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 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.
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, accident year loss estimates, 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
36
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 given our expertise in underwriting this market segment. 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 ongoing business initiatives, including: focusing on internal and customer-facing business process excellence; accelerating the settlement of open claims; diversifying our risk exposure across geographic markets; utilizing a multi-company pricing platform; utilizing territory-specific pricing; and leveraging data-driven strategies to target, price, and underwrite profitable classes of business across all of our markets.
There is significant competition in the national workers' compensation industry that is based on price and quality of services. We compete with other specialty workers' compensation carriers, state agencies, multi-line insurance companies, professional employer organizations, self-insurance funds, and state insurance pools.
Pricing on our renewals showed overall price decreases of 2.6% and 1.8% versus the rate levels in effect on such business a year ago for the
three
and
six
months ended
June 30, 2017
, respectively. Despite the competitive market conditions we currently face, through our efforts thus far in 2017, we believe that we have continued to write attractive business in new and existing states and have strengthened our relationships with our business partners. As a result, given the strength of our balance sheet, the strong execution of our underwriting, claims, and investment strategies, and our active capital management, we believe that we are well positioned for the current market cycle.
Results of Operations
A primary measure of our performance is our ability to increase our Adjusted stockholders' equity over the long-term. We believe that this measure is important to our investors, analysts, and other interested parties who benefit from having an objective and consistent basis for comparison with other companies within our industry. The following table shows a reconciliation of our stockholders' equity on a GAAP basis to our Adjusted stockholders' equity.
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2017
|
|
December 31, 2016
|
|
|
(in millions, except share data)
|
GAAP stockholders' equity
|
|
$
|
899.2
|
|
|
$
|
840.6
|
|
Deferred reinsurance gain–LPT Agreement
|
|
168.9
|
|
|
174.9
|
|
Less: Accumulated other comprehensive income, net
|
|
90.3
|
|
|
74.5
|
|
Adjusted stockholders' equity
(1)
|
|
$
|
977.8
|
|
|
$
|
941.0
|
|
|
|
(1)
|
Adjusted stockholders' equity is a non-GAAP measure consisting of total GAAP stockholders' equity plus the Deferred Gain, less Accumulated other comprehensive income, net.
|
Our net income was
$24.8 million
and
$48.0 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$26.8 million
and
$48.6 million
for the corresponding periods of
2016
. Our underwriting income was
$11.5 million
and
$20.5
million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$9.7 million
and
$18.4 million
for the same periods of
2016
. 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 three and six months ended June 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.
The components of net income are set forth in the following table:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
June 30,
|
|
June 30,
|
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
|
|
(in millions)
|
Gross premiums written
|
|
$
|
184.5
|
|
|
$
|
190.6
|
|
|
$
|
382.1
|
|
|
$
|
381.3
|
|
Net premiums written
|
|
$
|
183.0
|
|
|
$
|
188.7
|
|
|
$
|
379.1
|
|
|
$
|
377.4
|
|
|
|
|
|
|
|
|
|
|
Net premiums earned
|
|
$
|
171.7
|
|
|
$
|
176.9
|
|
|
$
|
347.1
|
|
|
$
|
349.5
|
|
Net investment income
|
|
18.2
|
|
|
18.4
|
|
|
36.9
|
|
|
36.2
|
|
Net realized gains on investments
|
|
1.1
|
|
|
6.0
|
|
|
3.3
|
|
|
7.5
|
|
Gain on redemption of notes payable
|
|
2.1
|
|
|
—
|
|
|
2.1
|
|
|
—
|
|
Other income
|
|
0.1
|
|
|
0.5
|
|
|
0.1
|
|
|
0.6
|
|
Total revenues
|
|
193.2
|
|
|
201.8
|
|
|
389.5
|
|
|
393.8
|
|
|
|
|
|
|
|
|
|
|
Losses and LAE
|
|
106.1
|
|
|
111.7
|
|
|
215.0
|
|
|
219.0
|
|
Commission expense
|
|
21.5
|
|
|
21.9
|
|
|
43.0
|
|
|
42.2
|
|
Underwriting and other operating expenses
|
|
32.6
|
|
|
33.6
|
|
|
68.6
|
|
|
69.9
|
|
Interest expense
|
|
0.4
|
|
|
0.4
|
|
|
0.8
|
|
|
0.8
|
|
Income tax expense
|
|
7.8
|
|
|
7.4
|
|
|
14.1
|
|
|
13.3
|
|
Total expenses
|
|
168.4
|
|
|
175.0
|
|
|
341.5
|
|
|
345.2
|
|
Net income
|
|
$
|
24.8
|
|
|
$
|
26.8
|
|
|
$
|
48.0
|
|
|
$
|
48.6
|
|
Less amortization of the Deferred Gain related to losses
|
|
$
|
2.5
|
|
|
$
|
2.2
|
|
|
$
|
4.9
|
|
|
$
|
4.8
|
|
Less amortization of the Deferred Gain related to contingent commission
|
|
0.6
|
|
|
0.5
|
|
|
1.1
|
|
|
1.0
|
|
Less impact of LPT Reserve Adjustments
(1)
|
|
—
|
|
|
3.1
|
|
|
—
|
|
|
3.1
|
|
Less impact of LPT Contingent Commission Adjustments
(2)
|
|
—
|
|
|
1.8
|
|
|
—
|
|
|
1.8
|
|
Net income before impact of the LPT Agreement
(3)
|
|
$
|
21.7
|
|
|
$
|
19.2
|
|
|
$
|
42.0
|
|
|
$
|
37.9
|
|
|
|
(1)
|
LPT Reserve Adjustments result in a cumulative adjustment to the Deferred Gain, which is recognized in losses and LAE incurred on our Consolidated Statements of Comprehensive Income, such that the Deferred Gain reflects the balance that would have existed had the revised reserves been recognized at the inception of the LPT Agreement.
|
|
|
(2)
|
LPT Contingent Commission Adjustments result in a cumulative adjustment to the Deferred Gain, which is recognized in losses and LAE incurred on our 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.
|
|
|
(3)
|
We define net income before impact of the LPT Agreement as net income before the impact of: (a) amortization of the Deferred Gain; (b) adjustments to the LPT Agreement ceded reserves; and (c) adjustments to the Contingent commission receivable–LPT Agreement. The Deferred Gain reflects the unamortized gain from the LPT Agreement. Under GAAP, this gain is deferred and is being amortized using the recovery method in which 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 our 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 our ongoing 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 affect 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 were
$184.5 million
and
$382.1 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$190.6 million
and
$381.3 million
for the corresponding periods of
2016
. The year-over-year decrease for the
three
months ended
June 30, 2017
was primarily due to $6.2 million decrease in final audit premiums and a decline in renewal business premium, partially offset by an increase in new business premium written year-over-year. The increase for the
six
months ended
June 30, 2017
was primarily due to an increase in new business premium, partially offset by a $2.3 million decrease in final audit premiums. The increases in new business premium were primarily driven by higher payroll exposure, partially offset by decreases in average rates of 2.6% and 1.8% for the
three
and
six
months ended
June 30, 2017
, respectively.
Net Premiums Written
Net premiums written were
$183.0 million
and
$379.1 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$188.7 million
and
$377.4 million
for the corresponding periods of
2016
. Reinsurance premiums ceded were
$1.5 million
and
$3.0 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$1.9 million
and
$3.9 million
for the corresponding periods of
2016
.
Net Premiums Earned
Net premiums earned were
$171.7 million
and
$347.1 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$176.9 million
and
$349.5 million
for the corresponding periods of
2016
. Net premiums earned are primarily a function of the amount and timing of net premiums previously written.
The following table shows the percentage change in our in-force premiums, policy count, average policy size, and payroll exposure upon which our premiums are based for California, where
56%
of our premiums were generated, and for all other states, excluding California:
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of June 30, 2017
|
|
Year-to-Date (Decrease) Increase
|
|
Year-Over-Year (Decrease) Increase
|
|
Overall
|
|
California
|
|
All Other States
|
|
Overall
|
|
California
|
|
All Other States
|
In-force premiums
|
0.4
|
%
|
|
0.2
|
%
|
|
0.8
|
%
|
|
1.1
|
%
|
|
0.5
|
%
|
|
1.9
|
%
|
In-force policy count
|
0.7
|
|
|
(1.8
|
)
|
|
3.3
|
|
|
0.8
|
|
|
(3.5
|
)
|
|
5.2
|
|
Average in-force policy size
|
(0.3
|
)
|
|
2.0
|
|
|
(2.4
|
)
|
|
0.3
|
|
|
4.2
|
|
|
(3.2
|
)
|
In-force payroll exposure
|
1.8
|
|
|
2.8
|
|
|
1.2
|
|
|
1.7
|
|
|
2.1
|
|
|
1.5
|
|
Our in-force premiums and policy count in the LA Area of California declined 7.3% and 10.6%, respectively, year-over-year as of
June 30, 2017
, while our in-force premiums and policy count in California outside of the LA Area increased 5.9% and 1.3%, respectively, during the same period. The year-over-year increase in overall in-force premiums was primarily driven by higher payroll exposure and increased policy count.
The following table shows our in-force premiums and number of policies in-force for each state with at least five percent of our in-force premiums and all other states combined for the periods presented:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2017
|
|
December 31, 2016
|
|
June 30, 2016
|
|
December 31, 2015
|
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
|
|
$
|
348.9
|
|
|
41,346
|
|
|
$
|
348.3
|
|
|
42,120
|
|
|
$
|
347.0
|
|
|
42,858
|
|
|
$
|
352.2
|
|
|
44,080
|
|
Florida
|
|
39.1
|
|
|
5,527
|
|
|
35.2
|
|
|
5,263
|
|
|
31.2
|
|
|
5,015
|
|
|
29.4
|
|
|
4,735
|
|
Illinois
|
|
28.4
|
|
|
3,023
|
|
|
30.6
|
|
|
3,106
|
|
|
31.9
|
|
|
3,224
|
|
|
32.5
|
|
|
3,286
|
|
Other
(33 states and D.C.)
|
|
205.0
|
|
|
35,546
|
|
|
204.5
|
|
|
34,333
|
|
|
204.4
|
|
|
33,671
|
|
|
205.4
|
|
|
32,395
|
|
Total
|
|
$
|
621.4
|
|
|
85,442
|
|
|
$
|
618.6
|
|
|
84,822
|
|
|
$
|
614.5
|
|
|
84,768
|
|
|
$
|
619.5
|
|
|
84,496
|
|
Our alternative distribution channels that utilize partnerships and alliances generated
$164.0 million
and
$150.2 million
, or
26.4%
and
24.4%
, of our in-force premiums as of
June 30, 2017
and
2016
, 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 in fixed maturity securities, equity securities, short-term investments, 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
1.1%
and
increased
1.9%
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to the same periods of
2016
. The average pre-tax book yield on invested assets remained consistent at
3.2%
as of
June 30, 2017
and
2016
, and the average tax-equivalent yield on our invested assets (which adjusts the book yield of our investments in tax-advantaged securities to an equivalent pre-tax book yield) was
3.7%
in each period. Average invested assets period over period remained relatively consistent. Additionally, Investment income was impacted by certain non-recurring investment management fees and expenses during the second quarter of 2017 that decreased our investment income during the period.
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
$1.1 million
and
$3.3 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$6.0 million
and
$7.5 million
for the corresponding periods of
2016
. The higher net realized gains on investments for the
three
and
six
months ended
June 30, 2016
was related to the sale of equity securities during the second quarter of
2016
, as part of a routine rebalancing of our equity investment portfolio. Net realized gains were partially offset by
$0.2 million
and
$5.3 million
in other-than-temporary impairments for the
six
months ended
June 30, 2017
and
2016
, respectively.
Additional information regarding our Investments is set forth under “—Liquidity and Capital Resources—Investments.”
Losses and LAE, Commission Expenses, and Underwriting and Other Operating Expenses
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. A combined ratio below 100% indicates that an insurance company is generating an underwriting profit, and conversely, a combined ratio above 100% indicates that an insurance company is generating an underwriting loss.
The following table provides the calculation of our calendar year combined ratios.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
June 30,
|
|
June 30,
|
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
Loss and LAE ratio
|
|
61.8
|
%
|
|
63.1
|
%
|
|
61.9
|
%
|
|
62.7
|
%
|
Underwriting and other operating expenses ratio
|
|
19.0
|
|
|
19.0
|
|
|
19.8
|
|
|
19.9
|
|
Commission expense ratio
|
|
12.5
|
|
|
12.4
|
|
|
12.4
|
|
|
12.1
|
|
Combined ratio
|
|
93.3
|
%
|
|
94.5
|
%
|
|
94.1
|
%
|
|
94.7
|
%
|
We include all of the operating expenses of our holding company in the calculation of our combined ratio, which served to increase our combined ratios by 2.0 and 2.1 percentage points for the
three
and
six
months ended
June 30, 2017
, respectively, compared to 1.6 and 1.7 percentage points for the corresponding periods of
2016
.
Loss and LAE Ratio
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 and management judgment.
Our indemnity claims frequency (the number of claims expressed as a percentage of payroll) continued to decrease year-over-year and, beginning in the first quarter of
2017
, our loss experience indicates a slight downward 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 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 1.3 and 0.8 percentage for the
three
and
six
months ended
June 30, 2017
, compared to the same periods of
2016
, while the amount of our losses and LAE
decreased
5.0%
and
1.8%
for the
three
and
six
months ended
June 30, 2017
, respectively. The decrease in the amounts of our loss and LAE were primarily attributable to decreases in net premiums earned and decreases in our current accident year loss estimates. Prior accident year favorable loss development was related to our assigned risk business.
Our current accident year loss and LAE ratios were
63.8%
for each of the
three
and
six
months ended
June 30, 2017
, compared to
68.6%
and
66.4%
for the corresponding periods of
2016
. The current accident year loss estimates for the
three
and
six
months ended
June 30, 2016
were also impacted by $6.5 million in large losses recognized in the second quarter of 2016, which resulted in a 3.7 and 1.9 percentage point increase in the current accident year loss estimates for the
three
and
six
months ended
June 30, 2016
, respectively. The decrease in our current accident year loss and LAE ratio also reflects the continued impact of key business initiatives, including: an emphasis on the settlement of open claims; diversifying our risk exposure across geographic markets; and leveraging data-driven strategies to target, underwrite, and price profitable classes of business across all of our markets.
Excluding the impact from the LPT Agreement, losses and LAE would have been
$109.2 million
and
$119.3 million
, or
63.6%
and
67.4%
of net premiums earned, for the three months ended
June 30, 2017
and
2016
, respectively. For the
six
months ended
June 30, 2017
and
2016
, losses and LAE, excluding the impact of the LPT, would have been
$221.0 million
and
$229.7 million
, or
63.7%
and
65.7%
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
|
|
Six Months Ended
|
|
|
June 30,
|
|
June 30,
|
|
|
2017
|
|
2016
|
|
2017
|
|
2016
|
|
|
(in millions)
|
Prior accident year favorable loss development, net
|
|
$
|
0.3
|
|
|
$
|
2.0
|
|
|
$
|
0.3
|
|
|
$
|
2.3
|
|
Amortization of the Deferred Gain related to losses
|
|
$
|
2.5
|
|
|
$
|
2.2
|
|
|
$
|
4.9
|
|
|
$
|
4.8
|
|
Amortization of the Deferred Gain related to contingent commission
|
|
0.6
|
|
|
0.5
|
|
|
1.1
|
|
|
1.0
|
|
Impact of LPT Reserve Adjustments
|
|
—
|
|
|
3.1
|
|
|
—
|
|
|
3.1
|
|
Impact of LPT Contingent Commission Adjustments
|
|
—
|
|
|
1.8
|
|
|
—
|
|
|
1.8
|
|
Total impact of the LPT on losses and LAE
|
|
3.1
|
|
|
7.6
|
|
|
6.0
|
|
|
10.7
|
|
Total losses and LAE reserve adjustments
|
|
$
|
3.4
|
|
|
$
|
9.6
|
|
|
$
|
6.3
|
|
|
$
|
13.0
|
|
Underwriting and Other Operating Expenses Ratio
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 was unchanged for the
three
months ended
June 30, 2017
and decreased 0.1 percentage point for the
six
months ended
June 30, 2017
, each compared to the corresponding periods of 2016. Underwriting and other operating expenses
decreased
3.0%
and
1.9%
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to the same periods of
2016
. The decrease for the
three
months ended
June 30, 2017
was primary due to a $0.7 million decrease in premium taxes and assessments.
During the
six
months ended
June 30, 2017
, our premium taxes and assessments decreased $1.4 million and our bad debt expense decreased $0.9 million, partially offset by a $1.4 million increase in our compensation-related expenses, compared to the same period of
2016
.
Commission Expense Ratio
Commission expenses include 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 0.1 and 0.3 percentage points for the
three
and
six
months ended
June 30, 2017
, respectively, compared to the same periods of
2016
. The increases in the commission expense ratios were primarily the result of a nine percent year-over-year increase in the percentage of business produced by our partnerships and alliances (which are subject to a higher commission rate), partially offset by decreases in net premiums earned.
Income Tax Expense
Income tax expense was
$7.8 million
and
$14.1 million
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
$7.4 million
and
$13.3 million
for the corresponding periods of
2016
. The effective tax rates were
23.9%
and
22.7%
for the
three
and
six
months ended
June 30, 2017
, respectively, compared to
21.6%
and
21.5%
for the same periods of
2016
. Tax-advantaged investment income, LPT Reserve Adjustments, Deferred Gain amortization, and certain other adjustments reduced our effective income tax rate below the U.S. statutory rate of 35%.
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 any outstanding debt obligations, provide additional surplus to our insurance subsidiaries, and fund our operating expenses.
Total cash and investments at the holding company were
$43.2 million
at
June 30, 2017
, consisting of
$7.3 million
of cash and cash equivalents,
$4.3 million
of short-term investments and
$31.6 million
of fixed maturity securities. We do not currently have a revolving credit facility because we believe that the holding company's cash needs for the foreseeable future will be met with its cash and investments on hand, as well as dividends available from its insurance subsidiaries.
Operating Subsidiaries' Liquidity
The primary sources of cash for our insurance operating subsidiaries are premium collections, investment income, sales and maturities of investments and reinsurance recoveries. The primary uses of cash for our insurance subsidiaries are payments of losses and LAE, commission expenses, underwriting and other operating expenses, ceded reinsurance, investment purchases and dividends paid to their parent.
Total cash and investments held by our operating subsidiaries was
$2,621.4 million
at
June 30, 2017
, consisting of
$33.5 million
of cash and cash equivalents,
$1.2 million
of short-term investments,
$2,386.5 million
of fixed maturity securities,
$199.7 million
of equity securities, and
$0.5 million
of other invested assets. Sources of immediate and unencumbered liquidity at our operating subsidiaries as of
June 30, 2017
consisted of $33.1 million of cash and cash equivalents, $155.1 million of publicly-traded equity securities whose proceeds are available within four business days, and $1,191.9 million of highly liquid fixed maturity securities whose proceeds are available within four business days. We believe that our subsidiaries' liquidity needs for the foreseeable future will be met with cash from operations, investment income, and maturing investments.
Each of our insurance subsidiaries is a member of the FHLB. 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, 2017, we entered into a new reinsurance program that is effective through June 30, 2018. 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 investment securities or letters of credit on deposit with certain states in which we do business. Securities having a fair value of
$1,176.4 million
and
$1,009.7 million
were on deposit at
June 30, 2017
and
December 31, 2016
, respectively. These laws and regulations govern both the amount and types of investment 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 our ceding reinsurers was
$25.1 million
and
$27.2 million
at
June 30, 2017
and
December 31, 2016
, respectively.
Sources of Liquidity
We monitor the cash flows of each of our subsidiaries individually, as well as collectively as a consolidated group. We use trend and variance analyses to project future cash needs, making adjustments to our forecasts, as appropriate.
The table below shows our net cash flows for the
six
months ended.
|
|
|
|
|
|
|
|
|
|
|
|
June 30,
|
|
|
2017
|
|
2016
|
|
|
(in millions)
|
Cash and cash equivalents provided by (used in):
|
|
|
|
|
Operating activities
|
|
$
|
42.6
|
|
|
$
|
42.7
|
|
Investing activities
|
|
(48.8
|
)
|
|
35.6
|
|
Financing activities
|
|
(18.4
|
)
|
|
(6.7
|
)
|
(Decrease) Increase in cash and cash equivalents
|
|
$
|
(24.6
|
)
|
|
$
|
71.6
|
|
For additional information regarding our cash flows, see Item 1, Consolidated Statements of Cash Flows.
Operating Activities
Net cash provided by operating activities for the
six
months ended
June 30, 2017
included net premiums received of $349.5 million, and investment income received of $44.5 million. These operating cash inflows were partially offset by net claims payments of $216.6 million, underwriting and other operating expenses paid of $79.9 million, and commissions paid of $39.2 million.
Net cash provided by operating activities for the
six
months ended
June 30, 2016
included net premiums received of $349.8 million, and investment income received of $43.6 million. These operating cash inflows were partially offset by net claims payments of $215.1 million, underwriting and other operating expenses paid of $88.8 million, and commissions paid of $40.5 million.
Investing Activities
Net cash used in investing activities for the
six
months ended
June 30, 2017
was primarily related to the investment of premiums received and the reinvestment of funds from maturities, redemptions, and interest income. These investing cash outflows were partially offset by investment sales whose proceeds were used to fund claims payments, underwriting and other operating expenses, stockholder dividend payments, and common stock repurchases.
Net cash provided by investing activities for the
six
months ended
2016
was primarily related to proceeds from the sales, maturities, and redemptions of investments, partially offset by the purchases of fixed maturity and equity securities.
Financing Activities
Net cash used in financing activities for the
six
months ended
June 30, 2017
was primarily related to stockholder dividend payments and the redemption of notes payable.
Net cash used in financing activities for the
six
months ended
June 30, 2016
included purchases of our common stock and stockholder dividend payments. These financing cash outflows were offset by net proceeds from stock-based compensation, mainly proceeds and income tax benefits from exercises of stock options.
Dividends
Stockholder dividends paid were
$9.8 million
and
$5.9 million
for the
six
months ended
June 30, 2017
and
2016
, respectively. On
July 26, 2017
, the Board of Directors declared a
$0.15
dividend per share and eligible RSU and PSU, payable
August 23, 2017
, to stockholders of record on
August 9, 2017
.
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
June 30, 2017
, we repurchased a total of
724,381
shares of common stock under the 2016 Program at an average price of
$29.08
per share, including commissions, for a total cost of
$21.1 million
. We made no repurchases of common stock during the
six
months ended
June 30, 2017
.
Capital Resources
As of
June 30, 2017
, the capital resources available to us consisted of: (i) $
20.0 million
of notes payable consisting of surplus notes maturing in 2034; (ii)
$899.2 million
of stockholders’ equity; and (iii) the
$168.9 million
Deferred Gain.
Notes Payable
In May of 2017, we redeemed $12.0 million of notes payable for $9.9 million, resulting in a $2.1 million gain.
Contractual Obligations and Commitments
The following table identifies our debt and contractual obligations as of
June 30, 2017
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Payment Due By Period
|
|
|
Total
|
|
Less Than
1-Year
|
|
1-3 Years
|
|
4-5 Years
|
|
More Than
5 Years
|
|
|
(in millions)
|
Operating leases
|
|
$
|
28.2
|
|
|
$
|
4.6
|
|
|
$
|
9.2
|
|
|
$
|
5.6
|
|
|
$
|
8.8
|
|
Purchase obligations
|
|
7.0
|
|
|
3.0
|
|
|
2.4
|
|
|
1.6
|
|
|
—
|
|
Notes payable
(1)
|
|
38.2
|
|
|
1.1
|
|
|
2.1
|
|
|
2.1
|
|
|
32.9
|
|
Capital leases
|
|
0.6
|
|
|
0.3
|
|
|
0.2
|
|
|
0.1
|
|
|
—
|
|
Losses and LAE reserves
(2)(3)
|
|
2,284.9
|
|
|
395.9
|
|
|
488.3
|
|
|
286.2
|
|
|
1,114.5
|
|
Total contractual obligations
|
|
$
|
2,358.9
|
|
|
$
|
404.9
|
|
|
$
|
502.2
|
|
|
$
|
295.6
|
|
|
$
|
1,156.2
|
|
|
|
(1)
|
Notes payable includes payments for the principal and estimated interest expense on our surplus notes outstanding based on LIBOR plus a margin. The interest rates used ranged from
5.2%
to
5.4%
.
|
|
|
(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 claims amounts due to variations between expected and actual payout patterns.
|
|
|
(3)
|
The unpaid losses and LAE reserves are presented gross of reinsurance recoverables for unpaid losses, which were as follows for each of the periods presented above:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries Due By Period
|
|
|
Total
|
|
Less Than
1-Year
|
|
1-3 Years
|
|
4-5 Years
|
|
More Than
5 Years
|
|
|
(in millions)
|
Reinsurance recoverables for unpaid losses and LAE
|
|
$
|
(559.8
|
)
|
|
$
|
(29.8
|
)
|
|
$
|
(56.6
|
)
|
|
$
|
(52.9
|
)
|
|
$
|
(420.5
|
)
|
Investments
Our investment portfolio is structured to support our need for: (i) optimizing our risk-adjusted total return; (ii) providing adequate liquidity; (iii) facilitating financial strength and stability; and (iv) ensuring regulatory and legal compliance.
As of
June 30, 2017
, the total amortized cost of our investment portfolio was
$2,485.0 million
and its fair value was
$2,623.9 million
. These investments provide a source of income, which may fluctuate with changes in interest rates and our current investment strategies.
As of
June 30, 2017
, our investment portfolio, which is classified as available-for-sale, consisted of
92.2%
fixed maturity securities. We strive to limit interest rate risk associated with fixed maturity investments by managing the duration of these securities. Our fixed maturity securities (excluding cash and cash equivalents) had a duration of
4.1
at
June 30, 2017
. 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
June 30, 2017
, with
55.6%
of the portfolio rated "AA" or better, based on market value.
We also have a modest portfolio of equity securities, which we record at fair value. We strive to limit the exposure to equity price risk associated with equity securities by investing primarily in mid-to-large capitalization issuers and by diversifying our holdings across several industry sectors. Equity securities represented
7.6%
of our investment portfolio at
June 30, 2017
.
We believe that our current asset allocation meets our strategy to preserve capital for claims and policy liabilities and to provide sufficient capital resources to support and grow our ongoing insurance operations.
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 (each based on the fair value of each category of invested assets) as of
June 30, 2017
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Category
|
|
Estimated Fair
Value
|
|
Percentage
of Total
|
|
Book Yield
|
|
Tax Equivalent Yield
|
|
|
(in millions, except percentages)
|
U.S. Treasuries
|
|
$
|
136.0
|
|
|
5.2
|
%
|
|
1.8
|
%
|
|
1.8
|
%
|
U.S. Agencies
|
|
13.5
|
|
|
0.5
|
|
|
4.1
|
|
|
4.1
|
|
States and municipalities
|
|
817.1
|
|
|
31.1
|
|
|
3.1
|
|
|
4.5
|
|
Corporate securities
|
|
1,009.3
|
|
|
38.5
|
|
|
3.1
|
|
|
3.1
|
|
Residential mortgage-backed securities
|
|
305.8
|
|
|
11.7
|
|
|
3.1
|
|
|
3.1
|
|
Commercial mortgage-backed securities
|
|
91.3
|
|
|
3.5
|
|
|
2.7
|
|
|
2.7
|
|
Asset-backed securities
|
|
45.7
|
|
|
1.7
|
|
|
2.5
|
|
|
2.5
|
|
Equity securities
|
|
199.7
|
|
|
7.6
|
|
|
6.0
|
|
|
7.9
|
|
Short-term investments
|
|
5.5
|
|
|
0.2
|
|
|
1.1
|
|
|
1.1
|
|
Total
|
|
$
|
2,623.9
|
|
|
100.0
|
%
|
|
|
|
|
|
Weighted average yield
|
|
|
|
|
|
|
|
3.2
|
%
|
|
3.7
|
%
|
The following table shows the percentage of total estimated fair value of our fixed maturity securities as of
June 30, 2017
by credit rating category, using the lower of ratings assigned by Moody's Investors Service or S&P.
|
|
|
|
|
Rating
|
|
Percentage of Total
Estimated Fair Value
|
“AAA”
|
|
8.8
|
%
|
“AA”
|
|
46.8
|
|
“A”
|
|
31.2
|
|
“BBB”
|
|
12.5
|
|
Below investment grade
|
|
0.7
|
|
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.
We believe that we have appropriately identified the declines in the fair values of our unrealized losses for the
six
months ended
June 30, 2017
. 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 principal value upon maturity.
We recognized an impairment of
$0.2 million
(from
one
equity security) during the
six
months ended
June 30, 2017
. The other-than-temporary impairment recognized during this period was the result of the severity and duration of the change in fair value of this equity security. Certain 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, and our intent to hold the securities until fair value recovers to above cost.
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 on Form 10-K. We have not experienced any material changes in market risk since
December 31, 2016
.
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
June 30, 2017
, our fixed maturity securities portfolio had a duration of
4.1
. 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, 2016
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.
Item 4. Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.