UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
For the quarterly period ended June 30, 2016
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 27, 2016 was 10,388.360.
HCI GROUP, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
Item 1
Financial Statements
Consolidated Balance Sheets:
June 30, 2016 (unaudited) and December 31, 2015
Consolidated Statements of Income:
Three and six months ended June 30, 2016 and 2015 (unaudited)
Consolidated Statements of Comprehensive Income:
Consolidated Statements of Cash Flows:
Six months ended June 30, 2016 and 2015 (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)
Fixed-maturity securities, available for sale, at fair value (amortized cost: $133,322 and $128,614, respectively)
Equity securities, available for sale, at fair value (cost: $46,045 and $47,548, respectively)
Limited partnership investments, at equity
Investment in unconsolidated joint venture, at equity
Real estate investments (Note 3 - Variable Interest Entity)
Total investments
Cash and cash equivalents (Note 3 - Variable Interest Entity)
Accrued interest and dividends receivable
Income taxes receivable
Premiums receivable
Prepaid reinsurance premiums
Deferred policy acquisition costs
Property and equipment, net
Deferred income taxes, net
Other assets (Note 3 - Variable Interest Entity)
Total assets
Losses and loss adjustment expenses
Unearned premiums
Advance premiums
Assumed reinsurance balances payable
Accrued expenses (Note 3 - Variable Interest Entity)
Long-term debt
Other liabilities (Note 3 - Variable Interest Entity)
Total liabilities
Commitments and contingencies ( Note 13)
Stockholders’ equity:
7% Series A cumulative convertible preferred stock (no par value, 1,500,000 shares authorized, no shares issued and outstanding)
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, 9,837,603 and 10,292,256 shares issued and outstanding at June 30, 2016 and December 31, 2015, respectively)
Additional paid-in capital
Retained income
Accumulated other comprehensive income (loss), 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
Net realized investment gains (losses)
Net other-than-temporary impairment losses recognized in income:
Total other-than-temporary impairment losses
Portion of loss recognized in other comprehensive income, before taxes
Net other-than-temporary impairment losses
Policy fee income
Gain on repurchases of convertible senior notes
Other
Total revenue
Expenses
Policy acquisition and other underwriting expenses
Salaries and wages
Interest expense
Other operating expenses
Total operating expenses
Income before income taxes
Income tax expense
Net income
Basic earnings per share
Diluted earnings per share
Dividends per share
2
Consolidated Statements of Comprehensive Income
(Amounts in thousands)
Other comprehensive income (loss):
Change in unrealized gain (loss) on investments:
Net unrealized gain (loss) arising during the period
Other-than-temporary impairment loss charged to income
Call and repayment losses charged to investment income
Reclassification adjustment for net realized (gains) losses
Net change in unrealized gain (loss)
Deferred income taxes on above change
Total other comprehensive income (loss), net of income taxes
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 tax benefits
Net realized investment (gains) losses
Other-than-temporary impairment losses
Income from real estate investments
(Income) loss from unconsolidated joint venture
Net loss from limited partnership interests
Net loss on disposal or sale of real estate investments
Foreign currency remeasurement loss
Changes in operating assets and liabilities:
Other assets
Income taxes
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
Investments in limited partnership interests
Investment in unconsolidated joint venture
Purchase of property and equipment
Purchase of real estate investments
Purchase of fixed-maturity securities
Purchase of equity securities
Distribution from limited partnership interests
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
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Consolidated Statements of Cash Flows, continued
Cash flows from financing activities:
Proceeds from the exercise of common stock options
Cash dividends paid
Cash dividends received under share repurchase forward contract
Proceeds from issuance of long-term debt
Repurchases of convertible senior notes
Repayment of debt
Repurchases of common stock
Repurchases of common stock under share repurchase plan
Debt issuance costs
Tax benefits on stock-based compensation
Net cash used in financing activities
Effect of exchange rate changes on cash
Net increase (decrease) 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
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Consolidated Statement of Stockholders’ Equity
Six Months Ended June 30, 2016
Balance at December 31, 2015
Total other comprehensive income, net of income taxes
Issuance of restricted stock
Forfeiture of restricted stock
Cancellation of restricted stock
Repurchase and retirement of common stock
Repurchase and retirement of common stock under share repurchase plan
Common stock dividends
Tax shortfalls on stock-based compensation
Balance at June 30, 2016
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Consolidated Statement of Stockholders’ Equity - continued
Six Months Ended June 30, 2015
Balance at December 31, 2014
Total other comprehensive loss, net of income taxes
Exercise of common stock options
Balance at June 30, 2015
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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 consolidated 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 consolidated financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position as of June 30, 2016 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, 2016. 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, 2015 included in the Company’s Form 10-K, which was filed with the SEC on March 4, 2016.
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 for reinsurance contracts 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.
Reclassifications. Certain reclassifications of prior year amounts have been made to conform to the current year presentation.
Note 2 — Recent Accounting Pronouncements
Accounting Standards Update No. 2016-13. In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2016-13 (“ASU 2016-13”), Financial Instruments - Credit Losses (Topic 326), which requires the measurement of credit losses for financial assets at each reporting date based on reasonable and supportable information. ASU 2016-13 also requires enhanced qualitative and quantitative disclosures on significant estimates and judgments used in estimating credit losses. ASU 2016-13 is effective for U.S Securities and
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Exchange Commission filers for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted for entities with fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
Accounting Standards Update No. 2016-12. In May 2016, the FASB issued Accounting Standards Update No. 2016-12 (“ASU 2016-12”), Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, which affects all entities that enter into contracts with customers to transfer goods or services in exchange for consideration. ASU 2016-12 addresses certain issues on assessing collectability, presentation of sales taxes, noncash consideration, completed contracts and contract modification at transition. The amendments in this update will become effective for the Company beginning with the first quarter of 2018. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
Accounting Standards Update No. 2016-10. In April 2016, the FASB issued Accounting Standards Update No. 2016-10 (“ASU 2016-10”), Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, which clarifies the standard on identifying performance obligation and improves the licensing implementation guidance. ASU 2016-10 is effective for the Company beginning with the first quarter of 2018. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
Accounting Standards Update No. 2016-09. In March 2016, the FASB issued Accounting Standards Update No. 2016-09 (“ASU 2016-09”), Compensation-Stock Compensation (Topic 718), which affects all entities that issue share-based awards to their employees. ASU 2016-09 amends the accounting for share-based payment transactions including the related income taxes, classification of awards as either equity or liabilities, and classification on the statement of cash flows. In addition, ASU 2016-09 allows for an accounting policy election to either estimate the number of awards that are expected to vest (current U.S. GAAP) or account for forfeitures when they occur. ASU 2016-09 is effective for all public entities for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
Accounting Standards Update No. 2016-02. In February 2016, the FASB issued Accounting Standards Update No. 2016-02 (“ASU 2016-02”), Leases (Topic 842), which supersedes Topic 840 and creates the new lease accounting standards for lessees and lessors, primarily related to the recognition of lease assets and liabilities by lessees for leases classified as operating leases. ASU 2016-02 is effective for all public entities for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
Accounting Standards Update No. 2016-01. In January 2016, the FASB issued Accounting Standards Update No. 2016-01 (“ASU 2016-01”), Financial Instruments (Subtopic 825-10), which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. One of the changes is to require certain equity investments to be measured at fair value with changes in fair value recognized in net income. ASU 2016-01 is effective for all public entities for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The Company is currently evaluating the impact of this guidance on the Company’s financial statements.
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Note 3 — Investments
Available-for-Sale Securities
The Company holds investments in fixed-maturity securities and equity securities that are classified as available-for-sale. At June 30, 2016 and December 31, 2015, 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, 2016
Fixed-maturity securities
U.S. Treasury and U.S. government agencies
Corporate bonds
State, municipalities, and political subdivisions
Exchange-traded debt
Redeemable preferred stock
Total
Equity securities
Total available-for-sale securities
As of December 31, 2015
As of June 30, 2016 and December 31, 2015, $119 and $113, respectively, of U.S. Treasury securities relate to a statutory deposit held in trust for the Treasurer of Alabama.
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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, 2016 and December 31, 2015 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
Sales of Available-for-Sale Securities
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, 2016 and 2015 were as follows:
Three months ended June 30, 2016
Three months ended June 30, 2015
Six months ended June 30, 2016
Six months ended June 30, 2015
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Other-than-temporary Impairment
The Company regularly reviews its individual investment securities for other-than-temporary impairment. The Company considers various factors in determining whether each individual security is other-than-temporarily impaired, including-
At December 31, 2015, the Company had two fixed-maturity securities that were other-than-temporarily impaired. In June 2016, the Company sold one other-than-temporarily impaired fixed-maturity security due to uncertainties surrounding the issuer’s recently announced restructuring plan. Prior to the sale, this security’s remaining $202 of impairment loss was reclassified from comprehensive income and recognized in total other-than-temporary impairment losses in the Company’s consolidated statement of income for the three months ended June 30, 2016. For the six months ended June 30, 2016, the Company recognized $495 of additional impairment loss in the consolidated statement of income, representing $26 of additional loss recorded during the period and the reclassification of $469 previously recorded in other comprehensive income. For the three and six months ended June 30, 2015, there was no other-than-temporary loss related to fixed-maturity securities.
The following table presents a rollforward of the cumulative credit losses in other-than-temporary impairment losses recognized in income from available for sale fixed-maturity securities:
Balance at January 1
Additional credit impairments on previously impaired securities
Balance at March 31
Credit impaired security fully disposed of for which there was no prior intent or requirement to sell
Reduction due to increase in expected cash flows recognized over the remaining life of the previously impaired security
Balance at June 30
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, the length of time each security has been in an unrealized loss position, the extent of the decline and the near term prospect for recovery. At June 30, 2016 and December 31, 2015, the Company had 15 and 17 equity securities, respectively, that were other-than-temporarily impaired. The Company recognized impairment losses of $340 and $293, respectively, for the three months ended June 30, 2016 and 2015. For the six months ended June 30, 2016 and 2015, the Company recognized impairment losses of $722 and $1,983, respectively.
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Securities with gross unrealized loss positions at June 30, 2016 and December 31, 2015, 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
At June 30, 2016, there were 78 securities in an unrealized loss position. Of these securities, 24 securities had been in an unrealized loss position for 12 months or greater.
At December 31, 2015, there were 101 securities in an unrealized loss position. Of these securities, 10 securities had been in an unrealized loss position for 12 months or more. The gross unrealized loss of corporate bonds in an unrealized loss position for twelve months or more included $581 of other-than-temporary impairment losses related to non-credit factors.
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Limited Partnership Investments
The Company has interests in limited partnerships that are not registered or readily tradeable on a securities exchange. These partnerships are private equity funds managed by general partners who make all decisions with regard to financial policies and operations. As such, the Company is not the primary beneficiary and does not consolidate these partnerships. The following table provides information related to the Company’s investments in limited partnerships.
Investment Strategy
Primarily in senior secured loans and, to a limited extent, in other debt and equity securities of private U.S. lower-middle-market companies. (b)(c)(e)
Value creation through active distressed debt investing primarily in bank loans, public and private corporate bonds, asset-backed securities, and equity securities received in connection with debt restructuring. (b)(d)(e)
Maximum long-term capital appreciation through long and short positions in equity and/or debt securities of publicly traded U.S. and non-U.S. issuers, derivative instruments and certain other financial instruments. (f)
High returns and long-term capital appreciation through investments in the power, utility and energy industries, and in the infrastructure sector. (b)(g)(h)
The following is the aggregated summarized unaudited financial information of limited partnerships, which in certain cases is presented on a three-month lag due to the unavailability of information at the Company’s respective balance sheet dates. In applying the equity method of accounting, the Company uses the most recently available financial information provided by each general partner. The financial statements of these limited partnerships are audited annually.
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Three Months Ended
June 30,
Six Months Ended
Operating results:
Total income
Total expenses
Net loss
Balance Sheet:
For the three and six months ended June 30, 2016, the Company recognized net investment losses of $196 and $1,065, respectively, for these investments. For the three and six months ended June 30, 2015, the Company recognized net investment losses of $197 and $462, respectively. At June 30, 2016 and December 31, 2015, the Company’s cumulative contributed capital to the partnerships totaled $29,724 and $27,276, respectively, and the Company’s maximum exposure to loss aggregated $25,269 and $23,930, respectively. During the three and six months ended June 30, 2016, the Company received one cash distribution of $44. There were no cash distributions received by the Company during the three and six months ended June 30, 2015.
Investment in Unconsolidated Joint Venture
The Company has an equity investment in one real estate development project, FMKT Mel JV, which is a limited liability company treated as a joint venture under U.S. GAAP. In January 2016, FMKT Mel JV sold a portion of its outparcel land for gross proceeds of $829, of which $515 was used to repay a portion of the construction loan obtained for this project. FMKT Mel JV recognized a $404 gain on the outparcel sale of which $383 was allocated to the Company in accordance with the profit allocation specified in the operating agreement.
At June 30, 2016 and December 31, 2015, the Company’s maximum exposure to loss relating to the variable interest entity was $5,015 and $4,787, respectively, representing the carrying value of the investment. At June 30, 2016, there was an undistributed gain of $228 compared with an undistributed loss of $148 at December 31, 2015 from this equity method investment, the amounts of which were included in the Company’s consolidated retained income. FMKT Mel JV’s partners received no cash distributions during the six months ended June 30, 2016 and 2015.
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The following tables provide FMKT Mel JV’s summarized unaudited financial results for the three and six months ended June 30, 2016 and 2015 and its unaudited financial positions at June 30, 2016 and December 31, 2015:
Total revenues and gain
Net (loss) income
The Company’s share of net (loss) income*
Construction in progress - real estate
Cash
Accounts receivable
Accounts payable
Construction loan
Other liabilities
Members’ capital
Total liabilities and members’ capital
Real Estate Investments
Real estate investments include one Acquisition, Development and Construction Loan Arrangement (“ADC Arrangement”), office and retail space that is leased to tenants, wet and dry boat storage, one restaurant, and fuel services with respect to marina clients and recreational boaters. Real estate investments consist of the following as of June 30, 2016 and December 31, 2015.
Land
Land improvements
Buildings
Total, at cost
Less: accumulated depreciation and amortization
Real estate, net
ADC Arrangement classified as real estate investment
Real estate investments
Depreciation and amortization expense related to real estate investments was $95 and $90 for the three months ended June 30, 2016 and 2015, respectively, and $188 and $193 for the six months ended June 30, 2016 and 2015, respectively.
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ADC Arrangement
At June 30, 2016 and December 31, 2015, the Company’s maximum exposure to loss relating to this variable interest was $10,200, representing the carrying value of the ADC Arrangement.
Management believes the credit risk associated with the ADC Arrangement is mitigated by the collateral used to secure the loan. As such, there were no credit loss allowances established as of June 30, 2016 and December 31, 2015.
Variable Interest Entity
The Company has an ongoing development project in Riverview, Florida through a joint venture in which the Company’s subsidiary has a controlling financial interest and, as a result, it is the primary beneficiary. The following table summarizes the assets and liabilities related to the Company’s consolidated variable interest entity which are included in the accompanying consolidated balance sheets.
Cash and cash equivalents
Accrued expenses
Net Investment Income
Net investment income (loss), by source, is summarized as follows:
Available-for-sale securities:
Investment expense
Limited partnership investments
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Note 4 — Fair Value Measurements
The Company records and discloses certain financial assets at their estimated fair value. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows:
Valuation Methodology
Cash and cash equivalents primarily consist of money-market funds. Their carrying value approximates fair value due to the short maturity and high liquidity of these funds.
Available-for-sale securities
Estimated fair values of the Company’s available-for-sale securities are determined in accordance with U.S. GAAP, using valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair values are generally measured using quoted prices in active markets for identical securities or other inputs that are observable either directly or indirectly, such as quoted prices for similar securities. In those instances where observable inputs are not available, fair values are measured using unobservable inputs. Unobservable inputs reflect the Company’s own assumptions about the assumptions that market participants would use in pricing the security and are developed based on the best information available in the circumstances. Fair value estimates derived from unobservable inputs are significantly affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. The derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange.
The estimated fair values for securities that do not trade on a daily basis are determined by management, utilizing prices obtained from an independent pricing service and information provided by brokers. Management reviews the assumptions and methods utilized by the pricing service and then compares the relevant data and pricing to broker-provided data. The Company gains assurance of the overall reasonableness and consistent application of the assumptions and methodologies and compliance with accounting standards for fair value determination through ongoing monitoring of the reported fair values.
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
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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.
As described in Note 3 — “Investments” under Limited Partnership Investments, the Company has interests in limited partnerships which are private equity funds. Pursuant to U.S. GAAP, these funds are required to use fair value accounting; therefore, the estimated fair value approximates the carrying value of these funds.
Long-term debt includes the Company’s 8% senior notes due 2020, 3.875% convertible senior notes due 2019 and 4% promissory note due through 2031. The 8% senior notes trade on the New York Stock Exchange. The estimated fair value of the 8% senior notes is based on the closing market price at each balance sheet date. The 3.875% convertible senior notes were sold in a private offering. The fair values of the 3.875% convertible senior notes and the 4% promissory note are estimated using a discounted cash flow method that relies on Level 3 inputs.
Assets Measured at Estimated Fair Value on a Recurring Basis
The following table presents information about the Company’s financial assets measured at estimated fair value on a recurring basis. The table indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value as of June 30, 2016 and December 31, 2015:
Financial Assets:
Fixed-maturity securities:
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Assets and Liabilities Carried at Other Than Fair Value
The following tables present fair value information for assets and liabilities that are carried on the balance sheet at amounts other than fair value as of June 30, 2016 and December 31, 2015.
Financial Liabilities:
Long-term debt:
8% Senior notes
3.875% Convertible senior notes
4% Promissory note
Total long-term debt
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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
Prepaid expenses
Restricted cash
Total other assets
In June 2016, the Company received cash payments totaling $37,800 under the terms of the retrospective reinsurance contracts which terminated May 31, 2016.
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
4% Promissory note, due through February 1, 2031
Total principal amount
Less: unamortized discount and issuance costs
Less: current portion*
As of June 30, 2016, future maturities of long-term debt are as follows:
Due in 12 months following June 30,
2016
2017
2018
2019
2020
Thereafter
For the three months ended June 30, 2016 and 2015, interest expense included the contractual interest coupon, discount amortization and amortization of issuance costs aggregating $2,611 and $2,679, respectively, the amounts of which included non-cash interest expense of $844 and $876, respectively. For the six months ended June 30, 2016 and 2015, interest expense of $5,440 and $5,340, respectively, included non-cash interest expense of $1,784 and $1,734, respectively. As of June 30, 2016, the remaining amortization period of the debt discount was 2.7 years.
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4% Promissory Note
On January 14, 2016, HCPCI Holdings, LLC, a subsidiary of the Company, entered into a 15-year secured loan agreement for proceeds of $9,200. The loan is collateralized by the Company’s Tampa, Florida real estate, which is owned by HCPCI Holdings, and the lease agreements associated with this property. The loan bears a fixed annual interest rate of 4%. Approximately $68 of principal and interest is payable in 180 monthly installments beginning March 1, 2016. The promissory note may be repaid in full after February 1, 2017 as long as the Company provides at least 60 days’ written notice and pays a prepayment premium as specified in the loan agreement. The proceeds will be used for real estate development projects or other general business purposes.
3.875% Convertible Senior Notes
Conversion Rate
Since January 2015, the Company’s cash dividends on common stock have exceeded $0.275 per share, resulting in adjustments to the conversion rate. As of June 30, 2016, each $1 of the Company’s convertible notes would have been convertible into 16.0705 shares of common stock, which was the equivalent of approximately $62.23 per share.
Repurchases of Convertible Senior Notes
During the first quarter of 2016, the Company repurchased an aggregate of $13,010 in principal of its 3.875% convertible senior notes in privately negotiated transactions for cash in the amount of $11,347, inclusive of $81 in commissions. As a result, the Company recognized a $153 gain on extinguishment net of $1,591 in unamortized debt discount and issuance costs and commissions associated with the notes that were repurchased during the first quarter of 2016.
Note 7 — Reinsurance
The Company cedes a portion of its homeowners’ insurance exposure to other entities under catastrophe excess of loss reinsurance treaties and one quota share agreement. 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 enters into reinsurance treaties with highly rated and reputable reinsurers and it 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 each year taking into consideration probable maximum losses and reinsurance market conditions.
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The impact of the reinsurance 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, 2016 and 2015, there were no recoveries pertaining to reinsurance contracts that were deducted from losses incurred. At June 30, 2016 and December 31, 2015, there were 35 and 21 reinsurers, respectively, participating in the Company’s reinsurance program. There were no amounts receivable with respect to reinsurers at June 30, 2016 and December 31, 2015. Thus, there were no concentrations of credit risk associated with reinsurance receivables as of June 30, 2016 and December 31, 2015. In addition, based on the insurance ratings and the financial strength of the reinsurers, management believes there was no credit risk associated with its reinsurers’ obligations to perform on any prepaid reinsurance contract as of June 30, 2016 and December 31, 2015.
Certain of the reinsurance contracts include retrospective provisions that adjust premiums or increase the amount of future coverage in the event losses are minimal or zero. Effective June 1, 2016, retrospective provisions include premium adjustments only. These adjustments are reflected in the consolidated statements of income as net reductions in ceded premiums of $3,001 and $6,241 for the three months ended June 30, 2016 and 2015, respectively, of which $413 and $1,520 relates to the Company’s contract with Oxbridge Reinsurance Limited (see Note 14 — Related Party Transactions). For the six months ended June 30, 2016 and 2015, these adjustments were $5,822 and $12,614, respectively, of which $740 and $2,125 relates to the Company’s contract with Oxbridge. In June 2016, the Company received a total of $37,800 in cash benefits related to two retrospective reinsurance contracts that terminated May 31, 2016 of which $7,560 was received from Oxbridge.
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At June 30, 2016 and December 31, 2015, other assets included $6,546 and $36,176, respectively, and prepaid reinsurance premiums included $277 and $2,625, respectively, which are related to these adjustments. Management believes the credit risk associated with the collectability of these accrued benefits is minimal as the amount receivable is concentrated with one reinsurer and the Company monitors the creditworthiness of this reinsurer based on available information about the reinsurer’s financial position.
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 these 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 estimates are adjusted. During the three and six months ended June 30, 2016, the Company experienced unfavorable development of $5,469 and $5,932, respectively, attributable to the settlement and further development of older claims and an increase in late reported claims, primarily claims related to the 2015 loss year.
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 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, 2016 and 2015, the Company recorded approximately $4,205 and $13,561, respectively, of income taxes, which resulted in effective tax rates of 37.4% and 38.1%, respectively. During the six months ended June 30, 2016 and 2015, the Company recorded approximately $7,846 and $29,229, respectively, of income taxes, which resulted in estimated annual effective tax rates of 37.5% and 38.1%, respectively. The decrease in the 2016 effective tax rate was primarily attributable to an increase in interest income earned from tax-exempt securities relative to overall book income. 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.
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 affect the computation of both basic and diluted earnings per share during periods of net income.
A summary of the numerator and denominator of the basic and diluted earnings per common share is presented below.
Less: Income attributable to participating securities
Basic Earnings Per Share:
Income allocated to common stockholders
Effect of Dilutive Securities:
Stock options
Convertible senior notes
Diluted Earnings Per Share:
Income available to common stockholders and assumed conversions
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Convertible senior notes*
Note 11 — Stockholders’ Equity
Common Stock
In December 2015, the Company’s Board of Directors authorized a one-year plan to repurchase up to $20,000 of the Company’s common shares before commissions and fees. During the three months ended June 30, 2016, the Company repurchased and retired a total of 189,938 shares at a weighted average price per share of $31.59 under this authorized repurchase plan. The total cost of shares repurchased, inclusive of fees and commissions, during the three months ended June 30, 2016 was $6,008, or $31.63 per share. During the six months ended June 30, 2016, the Company repurchased and retired a total of 376,796 shares at a weighted average price per share of $31.85. The total cost of shares repurchased, inclusive of fees and commissions, during the six months ended June 30, 2016 was $12,015, or $31.89 per share.
In 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. This one-year repurchase plan expired March 31, 2015; therefore, there were no shares repurchased during the three months ended June 30, 2015. During the six months ended June 30, 2015, the Company repurchased and retired a total of 37,869 shares at a weighted average price per share of $42.49. The total cost of shares repurchased, inclusive of fees and commissions, during the six months ended June 30, 2015 was $1,610, or $42.51 per share.
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On July 8, 2016, the Company’s Board of Directors declared a quarterly dividend of $0.30 per common share. The dividends are payable on September 16, 2016 to shareholders of record on August 19, 2016.
Note 12 — Stock-Based Compensation
Incentive Plans
The Company currently has outstanding stock-based awards granted under the 2007 Stock Option and Incentive Plan and the 2012 Omnibus Incentive Plan. Only the 2012 Plan is active and available for future grants. At June 30, 2016, there were 4,269,424 shares available for grant.
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.
A summary of the stock option activity for the three and six months ended June 30, 2016 and 2015 is as follows (option amounts not in thousands):
Outstanding at January 1, 2016
Outstanding at March 31, 2016
Outstanding at June 30, 2016
Exercisable at June 30, 2016
Outstanding at January 1, 2015
Outstanding at March 31, 2015
Exercised
Outstanding at June 30, 2015
Exercisable at June 30, 2015
There were no options exercised during the three and six months ended June 30, 2016. For the three and six months ended June 30, 2015, the Company recognized aggregate tax benefits of $1,192 for 80,000 options exercised of which the aggregate intrinsic value was $3,188.
Restricted Stock Awards
From time to time, the Company has granted and may grant restricted stock awards to its 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
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an award and then establishes fair value based on the most likely outcome. The determination of fair value with respect to the awards concerning only performance or service-based conditions is based on the market value of the Company’s common stock on the grant date.
Information with respect to the activity of unvested restricted stock awards during the three and six months ended June 30, 2016 and 2015 is as follows:
Nonvested at January 1, 2016
Vested
Cancelled
Forfeited
Nonvested at March 31, 2016
Granted
Nonvested at June 30, 2016
Nonvested at January 1, 2015
Nonvested at March 31, 2015
Nonvested at June 30, 2015
The Company recognized compensation expense related to restricted stock, which is included in other operating expenses, of $967 and $1,381 for the three months ended June 30, 2016 and 2015, respectively, and $1,948 and $2,789 for the six months ended June 30, 2016 and 2015, respectively. At June 30, 2016 and 2015, there was approximately $8,741 and $10,442, 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 21 months. The following table summarizes information about deferred tax benefits recognized and tax benefits realized related to restricted stock awards and paid dividends, and the fair value of vested restricted stock for the three and six months ended June 30, 2016 and 2015:
Deferred tax benefits recognized
Tax benefits realized for restricted stock and paid dividends
Fair value of vested restricted stock
During the three and six months ended June 30, 2016, no awards were issued with other than time-based vesting conditions.
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Note 13 — Commitments and Contingencies
Obligations under Multi-Year Reinsurance Contracts
As of June 30, 2016, the Company has contractual obligations related to multi-year reinsurance contracts. These contracts were effective June 1, 2016 and may be cancelled only with the other party’s consent. The future minimum aggregate premiums payable to these reinsurers is $19,400 due in each of the twelve-month periods following June 30, 2016 and 2017.
Capital Commitment
As described in Note 3 — “Investments” under Limited Partnership Investments, the Company is contractually committed to capital contributions under three limited partnership agreements. At June 30, 2016, there was an aggregate unfunded balance of $15,776.
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 related to the Department’s proposed disallowance of the entire amount of $1,754 in Florida salary credits applicable to that period. The proposed adjustment, which included interest through September 10, 2013, approximated $1,913. To resolve the matter, the Company entered into negotiations with the Department and reached an agreement in principle whereby certain of the Company’s subsidiaries would individually file and pay state reemployment taxes plus interest covering the periods under audit through the second quarter of 2014. Such filings were expected to yield a refund of reemployment taxes paid by the Company. In December 2015, the Department issued its Notice of Decision indicating the Company owed approximately $38 in full settlement of the premium tax and related interest, which the Company paid in February 2016. The Company received refunds totaling $57 related to its reemployment tax filings specific to the period for which the Company was required to file and pay the subsidiary reemployment tax returns as part of the negotiated settlement. As a result, the Company realized a net benefit of $19. Management believes this matter is fully resolved.
Note 14 — Related Party Transactions
Claddaugh Casualty Insurance Company, Ltd., the Company’s Bermuda domiciled reinsurance subsidiary has a reinsurance agreement with Oxbridge Reinsurance Limited whereby a portion of the business assumed from the Company’s insurance subsidiary, Homeowners Choice Property & Casualty Insurance Company, Inc., is ceded by Claddaugh to Oxbridge. With respect to the period from June 1, 2015 through May 31, 2016, Oxbridge assumed $11,600 of the total covered exposure for $3,340 in premiums. With respect to the period from June 1, 2016 through May 31, 2017, Oxbridge assumed $6,000 of the total covered exposure for approximately $3,400 in premiums. See Note 7 — Reinsurance – which includes the amounts due from and paid by Oxbridge during the six months ended June 30, 2016 and 2015 with respect to benefits accrued in connection with the Oxbridge agreements. The premiums charged by Oxbridge are at rates which management believes to
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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 Claddaugh, 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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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 4, 2016. 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 in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are in whole dollars 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. is a Florida-based company owning 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, 2016 and 2015, revenues from property and casualty insurance operations represented 90.7% and 95.4%, respectively, of total revenues of all operations. For the six months ended June 30, 2016 and 2015, revenues from property and casualty insurance
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operations represented 89.9% and 96.2%, respectively, of total revenues of all operations. There was no other operating segment representing ten percent or more of total operating revenues. As a result, our property and casualty insurance operations are our only reportable operating segment.
Insurance Operations
Property and Casualty Insurance
Homeowners Choice Property & Casualty Insurance Company, Inc.
Our principal operating 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. Since 2014, HCPCI has offered flood-endorsed and wind-only policies to eligible new and pre-existing Florida customers. In December 2015, HCPCI was approved by the Florida Office of Insurance Regulation to write standalone flood insurance policies for Florida homeowners. HCPCI strives to offer 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. This growth track has been beneficial to us although there are fewer policies available for assumption today as a result of increased competition in the Florida market. Thus, we plan to seek other opportunities to expand by providing new or additional product offerings in and outside the state of Florida.
TypTap Insurance Company
TypTap Insurance Company was organized by HCI Group, Inc. and approved by the Florida Office of Insurance Regulation in January 2016 to transact insurance business in the state of Florida. TypTap began writing standalone flood coverage to Florida homeowners in March 2016.
We expect the flood insurance product offered both by TypTap and HCPCI to become a significant contributor to future financial results.
Homeowners Choice Assurance Company, Inc.
In June 2016, Homeowners Choice Assurance voluntarily surrendered its certificate of authority to the Alabama Department of Insurance and, as a result, formally terminated its plan to conduct business in the state of Alabama. The withdrawal was effective on June 30, 2016.
Reinsurance
We have a Bermuda domiciled wholly-owned reinsurance subsidiary, Claddaugh Casualty Insurance Company Ltd. We selectively retain risk in Claddaugh, displacing the need for HCPCI to pay premiums to third party reinsurers. Claddaugh fully collateralizes its exposure to HCPCI by depositing funds into a trust account. Claddaugh also mitigates a portion of its risk through retrocession contracts.
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Other Operations
Real Estate
Our real estate operations consist of multiple properties we own and operate. In addition, we have investments in three commercial development projects that include two sites owned by us and managed through joint ventures.
Investment Projects
We have one ongoing real estate development and construction project in which our involvement is through an acquisition, development and construction loan arrangement (“ADC Arrangement”). Under the ADC Arrangement, we financed the acquisition, development and construction of a retail shopping center. Greenleaf Capital, one of our wholly owned subsidiaries, had an option to purchase the property when the construction project was completed contingent upon tenant rental commitments for at least 90% of rentable space being secured by the developer.
We also have two real estate development projects through joint venture arrangements, one in which we have a 90% non-controlling equity interest and another which we consolidate with our operations. We believe these opportunities will enable us to grow our real estate portfolio and diversify our future sources of income. See Note 3 — “Investments” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q for additional information.
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 in Noida, India and in Tampa, Florida, 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 designed to facilitate and improve our ongoing operations. Some of the technologies originally developed in-house for our own insurance operations have been launched for use by third parties. These products include the following:
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Recent Events
On July 8, 2016, our Board of Directors declared a quarterly dividend of $0.30 per common share. The dividends are payable on September 16, 2016 to stockholders of record on August 19, 2016.
RESULTS OF OPERATIONS
The following table summarizes our results of operations for the three and six months ended June 30, 2016 and 2015 (dollar amounts in thousands, except per share amounts):
Other income
Ratios to Net Premiums Earned:
Loss Ratio
Expense Ratio
Combined Ratio
Ratios to Gross Premiums Earned:
Earnings Per Share Data:
Basic
Diluted
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Comparison of the Three Months ended June 30, 2016 with the Three Months ended June 30, 2015
Our results of operations for the three months ended June 30, 2016 reflect income available to common stockholders of approximately $7,024,000, or $0.71 earnings per diluted share, compared with approximately $22,022,000, or $1.93 earnings per diluted share, for the three months ended June 30, 2015. The quarter-over-quarter decline was primarily due to a $12,853,000 decrease in gross premiums earned as well as a $5,006,000 increase in premiums ceded, resulting in a decrease in net premiums earned of $17,859,000. In addition, our 2016 results were affected by a $5,707,000 increase in losses and loss adjustment expenses.
Gross Premiums Earned for the three months ended June 30, 2016 and 2015 were approximately $94,912,000 and $107,765,000, respectively. The decrease in 2016 was attributable to policy attrition as well as a rate decrease effective on new and renewal policies beginning in January 2016.
Premiums Ceded for the three months ended June 30, 2016 and 2015 were approximately $36,384,000 and $31,378,000, respectively, representing 38.3% and 29.1%, respectively, of gross premiums earned. The $5,006,000 increase was primarily attributable to policies assumed outside of hurricane season in December 2014 and, as a result, we deemed it unnecessary to purchase reinsurance covering these policies until June 1, 2015. This resulted in lower reinsurance costs in the second quarter of 2015 compared with the same quarter of 2016. In addition, the reduction to our ceded premiums attributable to retrospective provisions under certain reinsurance contracts was lower as compared with the corresponding period in 2015.
Our reinsurance program for 2016/17 provides coverage, which according to catastrophe models approved by the FLOIR, is sufficient to cover the probable maximum loss resulting from a 1 in 165 year event. Our reinsurance program for 2015/16 provided coverage for a probable maximum loss resulting from a 1 in 260 year event. As a result of our program and pricing changes, we expect to reduce our reinsurance costs by approximately $48,000,000 for the 2016/17 program year as compared with the 2015/16 program year.
Our premiums ceded represent amounts paid to reinsurers to cover losses from catastrophes that exceed the retention levels defined by our catastrophe excess of loss reinsurance treaties and to assume a proportional share of losses defined in quota share arrangements, one of which was cancelled effective May 31, 2016. For the three months ended June 30, 2016 and 2015, premiums ceded reflect net reductions of approximately $3,001,000 and $6,241,000, respectively, related to the provisions under certain reinsurance contracts. See “Economic Impact of Reinsurance Contracts with Retrospective Provisions” under “Critical Accounting Policies and Estimates.” The rates we pay for reinsurance are based primarily on policy exposures reflected in gross premiums earned.
Net Premiums Written during the three months ended June 30, 2016 and 2015 totaled approximately $103,097,000 and $123,932,000, respectively. Net premiums written represent the premiums charged on policies issued during a fiscal period less any applicable reinsurance costs. The decrease in 2016 resulted from an increase of approximately $5,006,000 in premiums ceded during the year combined with a decrease of approximately $15,829,000 in gross premiums written. We had approximately 150,000 policies in force at June 30, 2016 as compared with approximately 170,000 policies in force at June 30, 2015.
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Net Premiums Earned for the three months ended June 30, 2016 and 2015 were approximately $58,528,000 and $76,387,000, respectively, and reflect the gross premiums earned less 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, 2016 and 2015 (amounts in thousands):
Net Premiums Written
Increase in Unearned Premiums
Net Premiums Earned
Net Investment Income for the three months ended June 30, 2016 and 2015 was approximately $1,725,000 and $1,795,000, respectively. The slight decrease in 2016 was primarily due to increased losses in real estate investments. See Note 3 — “Investments” under Net Investment Income to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q.
Net Other-Than-Temporary Impairment Losses for the three months ended June 30, 2016 and 2015 were approximately $542,000 and $293,000, respectively. During the second quarter of 2016, we recognized impairment losses specific to one fixed-maturity security and seven equity securities. An additional $202,000 impairment loss was recognized for one previously impaired fixed-maturity security due to the sale of this security in June 2016. Seven equity securities were deemed impaired due to the length of time each security had been in an unrealized loss position with no near term prospect of recovery. During the quarter ended June 30, 2015, we recognized impairment losses specific to four equity securities.
Policy Fee Income for the three months ended June 30, 2016 and 2015 was approximately $988,000 and $942,000, respectively. The slight increase from the corresponding period in 2015 was primarily attributable to the recognition of nonrefundable policy fees related to policies that were cancelled during the second quarter of 2016.
Our Losses and Loss Adjustment Expenses amounted to approximately $26,272,000 and $20,565,000 for the three months ended June 30, 2016 and 2015, respectively. The 2016 expenses were impacted by weather-related events and continued reserve strengthening due to trends involving assignment of benefits and related litigation. 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, 2016 and 2015 of approximately $10,879,000 and $10,443,000, respectively, primarily reflect brokerage fees as well as the amortization of deferred acquisition costs related to commissions payable to agents for production and renewal of policies and premium taxes. The $436,000 increase from the corresponding period in 2015 was primarily attributable to commissions and premium taxes related to the policies assumed from Citizens that have renewed and are included in 2016 premiums.
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Salaries and Wages for the three months ended June 30, 2016 and 2015 were approximately $5,680,000 and $5,236,000, respectively. The $444,000 increase from the corresponding period in 2015 was primarily attributable to an increase in employee headcount as well as merit increases during 2016 and 2015. As of June 30, 2016, we had 242 employees located at our offices in Florida compared with 215 employees as of June 30, 2015. We also had 85 employees located in Noida, India at June 30, 2016 versus 90 at June 30, 2015.
Other Operating Expenses for the three months ended June 30, 2016 and 2015 were approximately $4,849,000 and $4,562,000, respectively. The $287,000 increase was primarily attributable to a $701,000 increase in various administrative expenses offset by a $414,000 decrease in stock-based compensation.
Income Tax Expense for the three months ended June 30, 2016 and 2015 was approximately $4,205,000 and $13,561,000, respectively, for state, federal, and foreign income taxes resulting in an effective tax rate of 37.4% for 2016 and 38.1% for 2015.
Ratios:
The loss ratio applicable to the three months ended June 30, 2016 (losses and loss adjustment expenses incurred related to net premiums earned) was 44.9% compared with 26.9% for the three months ended June 30, 2015. The increase was primarily due to a reduction in net premiums earned and increased losses as described previously.
The expense ratio applicable to the three months ended June 30, 2016 (defined as underwriting expenses, salaries and wages, interest and other operating expenses related to net premiums earned) was 41.0% compared with 30.0% for the three months ended June 30, 2015. The increase in our expense ratio was primarily attributable to the decrease in net premiums earned.
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 three months ended June 30, 2016 was 85.9% compared with 56.9% for the three months ended June 30, 2015.
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, 2016 was 53.0% compared with 40.4% for the three months ended June 30, 2015.
Comparison of the Six Months ended June 30, 2016 with the Six Months ended June 30, 2015
Our results of operations for the six months ended June 30, 2016 reflect income available to common stockholders of approximately $13,080,000, or $1.31 earnings per diluted share, compared with approximately $47,400,000, or $4.14 earnings per diluted share, for the six months ended June 30, 2015. The period-over-period decline was primarily due to a $23,601,000 decrease in gross premiums earned as well as a $17,539,000 increase in premiums ceded, resulting in a decrease in net premiums earned of $41,140,000. In addition, our 2016 results were affected by a $13,748,000 increase in losses and loss adjustment expenses.
Gross Premiums Earned for the six months ended June 30, 2016 and 2015 were approximately $193,731,000 and $217,332,000, respectively. The decrease in 2016 was attributable to policy attrition as well as a rate decrease effective on new and renewal policies beginning in January 2016.
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Premiums Ceded for the six months ended June 30, 2016 and 2015 were approximately $76,756,000 and $59,217,000, respectively, representing 39.6% and 27.2%, respectively, of gross premiums earned. As mentioned earlier, we did not purchase reinsurance coverage for policies assumed in December 2014 until June 1, 2015. As a result, our reinsurance costs were lower in the six months ended June 30, 2015 as compared with the same period in 2016. In addition, the reduction to our ceded premiums attributable to retrospective provisions under certain reinsurance contracts was lower as compared with the corresponding period in 2015.
For the six months ended June 30, 2016 and 2015, premiums ceded reflected net reductions of approximately $5,822,000 and $12,614,000, respectively, related to the provisions under certain reinsurance contracts. See “Economic Impact of Reinsurance Contracts with Retrospective Provisions” under “Critical Accounting Policies and Estimates.” The rates we pay for reinsurance are based primarily on policy exposures reflected in gross premiums earned.
Net Premiums Written for the six months ended June 30, 2016 and 2015 totaled approximately $138,285,000 and $177,547,000, respectively. The decrease in 2016 resulted from a decrease of approximately $21,723,000 in gross premiums written combined with an increase of approximately $17,539,000 in premiums ceded during the year.
Net Premiums Earned for the six months ended June 30, 2016 and 2015 were approximately $116,975,000 and $158,115,000, respectively, and reflected the gross premiums earned less 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, 2016 and 2015 (amounts in thousands):
Net Other-Than-Temporary Impairment Losses for the six months ended June 30, 2016 and 2015 were approximately $1,217,000 and $1,983,000, respectively. During the six months ended June 30, 2016, we recognized impairment losses specific to one fixed-maturity security and 15 equity securities. The fixed-maturity security was subject to credit related loss impairment resulting from our analysis of its expected cash flows. Fifteen equity securities were impaired as a result of the length of time each security had been in an unrealized loss position with no near term prospect of recovery. During the six months ended June 30, 2015, we recognized impairment losses specific to six equity securities, one of which accounted for $1,598,000 of the total impairment losses.
Policy Fee Income for the six months ended June 30, 2016 and 2015 was approximately $1,995,000 and $1,483,000, respectively. Beginning in March 2015, we have used actual policy cancellations in our calculation of policy fee income whereas estimated attrition rates were used in this calculation prior to March 2015. In addition, the unearned portion of nonrefundable policy fee income was fully recognized for policies that were cancelled during the 2016 period. As a result, our 2016 policy fee income was higher than in 2015 despite the decline in gross premiums earned.
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Gain on Repurchases of Convertible Senior Notes for the six months ended June 30, 2016 was approximately $153,000. The gain was attributable to the repurchase of $13,010,000 in principal of our 3.875% Convertible Senior Notes during the first quarter of 2016. We did not repurchase any of our 3.875% Convertible Senior Notes during 2015. See Note 6 — “Long-term Debt” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q.
Our Losses and Loss Adjustment Expenses amounted to approximately $53,352,000 and $39,604,000, respectively, for the six months ended June 30, 2016 and 2015. Our 2016 losses and loss adjustment expenses were impacted by weather-related events and continued reserve strengthening. 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, 2016 and 2015 of approximately $21,989,000 and $20,242,000, respectively. The $1,747,000 increase from the corresponding period in 2015 was primarily attributable to commissions and premium taxes related to the policies assumed from Citizens that have renewed and are included in 2016 premiums.
Salaries and Wages for the six months ended June 30, 2016 and 2015 were approximately $11,064,000 and $10,134,000, respectively. The $930,000 increase from the corresponding period in 2015 was primarily attributable to an increase in employee headcount as well as merit increases during the 2016 and 2015.
Other Operating Expenses for the six months ended June 30, 2016 and 2015 were approximately $9,496,000 and $9,329,000, respectively. The $167,000 increase was primarily attributable to a $960,000 increase in various administrative expenses reduced by a $793,000 decrease in stock-based compensation.
Income Tax Expense for the six months ended June 30, 2016 and 2015 were $7,846,000 and $29,229,000, respectively, for state, federal, and foreign income taxes resulting in an effective tax rate of 37.5% for 2016 and 38.1% for 2015.
The loss ratio applicable to the six months ended June 30, 2016 was 45.6% compared with 25.0% for the six months ended June 30, 2015. The increase was primarily due to a reduction in net premiums earned and increased losses as described previously.
The expense ratio applicable to the six months ended June 30, 2016 was 41.0% compared with 28.5% for the six months ended June 30, 2015. The increase in our expense ratio is primarily attributable to the decrease in 2016 net premiums earned.
The combined ratio is the measure of overall underwriting profitability before other income. Our combined ratio for the six months ended June 30, 2016 was 86.6% compared with 53.5% for the six months ended June 30, 2015.
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, 2016 was 52.3% compared with 39.0% for the six months ended June 30, 2015.
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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. Although not as typical, we may also experience significant winter storm activity as we did during the first quarter of 2016. 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
Throughout our history, our liquidity requirements have been met through issuances 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 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 losses and loss adjustment expenses are paid out over a period of years. This period of time varies by the circumstances surrounding each claim. Substantially all of our losses and loss adjustment expenses are fully settled and paid within 100 days of the claim receipt date. Additional cash outflow occurs through payments of underwriting costs such as commissions, taxes, payroll, and general overhead expenses.
We believe that we maintain sufficient liquidity to pay 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 to fund operating expenses. In addition, we intend to continue investing in real estate to maximize returns and diversify our sources of income, pursue acquisition opportunities, or consider other strategic opportunities.
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Senior Notes and Promissory Note
The following table summarizes our long-term debt’s principal and interest payment obligations at June 30, 2016:
Interest Payment Due Date
8% Senior Notes
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 including information on repurchases of our convertible senior notes.
Our limited partnership investments consist of four private equity funds managed by their general partners. Three of these funds have unexpired capital commitments which are callable at the discretion of the fund’s general partner for funding new investments or expenses of the fund. At June 30, 2016, there was an aggregate unfunded capital balance of $15,776,000. See Limited Partnership Investments under Note 3 — “Investments” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q for additional information.
Share Repurchase Plan
On December 15, 2015, our Board of Directors approved a one-year plan to repurchase up to $20,000,000 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. At June 30, 2016, there was approximately $8,000,000 available under the plan. See Note 11 — “Stockholders’ Equity” to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q.
Real Estate Development in Progress
We currently have development projects through our joint ventures. Although we have no outstanding commitment to fund any of the existing projects and we expect to finance existing and future development projects with cash from real estate operations and through property financings, we may be required to make additional capital contributions when warranted.
Sources and Uses of Cash
Cash Flows for the Six months ended June 30, 2016
Net cash provided by operating activities for the six months ended June 30, 2016 was approximately $70,391,000, which consisted primarily of cash received from net premiums written less cash disbursed for operating expenses, losses and loss adjustment expenses and interest payments. Net cash used in investing activities of $8,097,000 was primarily due to the purchases of available-for-sale securities of $48,083,000, and the limited partnership investments of $2,448,000, offset by the proceeds from sales of available-for-sale securities of $42,679,000. Net cash used in
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financing activities totaled $20,741,000, which was primarily due to $11,347,000 used in the repurchases of our convertible senior notes, $12,015,000 used in our share repurchase plan and $5,936,000 of net cash dividend payments, offset by the proceeds from issuance of a 4% promissory note of $9,200,000.
Cash Flows for the Six months ended June 30, 2015
Net cash provided by operating activities for the six months ended June 30, 2015 was approximately $77,775,000, which consisted primarily of cash received from net premiums written less cash disbursed for operating expenses, losses and loss adjustment expenses and interest payments. Net cash used in investing activities of $110,954,000 was primarily due to the purchases of available-for-sale securities of $101,756,000, the funding of the ADC Arrangement of $3,285,000 and $20,628,000 used to fund the limited partnership investments, decreased by redemptions and repayments of fixed-maturity securities of $4,205,000, and the proceeds from sales of available-for-sale securities of $11,279,000. Net cash used in financing activities totaled $6,492,000, which was primarily due to $1,610,000 used in our share repurchase plan and $6,001,000 of net cash dividend payments, offset by $1,691,000 of tax benefits on stock-based compensation.
Investments
The main objective of our investment policy is to maximize our after-tax investment income with a reasonable level 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, 2016, we had $185,419,000 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 $10,000,000 in any one bank at any time. From time to time, we may have in excess of $10,000,000 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, 2016, we had unexpired capital commitments for three of the four limited partnerships in which we hold interests. Such commitments are not recognized in the financial statements but are 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.
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CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The following table summarizes our material contractual obligations and commitments as of June 30, 2016 (amounts in thousands):
Operating lease (1)
Service agreement (1)
Reinsurance contracts (2)
Unfunded capital commitments (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 consolidated 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 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 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 our insurance division’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 when the losses and loss adjustment expenses are adjusted.
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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, 2016, $32,833,000 of the total $54,727,000 we have reserved for losses and loss adjustment expenses is attributable to our estimate of IBNR. The remaining $21,894,000 relates to known cases which have been reported but not yet fully settled in which case we have established a reserve based on currently available information and our best estimate of the cost to settle each claim. At June 30, 2016, $13,989,000 of the $21,894,000 in reserves for known cases relates to claims incurred during prior years.
Our Reserves increased from $51,690,000 at December 31, 2015 to $54,727,000 at June 30, 2016. The $3,037,000 increase in our Reserves is comprised of $22,833,000 in reserves related to claims occurring in the 2016 loss year offset by reductions in our Reserves of $12,555,000 for 2015 and $7,241,000 for 2014 and prior loss years. The $22,833,000 in Reserves established for 2016 claims is primarily driven by an allowance for subsequent development of claims reported for the accident year and an allowance for those claims that have been incurred but not reported to the company as of June 30, 2016. The decrease of $19,796,000 specific to our 2015 and prior loss-year reserves is primarily due to settlement of claims related to those loss years.
Based on all information known to us, we consider our Reserves at June 30, 2016 to be adequate to cover our claims for losses that have occurred as of that date including losses yet to be reported to us. However, these estimates are continually reviewed by management as they are subject to significant variability and may be impacted by trends in claim severity and frequency or unusual exposures that have not yet been identified. 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.
Economic Impact of Reinsurance Contracts with Retrospective Provisions
Certain of our reinsurance contracts include retrospective provisions that adjust premiums or increase the amount of future coverage 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 during the contract term. Effective June 1, 2016, retrospective provisions include premium adjustments only.
For the three months ended June 30, 2016 and 2015, we accrued benefits of $3,947,000 and $5,989,000, respectively. For the three months ended June 30, 2016, we recognized net ceded premiums of $946,000, representing amortization of $1,223,000 of previously deferred reinsurance costs for increased coverage offset by $277,000 of ceded premiums deferred for the period. For the three months ended June 30, 2015, we deferred recognition of net ceded premiums of $252,000, representing $478,000 of ceded premiums deferred for the period decreased by amortization of $226,000 of previously deferred reinsurance costs for increased coverage. For the three months ended June 30, 2016 and 2015, net reductions in ceded premiums totaled $3,001,000 and $6,241,000, respectively.
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For the six months ended June 30, 2016 and 2015, we accrued benefits of $8,630,000 and $12,368,000, respectively. For the six months ended June 30, 2016, we recognized net ceded premiums of $2,808,000, representing amortization of $3,085,000 of previously deferred reinsurance costs for increased coverage offset by $277,000 of ceded premiums deferred for the period. For the six months ended June 30, 2015, we deferred recognition of net ceded premiums of $246,000, representing $538,000 of ceded premiums deferred for the period decreased by amortization of $292,000 of previously deferred reinsurance costs for increased coverage. For the six months ended June 30, 2016 and 2015, net reductions in ceded premiums totaled $5,822,000 and $12,614,000, respectively.
In June 2016, we received cash totaling $37,800,000 in connection with the benefits accrued for two retrospective reinsurance contracts that were terminated effective May 31, 2016. As of June 30, 2016, we had $6,546,000 of accrued benefits and $277,000 of ceded premiums deferred, 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. At December 31, 2015, we had $35,716,000 of accrued benefits and $3,085,000 of ceded premiums deferred related to these agreements.
We believe the credit risk associated with the collectability of these accrued benefits is minimal based on available information about the individual reinsurer’s financial position.
The above and other accounting estimates and their 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 4, 2016. For the six months ended June 30, 2016, there have been no material changes with respect to any of our critical accounting policies.
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 (unaudited).
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our investment portfolio at June 30, 2016 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 our 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. Our investment securities are managed primarily by outside investment advisors and are overseen by the investment committee appointed by our board of directors.
Our investment portfolios are 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.
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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.
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, 2016 (amounts 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 generally investment grade, by diversifying our investment portfolio to avoid concentrations in any single issuer or business sector, and by continually monitoring each individual security for declines in credit quality. While we emphasize credit quality in our investment selection process, significant downturns in the markets or general economy may impact the credit quality of our portfolio.
The following table presents the composition of our fixed-maturity securities, by rating, at June 30, 2016 (amounts in thousands):
Comparable Rating
AAA
AA+, AA, AA-
A+, A, A-
BBB+, BBB, BBB-
BB+, BB, BB-
B+, B, B-
CCC+, CC and Not rated
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Equity Price Risk
Our equity investment portfolio at June 30, 2016 included common stocks, perpetual preferred stocks, mutual funds and exchange traded funds. We may incur potential losses due to declines in equity security prices. We manage the risk primarily through industry and issuer diversification and asset mix.
The following table illustrates the composition of our equity securities at June 30, 2016 (amounts in thousands):
Stocks by sector:
Financial
Consumer
Energy
Industrial
Other (1)
Mutual funds and Exchange traded funds by type:
Debt
Equity
Foreign Currency Exchange Risk
At June 30, 2016, 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, 2016 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
As previously reported in our Form 10-K which was filed with the SEC on March 4, 2016, the Company, each of the directors and two shareholders agreed to a settlement with respect to demands by the two shareholders. As a result, certain of the directors’ restricted shares were cancelled March 2, 2016. The cancelled shares were made up of 148,000 shares that would vest in the event our share price reached $50.00 and 12,000 shares that would vest in the event our share price reached $95.00. Our board members and the Company have also implemented certain non-financial corporate governance changes. We are not aware of any other pending shareholder demands.
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 4, 2016.
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ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
The table below summarizes the number of common shares repurchased during the three months ended June 30, 2016 under a share repurchase plan and also 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 in May 2016 (dollar amounts in thousands, except share and per share amounts):
For the Month Ended
April 30, 2016
May 31, 2016
June 30, 2016
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.
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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 Florida Office of Insurance Regulation 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.
During the six months ended June 30, 2016, HCPCI paid a $19,000,000 dividend to HCI.
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:
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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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