excluding the impact of the LPT, would have been
$341.6 million
and
$341.0 million
, or
65.3%
and
67.0%
of net premium earned, respectively.
The table below reflects losses and LAE reserve adjustments and the impact of the LPT on net income before taxes.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
September 30,
|
|
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
(in millions)
|
Prior accident year favorable (unfavorable) loss development, net
|
|
$
|
(0.8
|
)
|
|
$
|
0.1
|
|
|
$
|
1.5
|
|
|
$
|
(1.3
|
)
|
Amortization of the Deferred Gain related to losses
|
|
$
|
2.5
|
|
|
$
|
2.3
|
|
|
$
|
7.2
|
|
|
$
|
7.1
|
|
Amortization of the Deferred Gain related to contingent commission
|
|
0.5
|
|
|
0.4
|
|
|
1.5
|
|
|
1.4
|
|
Impact of LPT Reserve Adjustments
|
|
—
|
|
|
—
|
|
|
3.1
|
|
|
6.4
|
|
Impact of LPT Contingent Commission Adjustments
|
|
—
|
|
|
—
|
|
|
1.8
|
|
|
2.6
|
|
Total impact of the LPT on losses and LAE
|
|
3.0
|
|
|
2.7
|
|
|
13.6
|
|
|
17.5
|
|
Total losses and LAE reserve adjustments
|
|
$
|
2.2
|
|
|
$
|
2.8
|
|
|
$
|
15.1
|
|
|
$
|
16.2
|
|
Underwriting and Other Operating Expenses Ratio.
The underwriting and other operating expenses ratio is the ratio of underwriting and other operating expenses to net premiums earned and measures an insurance company's operational efficiency in producing, underwriting, and administering its insurance business.
Underwriting and other operating expenses are those costs that we incur to underwrite and maintain the insurance policies we issue, excluding commission. These expenses include premium taxes and certain other general expenses that vary with, and are primarily related to, producing new or renewal business. Other underwriting expenses include policyholder dividends, changes in estimates of future write-offs of premiums receivable, general administrative expenses such as salaries and benefits, rent, office supplies, depreciation, and all other operating expenses not otherwise classified separately. Policy acquisition costs are variable based on premiums earned. Other operating expenses are more fixed in nature and become a smaller percentage of net premiums earned as premiums increase.
Our underwriting and other operating expenses ratio increased 0.6 and 0.3 percentage points, while the amount of our underwriting and other operating expenses
increased
0.3%
and
4.1%
for the three and
nine
months ended
September 30, 2016
, compared to the same periods of
2015
. During the three months ended
September 30, 2016
our policyholder dividends increased $0.3 million and our compensation-related expenses increased $0.2 million, partially offset by a $0.4 million decrease in our bad debt expense, compared to the same period of
2015
. During the
nine
months ended
September 30, 2016
our premium taxes and assessments increased $2.6 million, our compensation-related expenses increased $2.1 million, policyholder dividends increased $0.7 million and our IT related expenses increased $0.6 million, partially offset by a $1.6 million decrease in our bad debt expense, compared to the same period of
2015
.
Commission Expense Ratio.
The commission expense ratio is the ratio of commission expense to net premiums earned and measures the cost of compensating agents and brokers for the business we have written.
Commission expense includes direct commissions to our agents and brokers for the premiums that they produce for us, as well as incentive payments, other marketing costs, and fees.
Our commission expense ratio increased 0.6 percentage points for the three months ended
September 30, 2016
and decreased 0.2 percentage points for the
nine
months ended
September 30, 2016
, compared to the same periods of 2015, while our commission expense was $0.3 million higher for the three months ended
September 30, 2016
and $0.9 million lower
nine
months ended
September 30, 2016
, compared to the same periods of 2015.
Income Tax Expense
Income tax expense was
$7.8 million
and
$21.1 million
for the three and
nine
months ended
September 30, 2016
, respectively, compared to
$5.9 million
and
$14.1 million
for the corresponding periods of
2015
. Our effective tax rate was
25.7%
and
22.9%
for the three and
nine
months ended
September 30, 2016
, respectively, compared to
19.4%
and
17.2%
for the same periods of
2015
, respectively. The increases in income tax expense were primarily due to increases in our projected annual net income before taxes. Additionally, our income tax expense was decreased by $0.1 million and $1.4 million for the three and
nine
months ended
September 30, 2016
, respectively, as a result of the implementation of new accounting guidance related to stock-based compensation in the third quarter of 2016.
Liquidity and Capital Resources
Holding Company Liquidity
We are a holding company and our ability to fund our operations is contingent upon existing capital and the ability of our insurance subsidiaries to pay dividends up to the holding company. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws and regulations, including laws establishing minimum solvency and liquidity thresholds. We require cash to pay stockholder dividends, repurchase common stock, make interest and principal payments on our outstanding debt obligations, provide additional surplus to our insurance subsidiaries, and fund our operating expenses.
The holding company had
$53.6 million
of cash and cash equivalents and fixed maturity securities maturing within the next 24 months at
September 30, 2016
. Total cash and investments at the holding company was
$65.1 million
at
September 30, 2016
. We believe that the liquidity needs of the holding company over the next 24 months will be met with cash, investments, and dividends from our insurance subsidiaries.
Operating Subsidiaries' Liquidity
The primary sources of cash for our insurance operating subsidiaries are funds generated from underwriting operations, investment income, maturities and sales of investments, and capital contributions from the parent holding company. The primary uses of cash are payments of claims and operating expenses, purchases of investments, and payments of dividends to the parent holding company, which are subject to state insurance laws and regulations.
Our insurance subsidiaries had
$452.1 million
of cash and cash equivalents, short-term investments, and fixed maturity securities maturing within the next 24 months at
September 30, 2016
. We believe that our subsidiaries’ liquidity needs over the next 24 months will be met with cash from operations, investment income, and maturing investments.
Each of our insurance subsidiaries, EICN, ECIC, EPIC, and EAC, became a member of the Federal Home Loan Bank of San Francisco (FHLB) in January 2016. Membership allows our subsidiaries access to collateralized advances, which may be used to support and enhance liquidity management. The amount of advances that may be taken is dependent on statutory admitted assets on a per company basis. Currently, none of our subsidiaries has advances outstanding under the FHLB facility.
We purchase reinsurance to protect us against the costs of severe claims and catastrophic events. On July 1, 2016, we entered into a reinsurance program that is effective through June 30, 2017. The reinsurance program consists of one treaty covering excess of loss and catastrophic loss events in four layers of coverage. Our reinsurance coverage is $190.0 million in excess of our $10.0 million retention on a per occurrence basis, subject to certain exclusions. We believe that our reinsurance program meets our needs and that we are sufficiently capitalized.
Various state laws and regulations require us to hold securities or letters of credit on deposit with certain states in which we do business. Securities having a fair value of
$1.0 billion
and
$0.9 billion
were on deposit at
September 30, 2016
and
December 31, 2015
, respectively. These laws and regulations govern both the amount and types of fixed maturity securities that are eligible for deposit. Additionally, certain reinsurance contracts require Company funds to be held in trust for the benefit of the ceding reinsurer to secure the outstanding liabilities we assumed. The fair value of fixed maturity securities held in trust for the benefit of ceding reinsurers was
$27.7 million
and
$32.7 million
at
September 30, 2016
and
December 31, 2015
, respectively.
Sources of Liquidity
We monitor cash flows at both the consolidated and subsidiary levels. We use trend and variance analyses to project future cash needs, making adjustments to our forecasts as appropriate. For additional information regarding our cash flows, see Item 1, Unaudited Consolidated Statements of Cash Flows.
The table below shows our net cash flows for the
nine
months ended:
|
|
|
|
|
|
|
|
|
|
|
|
September 30,
|
|
|
2016
|
|
2015
|
|
|
(in millions)
|
Cash and cash equivalents provided by (used in):
|
|
|
|
|
Operating activities
|
|
$
|
97.0
|
|
|
$
|
94.0
|
|
Investing activities
|
|
(49.1
|
)
|
|
(139.1
|
)
|
Financing activities
|
|
(20.4
|
)
|
|
(2.3
|
)
|
Increase (Decrease) in cash and cash equivalents
|
|
$
|
27.5
|
|
|
$
|
(47.4
|
)
|
Operating Cash Flows.
Major components of net cash provided by operating activities for the
nine
months ended
September 30, 2016
included net premiums received of $525.0 million and investment income received of $65.8 million. These were partially offset by claims payments of $323.0 million (net of $22.7 million recovered from reinsurers), underwriting and other operating expenses paid of $97.2 million (including premium taxes paid of $24.1 million), and commissions paid of $62.3 million.
Major components of net cash provided by operating activities for the
nine
months ended
September 30, 2015
included net premiums received of $510.7 million and investment income received of $63.8 million. These were partially offset by claims payments of $314.9 million (net of $25.7 million recovered from reinsurers), underwriting and other operating expenses paid of $95.9 million (including premium taxes paid of $16.2 million), and commissions paid of $61.4 million.
Investing Cash Flows.
The major components of net cash used in investing activities for the
nine
months ended
September 30, 2016
and
2015
were the purchases of fixed maturity and equity securities, partially offset by proceeds from sales, maturities, and redemptions of investments.
Financing Cash Flows.
Cash used in financing activities for the
nine
months ended
September 30, 2016
was to repurchase common stock and to pay dividends to stockholders, partially offset by cash received related to the exercise of stock options.
The majority of cash used in financing activities for the
nine
months ended
September 30, 2015
was to pay dividends to stockholders, partially offset by cash received related to the exercise of stock options.
Dividends.
Dividends paid to stockholders were
$8.8 million
and
$5.8 million
for the
nine
months ended
September 30, 2016
and
2015
, respectively. On
October 26, 2016
, the Board of Directors declared a $0.09 dividend per share, payable
November 23, 2016
, to stockholders of record on
November 9, 2016
.
Share Repurchases.
On February 16, 2016, the Board of Directors authorized a share repurchase program for up to $50.0 million of our common stock from February 22, 2016 through February 22, 2018 (the 2016 Program). Through
September 30, 2016
, we repurchased a total of
642,024
shares of common stock under the 2016 Program at an average price of
$28.91
per share, including commissions, for a total cost of
$18.6 million
.
Capital Resources
Our capital structure is comprised of outstanding debt and stockholders’ equity. As of
September 30, 2016
, our capital structure consisted of $
32.0 million
in surplus notes maturing in 2034, and
$1.0 billion
of stockholders’ equity, including the Deferred Gain. Outstanding debt was
3.0%
of total capitalization, including the Deferred Gain, as of
September 30, 2016
.
Contractual Obligations and Commitments.
The following table identifies our long-term debt and contractual obligations as of
September 30, 2016
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Payment Due By Period
|
|
|
Total
|
|
Less Than
1-Year
|
|
1-3 Years
|
|
4-5 Years
|
|
More Than
5 Years
|
|
|
(in millions)
|
Operating leases
|
|
$
|
16.9
|
|
|
$
|
5.1
|
|
|
$
|
7.3
|
|
|
$
|
4.2
|
|
|
$
|
0.3
|
|
Purchased liabilities
|
|
5.4
|
|
|
3.4
|
|
|
1.4
|
|
|
0.6
|
|
|
—
|
|
Notes payable
(1)
|
|
60.6
|
|
|
1.6
|
|
|
3.2
|
|
|
3.2
|
|
|
52.6
|
|
Capital leases
|
|
0.7
|
|
|
0.3
|
|
|
0.3
|
|
|
0.1
|
|
|
—
|
|
Losses and LAE reserves
(2)(3)
|
|
2,330.0
|
|
|
375.6
|
|
|
465.0
|
|
|
273.4
|
|
|
1,216.0
|
|
Total contractual obligations
|
|
$
|
2,413.6
|
|
|
$
|
386.0
|
|
|
$
|
477.2
|
|
|
$
|
281.5
|
|
|
$
|
1,268.9
|
|
|
|
(1)
|
Notes payable obligations reflect payments for the principal and estimated interest expense based on LIBOR plus a margin. The estimated interest expense was based on the contractual obligations of the debt outstanding as of
September 30, 2016
. The interest rates range from
4.9%
to
5.1%
.
|
|
|
(2)
|
Estimated losses and LAE reserve payment patterns have been computed based on historical information. Our calculation of loss and LAE reserve payments by period is subject to the same uncertainties associated with determining the level of reserves and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of losses and LAE reserves vary from actual ultimate paid claims due to variations between expected and actual payout patterns.
|
|
|
(3)
|
The losses and LAE reserves are presented gross of reinsurance recoverables for unpaid losses, which are as follows for each of the periods presented above:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries By Period
|
|
|
Total
|
|
Less Than
1-Year
|
|
1-3 Years
|
|
4-5 Years
|
|
More Than
5 Years
|
|
|
(in millions)
|
Reinsurance recoverables for unpaid losses
|
|
$
|
(591.5
|
)
|
|
$
|
(30.5
|
)
|
|
$
|
(57.7
|
)
|
|
$
|
(53.6
|
)
|
|
$
|
(449.7
|
)
|
Investments
The cost or amortized cost of our investment portfolio was
$2.4 billion
and the fair value was
$2.6 billion
as of
September 30, 2016
.
We employ an investment strategy that emphasizes asset quality and considers the durations, maturities, and anticipated cash flows of securities against anticipated claim payments, other expenditures and liabilities, and capital and liquidity needs. Our investment portfolio is structured so that investments mature periodically in reasonable relation to current expectations of future claim payments. Currently, we make claim payments from positive cash flow from operations and use excess cash to fund growth in our business, invest in operations, invest in marketable securities, and return capital to our stockholders.
As of
September 30, 2016
, our investment portfolio, which is classified as available-for-sale, consisted of
92.9%
fixed maturity securities whose fair values may fluctuate due to prevailing market interest rates. We strive to limit interest rate risk by managing the duration of our fixed maturity securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of
4.2
at
September 30, 2016
. To minimize interest rate risk, our portfolio is weighted toward short-term and intermediate-term bonds; however, our investment strategy balances consideration of duration, yield, and credit risk. Our investment guidelines require that the minimum weighted average quality of our fixed maturity securities portfolio be "AA-," using ratings assigned by Standard & Poor's (S&P). Our fixed maturity securities portfolio had a weighted average quality of "AA-" as of
September 30, 2016
, with
56.9%
of the portfolio rated "AA" or better, based on fair value.
We carry our portfolio of equity securities on our balance sheet at fair value. We seek to minimize our exposure to equity price risk by investing primarily in the equity securities of mid-to-large capitalization issuers and by diversifying our equity holdings across several industry sectors. Equity securities represented
7.1%
of our investment portfolio at
September 30, 2016
.
Given current economic uncertainty and continuing market volatility, we believe that our current asset allocation best meets our strategy to preserve capital for policyholders, to provide sufficient income to support our insurance operations, and to effectively grow book value over a long-term investment horizon.
The following table shows the estimated fair value, the percentage of the fair value to total invested assets, the average book yield, and the average tax equivalent yield based on the fair value of each category of invested assets as of
September 30, 2016
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Category
|
|
Estimated Fair
Value
|
|
Percentage
of Total
|
|
Book Yield
|
|
Tax Equivalent Yield
|
|
|
(in millions, except percentages)
|
U.S. Treasuries
|
|
$
|
127.9
|
|
|
5.0
|
%
|
|
1.8
|
%
|
|
1.8
|
%
|
U.S. Agencies
|
|
13.0
|
|
|
0.5
|
|
|
4.3
|
|
|
4.3
|
|
States and municipalities
|
|
897.2
|
|
|
34.7
|
|
|
3.1
|
|
|
4.5
|
|
Corporate securities
|
|
996.5
|
|
|
38.7
|
|
|
3.1
|
|
|
3.1
|
|
Residential mortgage-backed securities
|
|
235.0
|
|
|
9.1
|
|
|
3.0
|
|
|
3.0
|
|
Commercial mortgage-backed securities
|
|
86.5
|
|
|
3.3
|
|
|
2.5
|
|
|
2.5
|
|
Asset-backed securities
|
|
27.8
|
|
|
1.1
|
|
|
1.8
|
|
|
1.8
|
|
Equity securities
|
|
184.5
|
|
|
7.1
|
|
|
5.7
|
|
|
7.5
|
|
Short-term investments
|
|
14.0
|
|
|
0.5
|
|
|
1.0
|
|
|
1.0
|
|
Total
|
|
$
|
2,582.4
|
|
|
100.0
|
%
|
|
|
|
|
|
Weighted average yield
|
|
|
|
|
|
|
|
3.1
|
%
|
|
3.7
|
%
|
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of
September 30, 2016
by credit rating category, using the lower of ratings assigned by Moody's Investor Services and/or S&P.
|
|
|
|
|
Rating
|
|
Percentage of Total
Estimated Fair Value
|
“AAA”
|
|
9.7
|
%
|
“AA”
|
|
47.2
|
|
“A”
|
|
28.8
|
|
“BBB”
|
|
13.5
|
|
Below investment grade
|
|
0.8
|
|
Total
|
|
100.0
|
%
|
Investments that we currently own could be subject to default by the issuer or could suffer declines in fair value that become other-than-temporary. We regularly assess individual securities as part of our ongoing portfolio management, including the identification of other-than-temporary declines in fair value. Our other-than-temporary impairment assessment includes reviewing the extent and duration of declines in the fair value of investments below amortized cost, historical and projected financial performance and near-term prospects of the issuer, the outlook for industry sectors, credit rating, and macro-economic changes. We also make a determination as to whether it is not more likely than not that we will be required to sell the security before its fair value recovers above cost, or maturity.
Based on our reviews of fixed maturity and equity securities, we believe that we appropriately identified the declines in the fair values of our unrealized losses for the
nine
months ended
September 30, 2016
. We determined that the unrealized losses on fixed maturity securities were primarily the result of prevailing interest rates and not the credit quality of the issuers. The fixed maturity securities whose fair value was less than amortized cost were not determined to be other-than-temporarily impaired given the severity and duration of the impairment, the credit quality of the issuers, the Company’s intent to not sell the securities, and a determination that it is not more likely than not that the Company will be required to sell the securities until fair value recovers to above cost, or maturity.
Based on reviews of the equity securities, the Company recognized a total impairment of
$5.3 million
in the fair value of
32
equity securities for the
nine
months ended
September 30, 2016
, as a result of our intent to sell and/or the severity and duration of the change in fair value of the securities. The remaining unrealized losses on equity securities were not considered to be other-than-temporary due to the financial condition and near-term prospects of the issuers. The other-than-temporary impairment of equity securities was primarily due to the downturn in the energy sector that occurred in the first quarter of
2016
.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Critical Accounting Policies
These unaudited interim consolidated financial statements include amounts based on the use of estimates and judgments of management for those transactions that are not yet complete. We believe that the estimates and judgments that were most critical to the preparation of the consolidated financial statements involved the following: (a) reserves for losses and LAE; (b) reinsurance recoverables; (c) recognition of premium income; (d) deferred income taxes; and (e) valuation of investments. These estimates and judgments require the use of assumptions about matters that are highly uncertain and therefore are subject to change as facts and circumstances develop. Our accounting policies are discussed under "Critical Accounting Policies" in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk, interest rate risk, and equity price risk, and are described in detail in our Annual Report. We have not experienced any material changes in market risk since
December 31, 2015
.
The primary market risk exposure to our investment portfolio, which consists primarily of fixed maturity securities, is interest rate risk. We have the ability to hold fixed maturity securities to maturity and we strive to limit interest rate risk by managing duration. As of
September 30, 2016
, our fixed maturity securities portfolio had a duration of
4.2
. We continually monitor the impact of interest rate changes on our investment portfolio and liquidity obligations. Changes to our market risk, if any, since
December 31, 2015
are reflected in Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements contained in this Form 10-Q.