UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
Form 10-Q
For the quarterly period ended June 30, 2014
OR
Commission File Number
001-34126
HCI Group, Inc.
(Exact name of Registrant as specified in its charter)
(IRS Employer
Identification No.)
5300 West Cypress Street, Suite 100
Tampa, FL 33607
(Address, including zip code, of principal executive offices)
(813) 849-9500
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate number of shares of the Registrant’s Common Stock, no par value, outstanding on July 24, 2014 was 11,202,338.
HCI GROUP, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
Item 1
Financial Statements
Consolidated Balance Sheets:
June 30, 2014 (unaudited) and December 31, 2013
Consolidated Statements of Income:
Three and six months ended June 30, 2014 and 2013 (unaudited)
Consolidated Statements of Comprehensive Income:
Consolidated Statements of Cash Flows:
Six months ended June 30, 2014 and 2013 (unaudited)
Consolidated Statements of Stockholders’ Equity:
Notes to Consolidated Financial Statements (unaudited)
Item 2
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3
Quantitative and Qualitative Disclosures about Market Risk
Item 4
Controls and Procedures
Legal Proceedings
Item 1A
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults upon Senior Securities
Mine Safety Disclosures
Item 5
Other Information
Item 6
Exhibits
Signatures
Certifications
PART I – FINANCIAL INFORMATION
Item 1 – Financial Statements
Consolidated Balance Sheets
(Dollar amounts in thousands, except share amounts)
Assets
Fixed-maturity securities, available for sale, at fair value (amortized cost: $117,944 and $110,738, respectively)
Equity securities, available for sale, at fair value (cost: $35,791 and $17,248, respectively)
Real estate investments
Total investments
Cash and cash equivalents
Accrued interest and dividends receivable
Premiums receivable
Prepaid reinsurance premiums
Deferred policy acquisition costs
Property and equipment, net
Other assets
Total assets
Liabilities and Stockholders’ Equity
Losses and loss adjustment expenses
Unearned premiums
Advance premiums
Assumed reinsurance balances payable
Accrued expenses
Dividends payable
Income taxes payable
Deferred income taxes, net
Long-term debt
Other liabilities
Total liabilities
Commitments and contingencies (Note 13)
Stockholders’ equity:
7% Series A cumulative convertible preferred stock (liquidation preference $10.00 per share), no par value, 1,500,000 shares authorized, 0 and 110,684 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively
Series B junior participating preferred stock (no par value, 400,000 shares authorized, no shares issued or outstanding)
Preferred stock (no par value, 18,100,000 shares authorized, no shares issued or outstanding)
Common stock, (no par value, 40,000,000 shares authorized, 10,690,069 and 10,939,268 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively)
Additional paid-in capital
Retained income
Accumulated other comprehensive income, net of taxes
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying Notes to Consolidated Financial Statements.
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Consolidated Statements of Income
(Unaudited)
(Dollar amounts in thousands, except per share amounts)
Revenue
Gross premiums earned
Premiums ceded
Net premiums earned
Net investment income
Policy fee income
Net realized investment gains (losses)
Other
Total revenue
Expenses
Policy acquisition and other underwriting expenses
Interest expense
Other operating expenses
Total expenses
Income before income taxes
Income tax expense
Net income
Preferred stock dividends
Income available to common stockholders
Basic earnings per common share
Diluted earnings per common share
Dividends per common share
2
Consolidated Statements of Comprehensive Income
(Amounts in thousands)
Other comprehensive income (loss):
Change in unrealized gain on investments:
Unrealized gain (loss) arising during the period
Call and repayment losses charged to investment income
Reclassification adjustment for realized (gains) losses
Net change in unrealized gain (loss)
Deferred income taxes on above change
Total other comprehensive income (loss)
Comprehensive income
3
Consolidated Statements of Cash Flows
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Stock-based compensation
Net amortization of premiums on investments in fixed-maturity securities
Depreciation and amortization
Deferred income taxes (benefits)
Net realized investment gains
Income from real estate investments
Gain on sale of real estate investment
Foreign currency remeasurement (gain) loss
Changes in operating assets and liabilities:
Premiums and reinsurance receivable
Accrued expenses and other liabilities
Net cash provided by operating activities
Cash flows from investing activities:
Investment in real estate under acquisition, development, and construction arrangement
Purchase of property and equipment, net
Purchase of real estate investments
Purchase of fixed-maturity securities
Purchase of equity securities
Proceeds from sales of fixed-maturity securities
Proceeds from calls, repayments and maturities of fixed-maturity securities
Proceeds from sales of equity securities
Proceeds from sales of real estate investments
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from the issuance of long-term debt
Proceeds from the exercise of common stock options
Cash dividends paid
Cash dividends received under share repurchase forward contract
Repurchases of common stock
Repurchases of common stock under share repurchase plan
Redemption of Series A preferred stock
Debt issuance costs
Tax benefits on stock-based compensation
Net cash (used in) provided by financing activities
(continued)
4
Consolidated Statements of Cash Flows, continued
Effect of exchange rate changes on cash
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosure of cash flow information:
Cash paid for income taxes
Cash paid for interest
Non-cash investing and financing activities:
Unrealized gain (loss) on investments in available-for-sale securities, net of tax
Conversion of Series A Preferred Stock to common stock
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Consolidated Statement of Stockholders’ Equity
Six Months Ended June 30, 2014
Balance at December 31, 2013
Total other comprehensive income, net of income taxes
Conversion of preferred stock to common stock
Issuance of restricted stock
Exercise of common stock options
Forfeiture of restricted stock
Repurchase and retirement of common stock
Repurchase and retirement of common stock under share repurchase plan
Deferred taxes on debt discount
Common stock dividends
Balance at June 30, 2014
6
Consolidated Statement of Stockholders’ Equity - continued
Six Months Ended June 30, 2013
Balance at December 31, 2012
Balance at June 30, 2013
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(Dollar amounts in thousands, except per share amounts, unless otherwise stated)
Note 1 — Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited, consolidated financial statements for HCI Group, Inc. and its subsidiaries (collectively, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information, and the Securities and Exchange Commission (“SEC”) rules for interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position as of June 30, 2014 and the results of operations and cash flows for the periods presented. The results of operations for the interim periods presented are not necessarily indicative of the results of operations to be expected for any subsequent interim period or for the fiscal year ending December 31, 2014. The accompanying unaudited consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2013 included in the Company’s Form 10-K, which was filed with the SEC on March 12, 2014.
In preparing the interim unaudited consolidated financial statements, management was required to make certain judgments, assumptions, and estimates that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the periods being reported upon. Certain of the estimates result from judgments that can be subjective and complex and consequently actual results may differ from these estimates.
Material estimates that are particularly susceptible to significant change in the near term are related to the Company’s losses and loss adjustment expenses, which include amounts estimated for claims incurred but not yet reported. The Company uses various assumptions and actuarial data it believes to be reasonable under the circumstances to make these estimates. In addition, accounting policies specific to reinsurance with retrospective provisions, deferred income taxes, and stock-based compensation expense involve significant judgments and estimates material to the Company’s consolidated financial statements.
All significant intercompany balances and transactions have been eliminated.
Acquisition, Development and Construction Loan Arrangement
The Company has an acquisition, development and construction loan arrangement (“ADC Arrangement”) under which it provides financing to a property developer for the acquisition, development, and construction of a retail shopping center. The Company also expects to participate in the residual profit resulting from the ultimate sale or other use of the property. Classification and accounting for the ADC Arrangement as a loan, an investment in real estate, or joint venture is determined by the Company’s evaluation of the characteristics and the risks and rewards of the ADC Arrangement. If the Company expects to receive more than 50% of the residual profit from the ADC arrangement and it has characteristics similar to a real estate investment, the costs of the real estate project will be capitalized and interest will be recognized in net investment income (see Note 3 — “Investments”).
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In addition, the Company considers any rights or features embedded in the ADC Arrangement that may require bifurcation and derivative accounting. Due to its participation in the expected residual profit, which is deemed a variable interest, the Company evaluates its involvements in the design and essential activities of the entity to which the Company provides financing for possible consolidation as the primary beneficiary under the Variable Interest Model prescribed by the Financial Accounting Standards Board (“FASB”).
Any subsequent changes in terms, rights or the developer’s equity interest that may result in a reclassification or a change in the accounting treatment of the ADC Arrangement will be evaluated. The Company will continually assess the collectability of principal, accrued interest and fees.
Note 2 — Recent Accounting Pronouncements
Accounting Standards Update No. 2014-12. In June 2014, the FASB issued Accounting Standards Update No. 2014-12 (“ASU 2014-12”), Compensation – Stock Compensation (Topic 718). ASU 2014-12 applies to all reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. ASU 2014-12 is effective for all entities for reporting periods beginning after December 15, 2015. Early adoption is permitted. Entities may apply the amendments in this Update either (a) prospectively to all awards granted or modified after the effective date or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. Although the Company has share-based awards with performance targets, none of the awards permit vesting when a performance target is achieved after termination of an employee’s service. Adoption of this guidance had no effect on the Company’s consolidated financial statements.
Accounting Standards Update No. 2014-09. In May 2014, the FASB issued Accounting Standards Update No. 2014-09 (“ASU 2014-09”), Revenue from Contracts with Customers (Topic 606). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the Codification. ASU 2014-09 also amends the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer to be consistent with the guidance on recognition and measurement in this Update. ASU 2014-09 is effective for public entities for reporting periods beginning after December 15, 2016. Early adoption is not permitted. While the guidance specifically excludes revenues from insurance contracts, investments and financial instruments from the scope of the new guidance, the guidance will be applicable to the Company’s other forms of revenue not specifically exempted from the guidance. The adoption of this guidance is not expected to have a material effect on the Company’s consolidated financial statements.
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Note 3 — Investments
The Company holds investments in fixed-maturity securities and equity securities that are classified as available-for-sale. At June 30, 2014 and December 31, 2013, the cost or amortized cost, gross unrealized gains and losses, and estimated fair value of the Company’s available-for-sale securities by security type were as follows:
As of June 30, 2014
Fixed-maturity securities
U.S. Treasury and U.S. government agencies
Corporate bonds
Commercial mortgage-backed securities
State, municipalities, and political subdivisions
Redeemable preferred stock
Total
Equity securities
Total available-for-sale securities
As of December 31, 2013
As of June 30, 2014 and December 31, 2013, $111 and $105, respectively, of U.S. Treasury securities relate to a statutory deposit held in trust for the Treasurer of Alabama.
Expected maturities will differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without penalties. The scheduled contractual maturities of fixed-maturity securities as of June 30, 2014 and December 31, 2013 are as follows:
Available-for-sale
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
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Investment Sales
Proceeds received, and the gross realized gains and losses from sales of available-for-sale securities, for the three and six months ended June 30, 2014 and 2013 were as follows:
Three months ended June 30, 2014
Three months ended June 30, 2013
Six months ended June 30, 2014
Six months ended June 30, 2013
Other-than-temporary Impairment (“OTTI”)
The Company regularly reviews its individual investment securities for OTTI. The Company considers various factors in determining whether each individual security is other-than-temporarily impaired, including:
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Securities with gross unrealized loss positions at June 30, 2014 and December 31, 2013, aggregated by investment category and length of time the individual securities have been in a continuous loss position, are as follows:
Total fixed-maturity securities
The Company believes there are no fundamental issues such as credit losses or other factors with respect to any of its available-for-sale securities. The unrealized losses on investments in fixed-maturity securities were caused primarily by interest-rate changes. It is expected that the securities will not be settled at a price less than the par value of the investments. In determining whether equity securities are other-than-temporarily impaired, the Company considers its intent and ability to hold a security for a period of time sufficient to allow for the recovery of cost. Because the declines in fair value are attributable to changes in interest rates or market conditions and not credit quality, and because the Company has the ability and intent to hold its available-for-sale investments until a market price recovery or maturity, the Company does not consider any of its investments to be other-than-temporarily impaired at June 30, 2014.
12
Real Estate Investments
Real estate investments consist of the following as of June 30, 2014 and December 31, 2013:
Land
Land improvements
Buildings
Total, at cost
Less: accumulated depreciation and amortization
Real estate, net
ADC Arrangement classified as real estate investment
Depreciation and amortization expense related to real estate investments was $100 and $96, respectively, for the three months ended June 30, 2014 and 2013 and $198 and $191, respectively, for the six months ended June 30, 2014 and 2013.
Acquisition, Development and Construction Loan Arrangement (“ADC Arrangement”)
In June 2014, the Company’s wholly owned subsidiary, Greenleaf Capital, LLC, entered into an ADC Arrangement under which it agreed to provide financing up to a maximum of $9,785 for the acquisition, development and construction of a retail shopping center and appurtenant facilities. Greenleaf Capital has an option to purchase the property when the construction project is completed contingent upon tenant rental commitments for at least 90% of rentable space being secured by the developer. The purchase price is calculated at maturity of the loan using a predetermined capitalization rate and the projected net operating income of the developed property. The loan has an initial term of 24 months and can be extended for an additional 12 months if the purchase option is not exercised by Greenleaf Capital. Prepayment is not permitted while the ADC Arrangement is in effect. The loan bears a fixed annual interest rate of 6% due monthly in arrears. The loan agreement is secured by a) a first mortgage on the land and improvements, b) assignment of all leases, rents, issues, and profits from the land and improvements, and c) personal guarantees.
Under this ADC Arrangement, Greenleaf Capital will provide substantially all necessary funds to complete the development and Greenleaf Capital will receive the entire residual profit of the developed property if it exercises the purchase option. The developer may make multiple draws on the credit facility as the construction progresses. Based on the characteristics of this ADC Arrangement which are similar to those of an investment, combined with the expected residual profit being greater than 50%, the arrangement is accounted for and reported in the balance sheet as a real estate investment. All project costs associated with the ADC Arrangement are capitalized. The loan commitment fee received by Greenleaf Capital is deferred and recognized in investment income on a straight-line basis over the term of the loan agreement.
Because of the purchase option and the substantial financial support provided by Greenleaf Capital, the developer who has no equity interest in the property is a variable interest entity (“VIE”). However, Greenleaf Capital’s involvement is solely as the lender on the mortgage loan with
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protective rights as the lender. Greenleaf Capital does not have power to direct the activities that most significantly impact economic performance of the VIE. As a result, Greenleaf Capital is not the primary beneficiary and is not required to consolidate the VIE. At June 30, 2014, the Company’s maximum exposure to loss relating to the VIE was $2,596 representing the carrying value of the ADC Arrangement.
In addition, Greenleaf Capital determined that the option to purchase the entire developed property is not a derivative financial instrument pursuant to U.S. GAAP. As such, the embedded feature is not required to be bifurcated and the fair value accounting for the embedded feature at each reporting date is not applicable.
Note 4 — Fair Value Measurements
The Company records and discloses certain financial assets at their estimated fair value but does not elect the fair value option for the ADC Arrangement and its long-term debt. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows:
The following table presents information about the Company’s financial assets measured at estimated fair value on a recurring basis, the estimated fair values of the real estate investment under the ADC Arrangement, and long-term debt that are reflected in the financial statements at carrying value. The table indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value as of June 30, 2014 and December 31, 2013:
Financial Assets:
Fixed-maturity securities:
Financial Liabilities:
Long-term debt:
8% Senior notes
3.875% Convertible senior notes
Total long-term debt
14
Valuation Methodology
ADC Arrangement Classified as Real Estate Investment. As described in Note 3 — “Investments” under ADC Arrangement, the ADC Arrangement represents a financing agreement with a purchase option between Greenleaf Capital and a property developer. Based on the characteristics of this ADC Arrangement which are similar to those of an investment, combined with the expected residual profit being greater than 50%, the arrangement is included in real estate investments at its carrying value in the balance sheet. Projected future cash inflows at maturity are discounted using a prevailing borrowing rate to estimate its fair value that relies on Level 3 inputs.
There were no transfers between Level 1, 2 or 3 during the three and six months ended June 30, 2014. During the year ended December 31, 2013, $10,684 of municipal bonds was transferred into Level 2 from Level 1.
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Note 5 — Other Assets
The following table summarizes the Company’s other assets:
Benefits receivable related to retrospective reinsurance contracts
Deferred costs related to retrospective reinsurance contracts
Deferred offering costs on senior notes issued in 2013
Prepaid expenses
Total other assets
In June 2014, the Company received $1,485 under the terms of one of the retrospective reinsurance contracts, which terminated May 31, 2014.
Note 6 — Long-Term Debt
The following table summarizes the Company’s long-term debt:
8% Senior Notes, due January 30, 2020
3.875% Convertible Senior Notes, due March 15, 2019*
For the three months ended June 30, 2014 and 2013, interest expense included the contractual interest coupon, discount amortization and amortization of allocated issuance costs aggregating $2,609 and $846, respectively, the amounts of which included non-cash interest expense of $806 and $41, respectively. For the six months ended June 30, 2014 and 2013, interest expense of $5,183 and $1,532, respectively, included non-cash interest expense of $1,588 and $74, respectively. As of June 30, 2014, the remaining amortization period of the debt discount was 4.7 years.
Note 7 — Reinsurance
The Company cedes a portion of its homeowners insurance exposure to other entities under catastrophe excess of loss reinsurance and quota share treaties. The Company remains liable for claims payments in the event that any reinsurer is unable to meet its obligations under the reinsurance agreements. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The Company contracts with a number of reinsurers to secure its annual reinsurance coverage, which generally becomes effective June 1st each year. The Company purchases reinsurance taking into consideration probable maximum losses and reinsurance market conditions.
16
The impact of the catastrophe excess of loss reinsurance and quota share treaties on premiums written and earned is as follows:
Premiums Written:
Direct
Assumed
Gross written
Ceded
Net premiums written
Premiums Earned:
Gross earned
During the three and six months ended June 30, 2014 and 2013, there were no recoveries pertaining to reinsurance contracts that were deducted from losses incurred. At June 30, 2014 and December 31, 2013, prepaid reinsurance premiums related to 28 and 27 reinsurers, respectively, and there were no amounts receivable with respect to reinsurers. Thus, there were no concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums as of June 30, 2014 and December 31, 2013.
Certain of the reinsurance contracts include retrospective provisions that adjust premiums, increase the amount of future coverage, or result in profit commissions in the event losses are minimal or zero. These adjustments are reflected in the statements of income as net reductions in ceded premiums of $5,056 and $1,301, respectively, for the three months ended June 30, 2014 and 2013 and $10,540 and $1,301, respectively, for the six months ended June 30, 2014 and 2013. At June 30, 2014 and December 31, 2013, other assets included $15,677 and $9,009, respectively, and prepaid reinsurance premiums included $5,898 and $3,512, respectively, which are related to these adjustments.
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Note 8 — Losses and Loss Adjustment Expenses
The liability for losses and loss adjustment expenses is determined on an individual case basis for all claims reported. The liability also includes amounts for unallocated expenses, anticipated future claim development and losses incurred, but not reported.
Activity in the liability for unpaid losses and loss adjustment expenses is summarized as follows:
Balance, beginning of period
Incurred related to:
Current period
Prior period
Total incurred
Paid related to:
Total paid
Balance, end of period
The establishment of loss reserves is an inherently uncertain process and changes in loss reserve estimates are expected as such estimates are subject to the outcome of future events. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustments are made. During the three and six months ended June 30, 2014, the Company experienced favorable development of $265 and $614, respectively, with respect to its net unpaid losses and loss adjustment expenses established as of March 31, 2014 and December 31, 2013. Factors attributable to this favorable development include a lower severity of claims and reduced frequency of claims.
The Company writes insurance in the state of Florida, which could be exposed to hurricanes or other natural catastrophes. The occurrence of a major catastrophe could have a significant effect on the Company’s monthly or quarterly results and cause a temporary disruption of the normal operations of the Company. However, the Company is unable to predict the frequency or severity of any such events that may occur in the near term or thereafter.
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Note 9 — Income Taxes
During the three months ended June 30, 2014 and 2013, the Company recorded approximately $9,953 and $10,172, respectively, of income taxes, which resulted in estimated annual effective tax rates of 37.7% and 38.5%, respectively. During the six months ended June 30, 2014 and 2013, the Company recorded approximately $20,643 and $22,955, respectively, of income taxes, which resulted in estimated annual effective tax rates of 37.7% and 38.5%, respectively. The slight decrease in the 2014 effective tax rate was attributable to an increase related to the investment income earned on tax-exempt securities. The Company’s estimated annual effective tax rate differs from the statutory federal tax rate due to state and foreign income taxes as well as certain nondeductible and tax-exempt items. The Company’s 2011 federal income tax return is currently being examined by the Internal Revenue Service. In addition, as of April 18, 2014, the Florida Department of Revenue completed an audit of the state income tax returns filed for 2010, 2011, and 2012. The audit resulted in no material changes to the state income taxes originally reported.
Note 10 — Earnings Per Share
U.S. GAAP requires the Company to use the two-class method in computing basic earnings per share since holders of the Company’s restricted stock have the right to share in dividends, if declared, equally with common stockholders. These participating securities effect the computation of both basic and diluted earnings per share during periods of net income.
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A summary of the numerator and denominator of the basic and diluted earnings per common share is presented below:
Less: Preferred stock dividends
Less: Income attributable to participating securities
Basic Earnings Per Share:
Income allocated to common stockholders
Effect of Dilutive Securities:
Stock options
Convertible preferred stock
Convertible senior notes
Diluted Earnings Per Share:
Income available to common stockholders and assumed conversions
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Note 11 — Stockholders’ Equity
Common Stock
Effective March 18, 2014, the Company’s Board of Directors authorized a plan to repurchase up to $40,000 of the Company’s common shares before commissions and fees. The repurchase plan allows the Company to repurchase shares from time to time through March 31, 2015. The shares may be purchased for cash in open market purchases, block transactions and privately negotiated transactions in accordance with applicable federal securities laws. The share repurchase plan may be modified, suspended, terminated or extended by the Company any time without prior notice. During the three and six months ended June 30, 2014, the Company repurchased and retired a total of 277,510 and 488,346 shares, respectively, at a weighted average price per share of $36.03 and $36.45, respectively, under this authorized repurchase plan. The total costs of shares repurchased, inclusive of fees and commissions, during the three and six months ended June 30, 2014 were $10,005, or $36.05 per share, and $17,810, or $36.47 per share, respectively. At June 30, 2014, a total of $22,200 is available in connection with this plan.
On June 26, 2014, the Company’s Board of Directors declared a quarterly dividend of $0.275 per common share. The dividends are payable on September 19, 2014 to stockholders of record on August 15, 2014.
Preferred Stock
On February 4, 2014, the Company announced its Board of Directors fixed April 1, 2014 as the cancellation date for the conversion rights on its 7% Series A cumulative convertible preferred stock. The Company later extended the conversion privilege in April 2014. On June 2, 2014, 3,386 shares of Series A Preferred were redeemed at $10 per share. During the three and six months ended June 30, 2014, holders of 6,820 and 107,298 shares of Series A Preferred converted their Series A Preferred shares to 6,820 and 107,298 shares of common stock, respectively. As of June 30, 2014, no shares of Series A Preferred were outstanding.
Note 12 — Stock-Based Compensation
Incentive Plans
The Company currently has outstanding stock options and restricted stock granted under the 2007 Stock Option and Incentive Plan and the 2012 Omnibus Incentive Plan. Only the 2012 Plan is available for future grants. At June 30, 2014, there were 4,248,960 shares available for grant under the 2012 plan.
Stock Options
Stock options granted and outstanding under the incentive plans vest over periods ranging from immediately vested to five years and are exercisable over the contractual term of ten years.
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A summary of the stock option activity for the three and six months ended June 30, 2014 and 2013 is as follows (option amounts not in thousands):
Outstanding at January 1, 2014
Exercised
Outstanding at March 31, 2014
Outstanding at June 30, 2014
Exercisable at June 30, 2014
Outstanding at January 1, 2013
Outstanding at March 31, 2013
Outstanding at June 30, 2013
Exercisable at June 30, 2013
The following table summarizes information about options exercised for the three and six months ended June 30, 2014 and 2013 (option amounts not in thousands):
Options exercised
Total intrinsic value of exercised options
Fair value of vested stock options
Tax benefits realized
$
603
The Company recognized compensation expense related to stock options, which is included in other operating expenses, of approximately $1 and $5, respectively, for the three months ended June 30, 2014 and 2013 and $6 and $9, respectively, for the six months ended June 30, 2014 and 2013. At June 30, 2014, there was no unrecognized compensation expense related to stock options. Deferred tax benefits related to stock options for the three and six months ended June 30, 2014 and 2013 were immaterial.
Restricted Stock Awards
From time to time, the Company has granted and may grant restricted stock awards to certain executive officers, other employees and nonemployee directors in connection with their service to the Company. The terms of the Company’s outstanding restricted stock grants may include service, performance and market-based conditions. The fair value of the awards with market-based conditions is determined using a Monte Carlo simulation method, which calculates many potential outcomes for an award and then establishes fair value based on the most likely outcome. The determination of fair value with respect to the awards with only performance or service-based conditions is based on the market value of the Company’s common stock on the grant date.
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Information with respect to the activity of unvested restricted stock awards during the three and six months ended June 30, 2014 and 2013 is as follows (share amounts not in thousands):
Nonvested at January 1, 2014
Granted
Vested
Forfeited
Nonvested at March 31, 2014
Nonvested at June 30, 2014
Nonvested at January 1, 2013
Nonvested at March 31, 2013
Nonvested at June 30, 2013
The Company recognized compensation expense related to restricted stock, which is included in other operating expenses, of $2,247 and $1,080, respectively, for the three months ended June 30, 2014 and 2013 and $4,327 and $1,465, respectively, for the six months ended June 30, 2014 and 2013. At June 30, 2014 and 2013, there was approximately $14,071 and $15,364, respectively, of total unrecognized compensation expense related to nonvested restricted stock arrangements. The Company expects to recognize the remaining compensation expense over a weighted-average period of 25 months. The following table summarizes information about deferred tax benefits recognized related to restricted stock awards as well as their paid dividends and the fair value of vested restricted stock for the three and six months ended June 30, 2014 and 2013:
Deferred tax benefits recognized
Fair value of vested restricted stock
During the three and six months ended June 30, 2014, none of the awards were issued with market-based conditions. The following presents assumptions used in a Monte Carlo simulation model to determine the fair value of the awards with market-based conditions for the three and six months ended June 30, 2013:
Expected dividends per share
Expected volatility
Risk-free interest rate
Estimated cost of capital
Expected life (in years)
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Note 13 — Commitments and Contingencies
Financing Commitment
As described in Note 3 — “Investments” under ADC Arrangement, the Company is contractually committed to provide financing to a property developer for real estate acquisition, development and construction. At June 30, 2014, $7,194 of the available commitment was unused by the property developer.
Premium Tax
In September 2013, the Company received a notice of intent to make audit adjustments from the Florida Department of Revenue in connection with the Department’s audit of the Company’s premium tax returns for the three-year period ended December 31, 2012. The auditor’s proposed adjustments primarily relate to the disallowance of the entire amount of $1,754 in Florida salary credits applicable to that period. The proposed adjustment, which includes interest through September 10, 2013, approximates $1,913. Management has held discussions with the FDR staff and continues working with the Department to resolve this matter. The Company is confident in the merits of its position in claiming the Florida salary credits and intends to vigorously defend its position. As such, and based on the current status of and likelihood of final resolution, the Company has no amount accrued as of June 30, 2014 related to this contingency.
Environmental Matters
In connection with the acquisition of one of the Company’s properties located in Pinellas County, Florida, the Company assumed the liability to complete a site assessment and remediation of environmental contamination that resulted from a petroleum release at the marina site in late 2009. Effective April 17, 2014, the Company received confirmation from the Florida Department of Health in Pinellas County, the agency authorized to administer this case, the site is acceptable and no further action is required.
Note 14 — Related Party Transactions
Claddaugh Casualty Insurance Company, Ltd., the Company’s Bermuda domiciled captive reinsurer has reinsurance treaties with Oxbridge Reinsurance Limited whereby a portion of the business assumed from the Company’s insurance subsidiary, Homeowners Choice Property & Casualty Insurance Company, Inc. (“HCPCI”), is ceded by Claddaugh to Oxbridge. With respect to the period from June 1, 2013 through May 31, 2014, Oxbridge assumed $10,100 of the total covered exposure for approximately $4,900 in premiums. With respect to the period from June 1, 2014 through May 31, 2015, Oxbridge assumed $17,800 of the total covered exposure for approximately $4,935 in premiums. The premiums charged by Oxbridge are at rates which management believes to be competitive with market rates available to Claddaugh. Oxbridge has deposited funds into a trust account to satisfy certain collateral requirements under its reinsurance contract with Claddaugh. Trust assets may be withdrawn by HCPCI, the trust beneficiary, in the event amounts are due under the Oxbridge reinsurance agreements. Among the Oxbridge shareholders are Paresh Patel, the Company’s chief executive officer, who is also chairman of the board of directors for Oxbridge, and members of his immediate family and three of the Company’s non-employee directors including Sanjay Madhu who serves as Oxbridge’s president and chief executive officer.
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Prior to June 1, 2014, Claddaugh also had one reinsurance treaty with Moksha Re SPC Ltd. and multiple capital partners whereby a portion of the business assumed from HCPCI was ceded by Claddaugh to Moksha. With respect to the period from June 1, 2013 through May 31, 2014, Moksha assumed approximately $15,400 of the total covered exposure for approximately $4,300 in premiums, a rate which management believes to be competitive with market rates available to Claddaugh. The $4,300 premium was fully paid by Claddaugh on June 27, 2013. Moksha deposited funds into a trust account to satisfy certain collateral requirements under its reinsurance contract with Claddaugh. Among the Moksha capital partner participants are the Company’s chief executive officer, Paresh Patel, and certain of his immediate family members and Sanjay Madhu, one of the Company’s non-employee directors. This agreement terminated effective May 31, 2014 and has not been renewed.
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ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion under this Item 2 in conjunction with our consolidated financial statements and related notes and information included elsewhere in this quarterly report on Form 10-Q and in our Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 12, 2014. Unless the context requires otherwise, as used in this Form 10-Q, the terms “HCI,” “we,” “us,” “our,” “the Company,” “our company,” and similar references refer to HCI Group, Inc., a Florida corporation incorporated in 2006, and its subsidiaries.
All dollar amounts, except per share amounts stated in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are in thousands unless specified otherwise.
Forward-Looking Statements
In addition to historical information, this quarterly report contains forward-looking statements as defined under federal securities laws. Such statements involve risks and uncertainties, such as statements about our plans, objectives, expectations, assumptions or future events. These statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from any future results, performances or achievements expressed or implied by the forward-looking statements. Typically, forward-looking statements can be identified by terminology such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions. The important factors that could cause actual results to differ materially from those indicated by such forward-looking statements include but are not limited to the effects of governmental regulation; changes in insurance regulations; the frequency and extent of claims; uncertainties inherent in reserve estimates; catastrophic events; changes in the demand for, pricing of, availability of or collectability of reinsurance; restrictions on our ability to change premium rates; increased rate pressure on premiums; and other risks and uncertainties detailed herein and from time to time in our SEC reports.
OVERVIEW – General
HCI Group, Inc. owns subsidiaries engaged in property and casualty insurance, information technology, real estate and reinsurance. Based on our organizational structure, revenue sources, and evaluation of financial and operating performances by management, we manage our operations under one business segment, which includes the following operations:
For the three months ended June 30, 2014 and 2013, revenues from property and casualty insurance operations represented 95.6% and 94.9%, respectively, of total revenues of all operating
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segments. For the six months ended June 30, 2014 and 2013, revenues from property and casualty insurance operations represented 95.9% and 94.8%, respectively, of total revenues of all operating segments. As a result, our property and casualty insurance operations are our only reportable operating segment.
Insurance Operations
Property and Casualty Insurance
Our subsidiary, Homeowners Choice Property & Casualty Insurance Company, Inc. (“HCPCI”), is a leading provider of property and casualty insurance in the state of Florida. HCPCI along with certain of our other subsidiaries currently provides property and casualty insurance to homeowners, condominium owners, and tenants in the state of Florida under our Homeowners Choice brand. HCPCI offers insurance products at competitive rates, while pursuing profitability using selective underwriting criteria.
HCPCI began operations in 2007 by participating in a “take-out program,” which is a legislatively mandated program designed to encourage private insurance companies to assume policies from Citizens Property Insurance Corporation, a Florida state-supported insurer. Our growth since inception has resulted primarily from a series of policy assumptions from Citizens and one from HomeWise Insurance Company. This growth track has been beneficial to us in terms of reduced policy acquisition costs and periods of lower reinsurance costs. Even though expanding our policyholder base through opportunistic assumptions continues to be important to our growth plan, we plan to seek other opportunities to expand and to provide new or additional product offerings. In January 2014, HCPCI began offering flood coverage on a limited basis as a policy endorsement to eligible new and pre-existing Florida customers.
As part of our plan for geographical expansion into other states, Homeowners Choice Assurance Company, Inc. (“HCA”) was organized to enter the Alabama property and casualty insurance market. HCA was approved and licensed by the Alabama Department of Insurance in August 2013. HCA expects to begin writing policies during 2015.
Reinsurance
We have a Bermuda domiciled wholly-owned reinsurance subsidiary, Claddaugh Casualty Insurance Company Ltd., which participates in HCPCI’s reinsurance program.
Other Operations
Information Technology
Our information technology operations include a team of experienced software developers with extensive knowledge in developing web-based products and applications for mobile devices. The operations, which are primarily in India, are focused on developing cloud-based, innovative products or services that can be marketed to the public in addition to providing affiliates with back-office technology support services that can facilitate and improve ongoing operations.
Some of the technologies originally developed in-house for our own insurance operations have been launched for use by third parties. ExzeoTM is a free to join, web-based application available at Exzeo.com that enables seamless integration between organizations, co-workers and business partners. Exzeo allows users to manage projects through communication and collaboration with other participants in a real-time work environment.
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We recently introduced to a selected group of independent insurance agents our new web-based tool called PropletTM. Agents can search a property’s insurance-related information such as wind mitigation reports, inspection reports, claims activity reports or flood zone areas by name, address or by dropping a pin on a specific location on a map interface. In addition, agents can get an instant insurance quote from HCPCI via Proplet. We plan to continually improve this technology as part of our commitment to exceptional service to policyholders and agents.
Real Estate
Our real estate operations consist of several properties we own including our headquarters building in Tampa, Florida and a secondary insurance operations site in Ocala, Florida. In addition, the Ocala location serves as our alternative site in the event we experience any significant disruption at our headquarters building. We also own investment real estate in Treasure Island, Florida and Tierra Verde, Florida with a combined 20 acres of waterfront property.
With the exception of the Ocala location, we lease office or retail space at each location to non-affiliates on various terms. In addition, we own and operate one full-service restaurant and two marinas that we acquired in connection with our purchase of the waterfront properties. The combined marina facilities offer to the general public: a) one dry-stack boat storage facility with capacity for approximately 180 boats; b) approximately 70 wet slips; c) two fuel facilities; and d) open areas for parking and storage. Dry-stack boat storage space is generally rented on a monthly or annual basis while the wet slips are rented on a daily or monthly basis.
In June 2014, the Company’s wholly owned subsidiary, Greenleaf Capital, LLC, entered into an Acquisition, Development and Construction loan arrangement (“ADC Arrangement”) under which it agreed to provide financing up to a maximum of $9,785 for the acquisition, development and construction of a retail shopping center and appurtenant facilities. Greenleaf Capital has an option to purchase the property when the construction project is completed contingent upon tenant rental commitments for at least 90% of rentable space being secured by the developer. We believe this opportunity will enable us to grow our real estate portfolio and diversify our future sources of income. See Note 3 — “Investments” under ADC Arrangement to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q for additional information.
Recent Events
On June 26, 2014, our Board of Directors declared a quarterly dividend of $0.275 per common share. The dividends are payable on September 19, 2014 to stockholders of record on August 15, 2014.
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RESULTS OF OPERATIONS
The following table summarizes our results of operations for the three and six months ended June 30, 2014 and 2013 (dollar amounts in thousands, except per share amounts):
Operating Revenue
Other income
Total operating revenue
Operating Expenses
Total operating expenses
Ratios to Net Premiums Earned:
Loss Ratio
Expense Ratio
Combined Ratio
Ratios to Gross Premiums Earned:
Per Share Data:
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Comparison of the Three Months ended June 30, 2014 to the Three Months ended June 30, 2013
Our results of operations for the three months ended June 30, 2014 reflect income available to common stockholders of $16,431, or $1.39 earnings per diluted common share, compared with $16,203, or $1.40 earnings per diluted common share, for the three months ended June 30, 2013.
Gross Premiums Earned for the three months ended June 30, 2014 and 2013 were $91,221 and $81,952, respectively. The $9,269 increase over the corresponding period in 2013 was primarily attributable to revenue from the Citizens assumption completed in November 2013.
Premiums Ceded for the three months ended June 30, 2014 and 2013 were approximately $28,572 and $24,617, respectively. Our premiums ceded represent amounts paid to reinsurers to cover losses from catastrophes that exceed thresholds defined by our catastrophe excess of loss reinsurance treaties. For the three months ended June 30, 2014 and 2013, premiums ceded reflect reductions of $5,056 and $1,301, respectively, related to the provisions under certain reinsurance contracts. See “Economic Impact of Reinsurance Contracts with Retrospective Provisions” under “Critical Accounting Policies and Estimates.” Our reinsurance rates are based primarily on policy exposures reflected in gross premiums earned. Premiums ceded were 31.3% and 30.0% of gross premiums earned during the three months ended June 30, 2014 and 2013, respectively.
Net Premiums Written during the three months ended June 30, 2014 and 2013 totaled $112,348 and $107,830, respectively. Net premiums written represent the premiums charged on policies issued during a fiscal period less any applicable reinsurance costs.
Net Premiums Earned for the three months ended June 30, 2014 and 2013 were $62,649 and $57,335, respectively, and reflect the gross premiums earned less the appropriate reinsurance costs as described above.
The following is a reconciliation of our total Net Premiums Written to Net Premiums Earned for the three months ended June 30, 2014 and 2013:
Net Premiums Written
Increase in Unearned Premiums
Net Premiums Earned
Net Investment Income for the three months ended June 30, 2014 and 2013 was $1,481 and $295, respectively. The increase in 2014 is primarily due to the increase in our investment portfolio, which has grown from $66,468 at June 30, 2013 to $179,180 at June 30, 2014.
Policy Fee Income for the three months ended June 30, 2014 and 2013 was $638 and $1,426, respectively. The decrease in 2014 from the corresponding period is primarily attributable to the change in the fourth quarter of 2013 in the method of recognizing policy fees, which are recognized ratably over the policy coverage period.
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Our Losses and Loss Adjustment Expenses amounted to $18,383 and $17,414, respectively, during the three months ended June 30, 2014 and 2013. See “Reserves for Losses and Loss Adjustment Expenses” under “Critical Accounting Policies and Estimates.”
Policy Acquisition and Other Underwriting Expenses for the three months ended June 30, 2014 and 2013 of $9,559 and $7,308, respectively, primarily reflect the amortization of deferred acquisition costs, commissions payable to agents for production and renewal of policies, premium taxes and brokerage fees. The $2,251 increase from the corresponding period in 2013 is primarily attributable to commissions and premium taxes related to the policies assumed from Citizens in 2012 and 2013 that have renewed and are included in 2014 direct written premiums.
Interest Expense for the three months ended June 30, 2014 and 2013 was $2,609 and $846, respectively. The $1,763 increase was a result of the 3.875% convertible debt offering completed in December 2013.
Other Operating Expenses for the three months ended June 30, 2014 and 2013 were $9,350 and $7,358, respectively. The $1,992 increase is primarily attributable to a $2,075 increase in compensation and related expenses of which $1,485 relates to stock-based compensation and accrued bonus expense. As of June 30, 2014, we had 176 employees located at our headquarters in Florida compared with 161 employees as of June 30, 2013. We also had 82 employees located in Noida, India at June 30, 2014 versus 64 at June 30, 2013.
Income Tax Expense for the three months ended June 30, 2014 and 2013 were $9,953 and $10,172, respectively, for state, federal, and foreign income taxes resulting in an effective tax rate of 37.7% for 2014 and 38.5% for 2013. The slight decrease in the 2014 effective tax rate was primarily attributable to investment income on tax-exempt securities.
Ratios:
The loss ratio applicable to the three months ended June 30, 2014 (losses and loss adjustment expenses incurred related to net premiums earned) was 29.3% compared with 30.4% for the three months ended June 30, 2013. (See Gross Premiums Earned and Losses and Loss Adjustment Expenses above).
The expense ratio applicable to the three months ended June 30, 2014 (defined as underwriting expenses, interest and other operating expenses related to net premiums earned) was 34.4% compared with 27.0% for the three months ended June 30, 2013. The increase in our expense ratio is primarily attributable to the increase in 2014 specific to compensation and related costs and interest expense.
The combined ratio (total of all expenses in relation to net premiums earned) is the measure of underwriting profitability before other income. Our combined ratio for the three months ended June 30, 2014 was 63.7% compared with 57.4% for the three months ended June 30, 2013.
Due to the impact our reinsurance costs have on net premiums earned from period to period, our management believes the combined ratio measured to gross premiums earned is more relevant in assessing overall performance. The combined ratio to gross premiums earned for the three months ended June 30, 2014 was 43.7% compared with 40.2% for the three months ended June 30, 2013.
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Comparison of the Six Months ended June 30, 2014 to the Six Months ended June 30, 2013
Our results of operations for the six months ended June 30, 2014 reflect income available to common stockholders of $34,054, or $2.84 earnings per diluted common share, compared with $36,556, or $3.20 earnings per diluted common share, for the six months ended June 30, 2013.
Gross Premiums Earned for the six months ended June 30, 2014 and 2013 were $185,109 and $164,499, respectively. The $20,610 increase over the corresponding period in 2013 was primarily attributable to revenue from the Citizens assumption completed in November 2013.
Premiums Ceded for the six months ended June 30, 2014 and 2013 were approximately $56,080 and $46,613, respectively. Our premiums ceded represent amounts paid to reinsurers to cover losses from catastrophes that exceed thresholds defined by our catastrophe excess of loss reinsurance treaties. During the six months ended June 30, 2014 and 2013, premiums ceded reflect reductions of $10,540 and $1,301, respectively, that relate to the provisions under certain reinsurance contracts. See “Economic Impact of Reinsurance Contracts with Retrospective Provisions” under “Critical Accounting Policies and Estimates.” Our reinsurance rates are based primarily on policy exposures reflected in gross premiums earned. Premiums ceded were 30.3% and 28.3% of gross premiums earned during the six months ended June 30, 2014 and 2013, respectively.
Net Premiums Written during the six months ended June 30, 2014 and 2013 totaled $163,779 and $155,083, respectively. Net premiums written represent the premiums charged on policies issued during a fiscal period less any applicable reinsurance costs.
Net Premiums Earned for the six months ended June 30, 2014 and 2013 were $129,029 and $117,886, respectively, and reflect the gross premiums earned less the appropriate reinsurance costs as described above.
The following is a reconciliation of our total Net Premiums Written to Net Premiums Earned for the six months ended June 30, 2014 and 2013:
Net Investment Income for the six months ended June 30, 2014 and 2013 was $2,540 and $434, respectively. The increase in 2014 is primarily due to the increase in our investment portfolio, which has grown from $66,468 at June 30, 2013 to $179,180 at June 30, 2014.
Policy Fee Income for the six months ended June 30, 2014 and 2013 was $895 and $2,198, respectively. The decrease in 2014 from the corresponding period is primarily due to the change in the fourth quarter of 2013 in the method of recognizing policy fees, which are recognized ratably over the policy coverage period.
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Our Losses and Loss Adjustment Expenses amounted to $36,948 and $33,286, respectively, during the six months ended June 30, 2014 and 2013. See “Reserves for Losses and Loss Adjustment Expenses” under “Critical Accounting Policies and Estimates.”
Policy Acquisition and Other Underwriting Expenses for the six months ended June 30, 2014 and 2013 of $18,688 and $13,276, respectively, primarily reflect the amortization of deferred acquisition costs, commissions payable to agents for production and renewal of policies, premium taxes and brokerage fees. The $5,412 increase from the corresponding period in 2013 is primarily attributable to commissions and premium taxes related to the policies assumed from Citizens in 2012 and 2013 that have renewed and are included in 2014 direct written premiums.
Interest Expense for the six months ended June 30, 2014 and 2013 was $5,183 and $1,532, respectively. The $3,651 increase was a result of the 3.875% convertible debt offering completed in December 2013.
Other Operating Expenses for the six months ended June 30, 2014 and 2013 were $18,889 and $13,473, respectively. The $5,416 increase is primarily attributable to a $5,386 increase in compensation and related expenses of which $4,098 relates to stock-based compensation and accrued bonus expense. As of June 30, 2014, we had 176 employees located at our headquarters in Florida compared to 161 employees as of June 30, 2013. We also have 82 employees located in Noida, India at June 30, 2014 versus 64 at June 30, 2013.
Income Tax Expense for the six months ended June 30, 2014 and 2013 were $20,643 and $22,955, respectively, for state, federal, and foreign income taxes resulting in an effective tax rate of 37.7% for 2014 and 38.5% for 2013.
The loss ratio applicable to the six months ended June 30, 2014 (losses and loss adjustment expenses incurred related to net premiums earned) was 28.6% compared with 28.2% for the six months ended June 30, 2013. (See Gross Premiums Earned and Losses and Loss Adjustment Expenses above).
The expense ratio applicable to the six months ended June 30, 2014 (defined as underwriting expenses, interest and other operating expenses related to net premiums earned) was 33.2% compared with 24.0% for the six months ended June 30, 2013. The increase in our expense ratio is primarily attributable to the increase in 2014 specific to compensation and related costs and interest expense.
The combined ratio (total of all expenses in relation to net premiums earned) is the measure of overall underwriting profitability before other income. Our combined ratio for the six months ended June 30, 2014 was 61.8% compared with 52.2% for the six months ended June 30, 2013.
Due to the impact our reinsurance costs have on net premiums earned from period to period, our management believes the combined ratio measured to gross premiums earned is more relevant in assessing overall performance. The combined ratio to gross premiums earned for the six months ended June 30, 2014 was 43.1% compared with 37.4% for the six months ended June 30, 2013.
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Seasonality of Our Business
Our insurance business is seasonal as hurricanes and tropical storms typically occur during the period from June 1 through November 30 each year. Moreover, with our reinsurance treaty year effective June 1 each year, any variation in the cost of our reinsurance, whether due to changes in reinsurance rates or changes in the total insured value of our policy base, will occur and be reflected in our financial results beginning June 1 each year.
LIQUIDITY AND CAPITAL RESOURCES
Over the years, our liquidity requirements have been met through issuance of our common and preferred stock, debt offerings and funds from operations. We expect our future liquidity requirements will be met by funds from operations, primarily the cash received by insurance subsidiaries from premiums written and investment income. We may consider raising additional capital through debt and equity offerings to support our growth and future investment opportunities.
Our insurance subsidiary, Homeowners Choice Property & Casualty Insurance Company, Inc. (“HCPCI”) requires liquidity and adequate capital to meet ongoing obligations to policyholders and claimants and to fund operating expenses. In addition, we attempt to maintain adequate levels of liquidity and surplus to manage any differences between the duration of our liabilities and invested assets. In the insurance industry, cash collected for premiums from policies written is invested, interest and dividends are earned thereon, and loss and loss adjustment expenses are paid out over a period of years. This period of time varies by the circumstances surrounding each claim. A substantial portion of our losses and loss adjustment expenses are fully settled and paid within 90 days of the claim receipt date. Additional cash outflow occurs through payments of commissions, taxes, payroll, and general overhead expenses.
We believe that we maintain sufficient liquidity to pay HCPCI’s claims and expenses, as well as to satisfy commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies. We maintain a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard our financial position.
In the future, we anticipate our primary use of funds will be to pay claims, reinsurance premiums, interest, and dividends and also to fund operating expenses.
Senior Notes
Our long-term debt at June 30, 2014 consisted of 8% Senior Notes due 2020 and 3.875% Senior Convertible Notes due 2019, both of which were issued for gross proceeds of $40,250 and $103,000, respectively, during 2013. We make quarterly interest payments of $805 on the senior notes due 2020 with quarterly payments due on January 30, April 30, July 30 and October 30. We make semiannual interest payments of approximately $1,996 on the convertible notes with payments due in arrears on March 15 and September 15 of each year. See Note 6 — “Long-Term Debt” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q for additional information.
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Share Repurchase Plan
On March 18, 2014, our Board of Directors approved a one-year plan to repurchase up to $40,000 of common shares under which we may purchase shares of common stock in open market purchases, block transactions and privately negotiated transactions in accordance with applicable federal securities laws. See Note 11 — “Stockholders’ Equity” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q and “Part II – Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds” for additional information.
Cash Flows
Cash Flows for the Six months ended June 30, 2014
Net cash provided by operating activities for the six months ended June 30, 2014 was approximately $59,930, which consisted primarily of cash received from net written premiums less cash disbursed for operating expenses, losses and loss adjustment expenses and interest payments. Net cash used in investing activities of $28,069 was primarily due to the purchases of available-for-sale securities of $52,523 and the funding of the ADC Arrangement of $2,591 offset by redemptions and repayments of fixed-maturity securities of $1,630, and the proceeds from sales of available-for-sale securities of $25,892. Net cash used in financing activities totaled $23,223, which was primarily due to $17,810 used in our share repurchase plan and $5,977 of net cash dividend payments.
Cash Flows for the Six months ended June 30, 2013
Net cash provided by operating activities for the six months ended June 30, 2013 was approximately $42,541, which consisted primarily of cash received from net written premiums less cash disbursed for operating expenses, reinsurance premiums and losses and loss adjustment expenses. Net cash used in investing activities of $9,582 was primarily due to the purchases of available-for-sale securities of $11,183, the purchase of $2,692 in property and equipment and the purchase of $115 in other investments offset by redemptions and repayments of fixed-maturity securities of $1,736, and the proceeds from sales of available-for-sale securities of $2,672. Net cash provided by financing activities totaled $33,676, which was primarily due to $40,250 from the sale of the Notes offset by $1,525 in related underwriting and issuance costs paid during the period and $5,094 of cash dividend payments.
Investments
The main objective of our investment policy is to maximize our after-tax investment income with a minimum of risk given the current financial market. Our excess cash is invested primarily in money market accounts and available-for-sale investments.
At June 30, 2014, we had $160,242 of available-for-sale investments, which are carried at fair value. Changes in the general interest rate environment affect the returns available on new fixed-maturity investments. While a rising interest rate environment enhances the returns available on new investments, it reduces the market value of existing fixed-maturity investments and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new fixed-maturity investments but increases the market value of existing fixed-maturity investments, creating the opportunity for realized investment gains on disposition.
With the exception of large national banks, it is our current policy not to maintain cash deposits of more than an aggregate of $5,500 in any one bank at any time. From time to time, we
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may have in excess of $5,500 of cash designated for investment and on deposit at a single national brokerage firm. In the future, we may alter our investment policy as to investments in federal, state and municipal obligations, preferred and common equity securities and real estate mortgages, as permitted by applicable law, including insurance regulations.
OFF-BALANCE SHEET ARRANGEMENTS
As of June 30, 2014, we are contractually committed to provide financing for the acquisition, development and construction of one real estate property. Such commitment is not recognized in the financial statements but is required to be disclosed in the notes to the financial statements. See Note 13 — “Commitments and Contingencies” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q and Contractual Obligations and Commitment below for additional information. As of December 31, 2013, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of SEC Regulation S-K.
CONTRACTUAL OBLIGATIONS AND COMMITMENT
The following table summarizes our contractual obligations and commitment as of June 30, 2014:
Operating lease (1)
Service agreement (1)
Reinsurance contracts (2)
Acquisition, development and construction loan commitment (3)
Long-term debt obligations (4)
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We have prepared our consolidated financial statements and related disclosures in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements and related disclosures requires us to make judgments, assumptions and estimates to develop amounts reflected and disclosed in our financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances. Actual results may differ from these estimates and such differences may be material.
We believe our critical accounting policies and estimates are those related to losses and loss adjustment expenses, reinsurance with retrospective provisions, deferred income taxes, and stock-based
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compensation expense. These policies are critical to the portrayal of our financial condition and operating results. They require management to make judgments and estimates about inherently uncertain matters. Material estimates that are particularly susceptible to significant change in the near term are related to our losses and loss adjustment expense reserves, which include amounts estimated for claims incurred but not yet reported, income taxes and reinsurance contracts with retrospective provisions.
Reserves for Losses and Loss Adjustment Expenses
Our liability for losses and loss adjustment expense (“Reserves”) are specific to property insurance, which is HCPCI’s only line of business. The Reserves include both case reserves on reported claims and our reserves for incurred but not reported (“IBNR”) losses. At each period end date, the balance of our Reserves is based on our best estimate of the ultimate cost of each claim for those known cases and the IBNR loss reserves are estimated based primarily on our historical experience. Changes in the estimated liability are charged or credited to operations as the losses and loss adjustment expenses are adjusted.
The IBNR represents our estimate of the ultimate cost of all claims that have occurred but have not been reported to us, and in some cases may not yet be known to the insured, and future development of reported claims. Estimating the IBNR component of our Reserves involves considerable judgment on the part of management. At June 30, 2014, $21,516 of the total $43,044 we have reserved for losses and loss adjustment expenses is specific to our estimate of IBNR. The remaining $21,528 relates to known cases which have been reported but not yet fully settled in which case we have booked a reserve based on our best estimate of the ultimate cost of each claim. At June 30, 2014, $11,317 of the $21,528 in reserves for known cases relates to claims incurred during prior years.
Our Reserves decreased from $43,686 at December 31, 2013 to $43,044 at June 30, 2014. The $642 decrease in our Reserves is comprised of $18,728 in new reserves specific to the 2014 loss year offset by reductions in our Reserves of $13,437 for 2013 and $5,933 for 2012 and prior loss years. The $18,728 in Reserves established for 2014 claims is primarily due to the increase in our policy count and exposures. The decrease of $19,370 specific to our 2013 and prior loss-year reserves is due both to settlement of claims and favorable development related to those loss years. Factors that are attributable to favorable development may include a lower severity of claims than the severity of claims considered in establishing our Reserves, a lower number of new claims reported than anticipated, and actual case development may be more favorable than originally anticipated.
Based on all information known to us, we believe our Reserves at June 30, 2014 are adequate to cover our claims for losses that had occurred as of that date including losses yet to be reported to us. However, these estimates are subject to trends in claim severity and frequency and must continually be reviewed by management. As part of the process, we review historical data and consider various factors, including known and anticipated regulatory and legal developments, changes in social attitudes, inflation and economic conditions. As experience develops and other data becomes available, these estimates are revised, as required, resulting in increases or decreases to the existing unpaid losses and loss adjustment expenses. Adjustments are reflected in the results of operations in the period in which they are made and the liabilities may deviate substantially from prior estimates.
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Economic Impact of Reinsurance Contracts with Retrospective Provisions
Certain of the reinsurance agreements include retrospective provisions that adjust premiums, increase the amount of future coverage, or result in profit commissions in the event losses are minimal or zero. In accordance with accounting principles generally accepted in the United States of America, we will recognize an asset in the period in which the absence of loss experience gives rise to an increase in future coverage or obligates the reinsurer to pay cash or other consideration under the contract. In the event that a loss arises, we will derecognize such asset in the period in which a loss arises. Such adjustments to the asset, which accrue throughout the contract term, will negatively impact our operating results when a catastrophic loss event occurs.
For the three months ended June 30, 2014 and 2013, we accrued benefits of $4,007 and $802, respectively, and deferred recognition of $1,049 and $499, respectively, in ceded premiums for total reductions in ceded premiums of $5,056 and $1,301, respectively. For the six months ended June 30, 2014 and 2013, we accrued benefits of $7,995 and $802, respectively, and deferred recognition of $2,545 and $499, respectively, in ceded premiums for total reductions in ceded premiums of $10,540 and $1,301, respectively. As of June 30, 2014, we have accrued a benefit of $15,324 and deferred recognition of $6,252 in ceded premiums, amounts that would be charged to earnings in the event we experience a catastrophic loss that exceeds the coverage limits provided under such agreements and in the period that the increased coverage is applicable, respectively.
In addition to Reserves and reinsurance contracts, we believe our accounting policies specific to deferred income taxes and stock-based compensation expense involve our most significant judgments and estimates material to our consolidated financial statements. These accounting estimates and related risks that we consider to be our critical accounting estimates are more fully described in our Annual Report on Form 10-K, which we filed with the SEC on March 12, 2014. For the six months ended June 30, 2014, there have been no material changes with respect to any of our critical accounting policies.
Income Taxes
We account for income taxes in accordance with U.S. GAAP, resulting in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. We determine deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur. Valuation allowances are provided against assets that are not likely to be realized, if any. We have elected to classify interest and penalties, if any, as income tax expense as permitted by current accounting standards.
Stock-Based Compensation
We account for our stock options and restricted stock under the fair value recognition provisions of accounting principles generally accepted in the United States of America, which require the measurement, and recognition of compensation for all stock-based awards made to employees and directors based on estimated fair values. We recognize stock-based compensation in the consolidated statements of income on a straight-line basis over the vesting period. We use the Black-Scholes option-pricing model, which requires the following variables for input to calculate the fair value of each stock option on the grant date: 1) expected volatility of our stock price, 2) the risk-free interest rate, 3) expected term of each award, 4) expected dividends, and 5) an expected forfeiture
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rate. For restricted stock awards with market-based conditions, we estimate their fair values by using a Monte Carlo simulation model, which requires for input the following variables: 1) expected dividends per share, 2) expected volatility, 3) risk-free interest rate, 4) estimated cost of capital, and 5) expected term of each award.
RECENT ACCOUNTING PRONOUNCEMENTS
For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 2 to our Notes to Consolidated Financial Statements.
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our investment portfolio at June 30, 2014 included fixed-maturity and equity securities, the purposes of which are not for trading or speculation. Our main objective is to maximize after-tax investment income and maintain sufficient liquidity to meet policyholder obligations while minimizing market risk, which is the potential economic loss from adverse fluctuations in securities prices. We consider many factors including credit ratings, investment concentrations, regulatory requirements, anticipated fluctuation of interest rates, durations and market conditions in developing investment strategies. Investment securities are managed primarily by investment companies and are overseen by the investment committee appointed by our board of directors.
Our investment portfolios are primarily exposed to interest rate risk, credit risk and equity price risk. Fiscal and economic uncertainties caused by any government action or inaction may exacerbate these risks and potentially have adverse impacts on the value of our investment portfolios.
We classify our fixed-maturity and equity securities as available-for-sale and report any unrealized gains or losses, net of deferred income taxes, as a component of other comprehensive income within our stockholders’ equity. As such, any material temporary changes in their fair value can adversely impact the carrying value of our stockholders’ equity.
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Interest Rate Risk
Our fixed-maturity securities are sensitive to potential losses resulting from unfavorable changes in interest rates. We manage the risk by analyzing anticipated movement in interest rates and considering our future capital needs.
The following table illustrates the impact of hypothetical changes in interest rates to the fair value of our fixed-maturity securities at June 30, 2014 (in thousands):
Hypothetical Change in Interest Rates
300 basis point increase
200 basis point increase
100 basis point increase
100 basis point decrease
200 basis point decrease
300 basis point decrease
Credit Risk
Credit risk can expose us to potential losses arising principally from adverse changes in the financial condition of the issuers of our fixed-maturity securities. We mitigate the risk by investing in fixed-maturity securities that are primarily investment grade and by diversifying our investment portfolio to avoid concentrations in any single issuer or business sector.
The following table presents the composition of our fixed-maturity securities, by rating, at June 30, 2014 (in thousands):
Comparable Rating
AAA
AA+, AA, AA-
A+, A, A-
BBB+, BBB, BBB-
BB+, BB, BB-
Not rated
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Equity Price Risk
Our equity investment portfolio at June 30, 2014 included common stocks, perpetual preferred stocks, mutual funds and exchange traded funds. We may incur potential losses due to adverse changes in equity security prices. We manage the risk primarily through industry and issuer diversification and asset allocation techniques.
The following table illustrates the composition of our equity securities at June 30, 2014 (in thousands):
Stocks by sector:
Financial
Energy
Other (1)
Mutual funds and Exchange traded funds by type:
Debt
Equity
Foreign Currency Exchange Risk
At June 30, 2014, we did not have any material exposure to foreign currency related risk.
ITEM 4 – CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our chief executive officer (our principal executive officer) and our chief financial officer (our principal financial officer), we have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report, and, based on this evaluation, our chief executive officer and our chief financial officer have concluded that these disclosure controls and procedures are effective.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal controls over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Limitations on Effectiveness of Controls and Procedures
In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, implementation of possible controls and procedures depends on management’s judgment in evaluating their benefits relative to costs.
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PART II – OTHER INFORMATION
ITEM 1 – LEGAL PROCEEDINGS
The Company is a party to claims and legal actions arising routinely in the ordinary course of our business. Although we cannot predict with certainty the ultimate resolution of the claims and lawsuits asserted against us, we do not believe that any currently pending legal proceedings to which we are a party will have a material adverse effect on our consolidated financial position, results of operations or cash flows.
ITEM 1a – RISK FACTORS
There have been no material changes from the risk factors previously disclosed in the section entitled “Risk Factors” in our Form 10-K, which was filed with the SEC on March 12, 2014.
ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
The table below summarizes the number of shares of common stock surrendered by employees to satisfy their minimum federal income tax liability associated with the vesting of restricted shares and also the number of common shares repurchased under a share repurchase plan during the three months ended June 30, 2014 (share amounts not in thousands):
For the Month Ended
April 30, 2014
May 31, 2014
June 30, 2014
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Working Capital Restrictions and Other Limitations on Payment of Dividends
We are not subject to working capital restrictions or other limitations on the payment of dividends. Our insurance subsidiary, however, is subject to restrictions on the dividends it may pay. Those restrictions could impact HCI’s ability to pay future dividends.
Under Florida law, a domestic insurer such as our insurance subsidiary, HCPCI, may not pay any dividend or distribute cash or other property to its stockholder except out of that part of its available and accumulated capital and surplus funds which is derived from realized net operating profits on its business and net realized capital gains. Additionally, Florida statutes preclude our insurance subsidiary from making dividend payments or distributions to its stockholder, HCI, without prior approval of the Florida Office of Insurance Regulation if the dividend or distribution would exceed the larger of (1) the lesser of (a) 10.0% of its capital surplus or (b) net income, not including realized capital gains, plus a two year carry forward, (2) 10.0% of capital surplus with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains or (3) the lesser of (a) 10.0% of capital surplus or (b) net investment income plus a three year carry forward with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains.
Alternatively, a Florida domestic insurer may pay a dividend or distribution without the prior written approval of the Florida Office of Insurance Regulation (1) if the dividend is equal to or less than the greater of (a) 10.0% of the insurer’s capital surplus as regards policyholders derived from realized net operating profits on its business and net realized capital gains or (b) the insurer’s entire net operating profits and realized net capital gains derived during the immediately preceding calendar year, (2) the insurer will have policy holder capital surplus equal to or exceeding 115.0% of the minimum required statutory capital surplus after the dividend or distribution, (3) the insurer files a notice of the dividend or distribution with the Florida Office of Insurance Regulation at least ten business days prior to the dividend payment or distribution and (4) the notice includes a certification by an officer of the insurer attesting that, after the payment of the dividend or distribution, the insurer will have at least 115% of required statutory capital surplus as to policyholders. Except as provided above, a Florida domiciled insurer may only pay a dividend or make a distribution (1) subject to prior approval by the FLOIR or (2) 30 days after the Florida Office of Insurance Regulation has received notice of such dividend or distribution and has not disapproved it within such time.
ITEM 3 – DEFAULTS UPON SENIOR SECURITIES
ITEM 4 – MINE SAFETY DISCLOSURES
ITEM 5 – OTHER INFORMATION
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ITEM 6 – EXHIBITS
The following documents are filed as part of this report:
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, who has signed this report on behalf of the Company.
/s/ Paresh Patel
/s/ Richard R. Allen
A signed original of this document has been provided to HCI Group, Inc. and will be retained by HCI Group, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.
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