Item 1:Business
Overview
We are a leading specialty provider of property and casualty insurance operating in two niche markets across the United States. In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for ceding fees. In our Lender Services segment, we specialize in providing collateral protection insurance (“CPI”), which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies. Both of these businesses have a long track record of profitable operations.
Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. These reinsurers are domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business. Issuing carrier (“fronting”) arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. Our broad licensing authority, strong A.M. Best “A” (Excellent) rating, which is the third
highest out of fifteen rating categories used by A.M. Best, and track record of over 28 consecutive years of profitable operations allow us to act as the policy-issuing carrier for business produced by GAs.
We reinsure substantially all of the underwriting and operating risks in connection with our fronting arrangements to our capacity providers. In many cases, we hold significant collateral to secure the associated reinsurance recoverables. We have ceded over $13 billion in premiums over the past 28 years with no unpaid reinsurance recoverables. Because we generally only write in these lines on a fronting basis, GAs and reinsurers can be confident that we will not compete with them with respect to the business they write through us. In exchange for providing our insurance capacity, licensing and rating to our GA and capacity provider clients, we receive ceding fees averaging in excess of 5% of gross written premiums. In addition, we require minimum annual fees, which we refer to as “capacity fees” for smaller programs, programs with uncertain premium volume or a program that involves exclusivity.
Our Lender Services segment generates premium primarily from providing CPI to our credit union, bank and specialty finance clients. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling. We believe that we are the only vertically integrated CPI provider focused primarily on this product offering, and that the breadth and flexibility of our services enable us to provide our lender clients with responsive and customized policy terms, services and reporting to better serve their needs. We service our CPI clients through InsurTrak, our proprietary technology platform that allows both us and our clients to track and manage a CPI program. We believe our InsurTrak system is highly scalable with the capacity to service a much larger volume of business without significant changes to the system. As of December 31, 2016, we had over 600 CPI clients with portfolios totaling 5.1 million CPI loans. In addition, our integrated CPI platform and InsurTrak have contributed to our ability to write business for credit unions, banks and specialty finance companies.
We have an exclusive relationship with CUNA Mutual Insurance Society (“CUNA Mutual”) to provide CPI to credit unions. CUNA Mutual is a leading insurance company focused on providing a range of insurance products to credit unions in the U.S. This alliance has enabled us to achieve a leading market share in the credit union CPI market. In 2014, we amended our relationship with CUNA Mutual to increase our retention of the business subject to the alliance to 70% from 50% for policies written on or after July 1, 2014.
We write our insurance business through our insurance company subsidiaries, which have expansive licenses to write insurance in the U.S. State National Insurance Company, Inc. (“SNIC”) and National Specialty Insurance Company (“NSIC”) are admitted carriers licensed to write property and casualty business in all 50 states and the District of Columbia. City National Insurance Company (“CNIC”) is an admitted carrier licensed to write property and casualty business in 49 states and the District of Columbia. United Specialty Insurance Company (“USIC”) is an admitted carrier in Delaware and is eligible to write surplus lines in all 50 states and the District of Columbia. Effective January 1, 2017, the Company acquired Fireman’s Fund Insurance Company of Ohio, an excess and surplus lines, or non-admitted, shell company. The company was subsequently renamed Independent Specialty Insurance Company (“ISIC”). SNIC, NSIC and USIC operate under an intercompany pooling arrangement in order to take advantage of our strong “A” (Excellent) group rating from A.M. Best. We have received regulatory approval to add CNIC and ISIC to the intercompany pooling arrangement in 2017.
Our long history of profitable operations has enabled us to maintain our “A” (Excellent) A.M. Best rating while writing gross premiums in excess of $1.4 billion in 2016 on approximately $296 million of shareholders’ equity, or over four times operating leverage at December 31, 2016. As of December 31, 2016, we had total assets of approximately $2.9 billion. The following table sets forth selected financial data for the periods presented:
(1)
Adjusted pre-tax income is considered a non-GAAP financial measure because it reflects the following adjustments to pre-tax income, which is the most directly comparable measure calculated in accordance with GAAP: the amount of founder special compensation, non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. Management uses adjusted pre-tax income to evaluate core financial performance against historical results without the effect of these items. For a reconciliation of this non-GAAP financial measure, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Results of Operations-Consolidated Results of Operations.”
(2)
Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation, non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. For a reconciliation of this non-GAAP financial measure, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Results of Operations-Consolidated Results of Operations.”
Our Business Segments and Services
We have two primary business segments, Program Services and Lender Services.
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Program Services - Our Program Services segment is a fronting business. We leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and
casualty insurance market to capacity providers in exchange for ceding fees. Through our fronting business, we write a wide variety of insurance products, principally including general liability insurance, commercial liability insurance, commercial multi-peril insurance, property insurance and workers compensation insurance. We are able to reinsure substantially all of the underwriting and operating risks associated with our fronting arrangements to our capacity providers. We mitigate the credit risk of our capacity providers generally by either selecting well capitalized, highly rated authorized reinsurers or requiring that the reinsurer post substantial collateral to secure the reinsured risks.
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Lender Services - Our Lender Services segment specializes in providing CPI, which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies. Our lender clients pay us directly for CPI and then add the cost of CPI to the loans of borrowers who do not uphold their obligation to the lender to insure the collateral underlying the loan. We also provide ancillary insurance products that currently are not actively marketed.
Our History
The Ledbetter family founded a small general agency in 1973 selling CPI exclusively in Texas. By the late 1970s, the Company began to expand the CPI business beyond Texas. Also at that time, we began to receive inquiries from other carriers and GAs seeking to access the Texas non-standard automobile market, and recognized the opportunity to act as an issuing carrier. The volume of this fronting business grew significantly. Most of this business was non-standard automobile insurance in the state of Texas written by a county mutual insurance company that we managed, and all of this business was 100% reinsured. No A.M. Best rating was required and the business could be written at very high leverage ratios. This high degree of leverage, the related reinsurer credit underwriting undertaken to support that leverage, and the significant collateral held against potential losses, were the foundation of our Program Services business model.
In 1984, we formed SNIC to write our CPI business directly. SNIC received an “A” (Excellent) rating from A.M. Best in 1993, and has maintained the rating for over 20 years. Over the years, we expanded our fronting and CPI operations outside of Texas and acquired additional insurance subsidiaries.
In 2009, we formed an exclusive relationship with CUNA Mutual, a leading provider of insurance products to credit unions. This alliance has enabled us to achieve a leading market share in the credit union CPI market.
On June 25, 2014, we completed the sale of an aggregate of 31,050,000 shares of our common stock in a private placement exempt from registration under the Securities Act of 1933, which we refer to in this report as the private placement. Subsequently, we registered the resale of these shares with the Securities and Exchange Commission and our common stock began trading on the Nasdaq Global Select Market on November 3, 2014.
Program Services Segment
Business Overview
In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses, and reputation to provide access to the U.S. property and casualty insurance market in exchange for ceding fees. This access is sought by GAs and capacity providers in the U.S. property and casualty insurance market. The most common underlying business reasons are set out below:
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GAs writing specialized books of business supported by capacity providers; and
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Capacity providers seeking a fronting arrangement, including:
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insurers that have access to origination but require broader licensing or given their lower rating, the use of an “A” A.M. Best rating to access business;
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foreign insurers writing in the United States, either directly or through GAs;
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domestic insurers seeking additional business free of channel conflicts;
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insurers looking to reduce financial leverage; and
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institutional risk investors that need to write through licensed, highly rated entities.
Many of our fronting programs are arranged with the assistance of brokers that are seeking to provide customized insurance solutions for specialty insurance business that requires an A.M. Best “A” rated carrier. In exchange for access to our rating, licensing and reputation, we generally charge ceding fees ranging between 5% and 6% of gross written premium. We are able to do this profitably because our specialized fronting business model relies on our GAs or capacity providers to provide the infrastructure associated with providing policy administration, claims handling, cash handling, underwriting, or other traditional insurance company services. Our low expense structure enables the Program Services segment to produce significant additional premium volume with only minimal incremental expense increase. Using our model, we are able to generate significant gross written premiums on a relatively small capital base compared to other insurance carriers.
We reinsure substantially all of the underwriting risk and business risk to the capacity providers and collect ceding fees on the transactions we facilitate. We remain exposed to the credit risk of capacity providers, or the risk that one of our capacity providers becomes insolvent or otherwise unable or unwilling to pay policyholder claims. To mitigate this credit risk of capacity providers, we have established financial criteria for selecting capacity providers as well as comprehensive methodologies and systems to monitor and mitigate this risk. See “-Relationships with Capacity Providers and Producers” below.
Relationships with Capacity Providers and Producers
The primary capacity providers that partner with us either make the strategic decision not to write certain business directly or cannot write directly. We offer a fully licensed platform with a strong capital position and strong relationships with regulators and rating agencies that have been cultivated for over three decades. Our low cost business model allows us to charge ceding fees that we believe are on the lower end of the market range, which is an additional attraction for capacity providers to work with us. We typically enter into these arrangements with respect to specified portions of a capacity provider’s business, rather than all of their portfolio.
In connection with writing Program Services business, we enter into agency and reinsurance agreements with both the producer (typically GAs) and the capacity provider (reinsurer) whereby the producer and capacity provider are generally required to deal directly with each other to develop business structures and terms and to implement and maintain the ongoing contractual relationship. In a number of cases, the producer and capacity provider for a program are part of the same organization or are otherwise affiliated. The producer generally is the party that will handle the marketing and underwriting of the policies (subject to certain limitations), the overall administration of the business, including preparing reports and making payments (i.e. premiums, commissions, losses, loss adjustment expenses, assessments, etc.) required pursuant to the applicable agreements, and handling of claims (up to certain limits and in some cases in conjunction with the reinsurer). The reinsurer typically undertakes to monitor the producer and to be responsible for the performance of the producer. As a result of our contract design, substantially all of the underwriting risk and business risk inherent in the arrangement is borne by the reinsurer. We take the risk of insolvency or other failure to pay by a capacity provider and also have potential liability for a breach of our obligations on limited matters, such as a fraudulent or criminal act on our part, fines or penalties assessed for our willful misconduct, a failure to defend an action or prosecute an appeal or our bad faith or negligent rejection of a settlement within policy limits.
To the extent the funds for premiums, commissions, losses, assessments and other payments are not the obligation of the Company and are settled directly between the producer and reinsurer, we do not record any receivables or payables. This direct settlement of balances due between the parties has several benefits to us, including reduced leverage ratios, increased Best’s Capital Adequacy Ratio (“BCAR”) score (used by A.M. Best to monitor capital adequacy), and reduced staffing requirements.
As compensation for writing this business, we receive ceding fees generally from the GAs or other producers. If a producer defaults on its obligation to pay these fees (or any other amount due), the capacity provider is generally obligated to make the payment under the guarantee contained in the contracts. We charge ceding fees averaging in excess of 5% of gross written premium. The fee may be adjusted upward if, for example, the business uses more surplus (i.e., has a longer tail) or requires more administration or oversight due to collateral requirements. In addition, we require minimum annual fees, which we refer to as “capacity fees” for smaller programs, programs with uncertain premium volume or a program that involves exclusivity.
We select GAs based on their experience, capacity to provide the necessary services, reputation and financial stability. We regularly monitor the performance of our GAs to ensure that there is no material deterioration with respect to such factors over time.
We generally require new capacity providers to either have an A.M. Best rating of “A-” (Excellent) or better, have equity and/or capital and surplus of at least $300 million and not have other issues that impact credit quality negatively or post substantial collateral. If a capacity provider does not meet our selection criteria, we utilize a number of risk mitigating levers, including requiring the posting of collateral and excess collateral, equity and/or capital and surplus and financial covenants, guarantees by affiliates and premium and/or policy limit caps. We review historical financial results of proposed capacity providers to assess financial stability.
Our contracts relating to collateral typically provide for changes in the level of collateral required based on estimates of reinsurance recoverables. Our contracts may also provide for changes in level of collateral required based on certain events, such as changes in a capacity provider’s ratings and level of equity and/or capital and surplus. See “-Reinsurance.”
Products
In our Program Services segment we act as an issuing carrier for foreign and domestic insurance and reinsurance companies in exchange for ceding fees, writing a wide variety of insurance products, principally including general liability insurance, commercial liability insurance, commercial multi-peril insurance, property insurance and workers compensation insurance.
Sales and Marketing
We source our fronting arrangements from reinsurance brokers and directly with GAs and capacity providers. Historically, we have been able to fully leverage our capital base through our traditional distribution channels with only a modest sales and marketing effort and using our existing infrastructure. We historically have been opportunistic and relationship-driven, rather than systematic, with respect to new business generation but recently began actively marketing our services. We continue to build direct relationships with GAs and capacity providers and have hired additional fully-dedicated sales staff. Also, we are now attending international conferences in addition to meetings by our senior executives with capacity providers in London and Bermuda. These meetings and conferences along with the direct marketing campaign with GAs have produced new business and viable leads.
We do not expect that developing direct relationships will have a negative effect on existing large brokerage relationships. In our experience, brokers typically view fronting deals as opportunistic rather than core to their business and generally accept that companies that primarily act as issuing carriers will and must develop direct relationships. We have a number of long-term relationships with GAs, brokers and reinsurers. Turnover generally occurs when capacity providers choose not to use a fronting arrangement, loss performance deteriorates, a GA forms its own insurance company, or a capacity provider exits a particular line of business. We have historically been able to more than offset cancelled programs with a combination of new fronting arrangements and organic growth in existing fronting arrangements.
Competition
We believe there are relatively few active competitors in the fronting business. We compete primarily on the basis of price, customer service, geographic coverage, financial strength ratings, licenses, reputation, business model, experience and generally not offering State National’s products for our own account. Our principal competitors are companies such as James River Group Holdings, Ltd., Clear Blue Financial Holdings, LLC., Spinnaker Insurance Company, AmTrust Financial Services, Inc. and Argo Group, which we believe only act as an issuing carrier on a limited basis or if a GA chooses to use an alternative structure in which the insurer retains the risk as opposed to that involves an issuing carrier. Unlike us, some of our competitors offer policy administration and are willing to assume a significant portion of the underwriting risk. We believe our long track record of success in this market and long-standing relationship and credibility with A.M. Best enable us to maintain our “A” (Excellent) A.M. Best rating with a relatively high operating leverage that we expect would be difficult for a competitor to obtain.
Geographic Distribution
We write our insurance business through our insurance company subsidiaries. The following table sets forth the distribution of our Program Services gross premium written by state as a percent of total gross premium written for the years ended December 31, 2016, 2015 and 2014:
Lender Services Segment
Business Overview
In our Lender Services segment, we primarily offer CPI, which insures automobiles or other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies. CPI is added by lenders to the loans of borrowers who do not uphold their obligation to the lender to insure the collateral underlying the loan. The product is underwritten directly by us. We also provide ancillary insurance products that we do not actively market. For the year ended December 31, 2016, approximately 95% of our CPI business was written with credit unions. In our CPI business, for 2016, the average lender loan balance was approximately $15,100 and our average claim was approximately $2,900. As of December 31, 2016, we had over 600 CPI clients and with portfolios totaling 5.1 million CPI loans.
Relationship with CUNA Mutual. We entered into a Collateral Protection Alliance Agreement with CUNA Mutual in 2009, which we refer to as the alliance agreement, which provided us access to a wider array of credit union clients and added significant additional scale to our CPI business. This alliance has enabled us to achieve a leading market share in the credit union CPI market. Pursuant to the alliance with CUNA Mutual, CUNA Mutual outsourced CPI administration and claims handling to us.
In connection with the alliance agreement, the parties also entered into a reinsurance agreement pursuant to which we initially agreed to cede 50% of the alliance business to CUNA Mutual. However, in 2014 we amended the alliance agreement to increase our retention of the business subject to the alliance to 70% from 50% for business written on or
after July 1, 2014, and in exchange we made payments to CUNA Mutual totaling $17.8 million. In addition, CUNA Mutual pays a ceding commission of 21% and reimburses a proportional share of direct commissions and other reimbursable expenses paid to accounts. The policies subject to the reinsurance agreement with CUNA Mutual insure automobiles or other vehicles held as collateral for loans made by credit unions across the U.S. For a description of the coverages under these policies, see “-CPI Product” below.
Vertical Integration. Our CPI business is fully integrated in that our operations in this segment cover sales, policy issuance, policy administration, underwriting, claims handling and all other aspects of the CPI business cycle. We believe we are the only vertically integrated CPI provider focused primarily on this product offering. Because we control all aspects of the CPI business operations, we can readily customize our product coverage and reporting to each client. We underwrite each of our lender client accounts and have the ability to move quickly to re-price the business in response to market or financial changes.
CPI Product
Coverages. A basic CPI policy provides coverage for physical damage to an insured’s automobile or other vehicles. The key difference between CPI and traditional automobile physical damage coverage is that CPI is purchased by lenders to protect their interest in collateral when it has been established that a borrower has not fulfilled his or her obligation to the lending institution to purchase adequate insurance coverage. By contrast, traditional automobile coverage is secured by individuals to protect their interests in the automobile in addition to their lienholder’s interest, if applicable.
CPI coverage can be written to protect the interest of the lending institution in the automobile, which is known as single interest coverage, or it can be written to protect the interest of both the lender and the borrower, which is known as dual interest coverage. At the lender’s request, a CPI program may also include a variety of additional coverage options supplementing the basic physical damage protection. Although the lender is generally responsible for paying our premiums, some of the coverage we offer provides for reimbursement of premiums the lender paid to us in the event of a borrower default. The most significant coverage options include:
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Collision: Covers accidental loss or damage to the collateral caused by collision with another object or rollover.
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Premium Deficiency: Provides for reimbursement of earned premiums subject to a wide range of options such as physical damage status and loss ratio.
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Conversion/Skip Loss: Provides coverage for the loss due to concealment, disposal, or misappropriation of the collateral by the borrower.
Allowance for Policy Cancellations. We experience a high level of policy cancellations with our CPI product because borrowers often purchase insurance at the traditional rates that provides protection for them in addition to their lender. As such, our recorded CPI premiums written are those that we expect to earn, and we record an allowance for policy cancellations for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes, associated with expected future policy cancellations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Critical Accounting Estimates-Allowance for Policy Cancellations” in Item 7 of this report.
Ancillary Products
As part of our agreement with CUNA Mutual, we no longer market any non-CPI products to credit unions, which include, for example, Guaranteed Auto Protection (“GAP”) insurance (covers the difference between the value of the collateral and the outstanding loan balance) and, mortgage protection insurance. For all non-CPI products, except for GAP, we act as an agent rather than an underwriter.
Sales and Marketing
Because of our exclusive relationship with CUNA Mutual, we have focused our CPI sales efforts primarily on credit unions. We have also sold CPI programs opportunistically to banks and specialty lending institutions. As of December 31, 2016, we had over 600 CPI clients nationwide and focus on developing new relationships on an ongoing basis. Measured by premium volume, as of December 31, 2016, approximately 89% of our CPI clients have been with us for two or more years and approximately 73% have been with us for five or more years.
CPI is sold by full-time sales professionals whose territories are organized geographically in order to facilitate extensive face-to-face interactions and to develop and leverage regional expertise. Sales managers are paid bonuses monthly based on sales volume. These bonuses are uncapped and may exceed annual salary. Most sales managers we hire have prior experience selling to financial institutions. In addition, our alliance with CUNA Mutual provides us with access to their sales force. That sales force is valuable, in part, because CUNA Mutual has business relationships with most credit unions nationwide. The alliance agreement with CUNA Mutual requires CUNA Mutual to assist in the sale of new CPI loans, and CUNA Mutual provides incentives to their sales force to achieve sales goals.
Client Servicing
We believe that our vertical integration is a key differentiator for us relative to competitors. We act as the agency, program administrator, and underwriter for our clients. Some of the key functions offered include new client assistance, tracking, borrower notification, contact center performance and claims. We believe that other CPI market participants that contract out certain functions of the business are not as well positioned to adapt to market and product changes or offer customized solutions.
Proprietary Technology - InsurTrak. A key component of our product and service offering is InsurTrak, our proprietary insurance tracking system. InsurTrak delivers real-time visibility into the current borrower insurance information. A key feature of InsurTrak is that it is highly customizable for the client at virtually no incremental cost to us. Clients have their own ways of managing their businesses, and, therefore, require different analyses, data, and reporting outputs. The platform allows clients and us to view transaction histories, monitor calls, submit insurance updates and claims, and view reports.
Service Operations Center. Another key component of our service offering is our service operations center. The service operations center handles calls from borrowers and is available 24 hours a day, 7 days a week. During regular business hours, borrowers can speak with a representative, while after hours callers receive answers to routine insurance questions using an interactive voice response system. Borrowers can also submit insurance information online, through the mail to a dedicated P.O. Box, or via a dedicated fax line.
Additionally, we take measures to assist borrowers in becoming compliant with insurance requirements of their loans. We send at least two customized borrower notices, and each month make thousands of outbound insurance verifications in order to avoid unnecessary CPI placements.
Once a policy has been issued, if a loss event occurs, we offer an easy electronic claim submission process to clients. Clients can file electronic claims for single or multiple losses through InsurTrak and can track the status, appraisers’ reports, and final settlement sheets of all claims remotely using this system.
Competition
The CPI market is very competitive. However, we believe the CPI market is mature and has significant barriers to entry, such as the required investment in technology and industry-specific knowledge. We compete primarily on the basis of price, coverages offered, claims handling, customer service, geographic coverage, financial strength ratings, licenses, reputation, technology, relationships with business partners and experience. We compete in the credit union market chiefly with two other CPI providers, Allied Solutions (“Allied”) and Southwest Business Corporation (“SWBC”). Allied is a Carmel, Indiana-based independent agency selling over 100 commercial and consumer insurance products with a similar market share to us. Allied has grown principally through acquisitions since its founding in 1977
and was sold to Securian, the parent corporation of Minnesota Life Insurance Company, in 2004. SWBC is a San Antonio, Texas-based GA selling a wide range of insurance, mortgage and investment products to commercial and consumer clients. Together with these two companies, we served approximately 72% of the total credit union CPI market in 2016, with the remainder being assorted smaller players and businesses which have opted to self-insure.
While we sell CPI almost exclusively, our two main competitors in the credit union market, Allied and SWBC, sell a much wider range of products, many of which are offered by CUNA Mutual. We believe that our monoline focus, vertical integration and proprietary technology platform provide for faster underwriting and better servicing of CPI clients and continue to serve as a key differentiator in the eyes of our clients.
We believe that a strengthening economy, an aging automobile fleet, and easier access to credit have contributed to recent increases in vehicle sales. In addition, the size of lenders’ automobile loan portfolios has been growing, reflecting the lenders’ willingness to lend and their willingness to lend at a higher loan-to-value ratio. We believe that there is opportunity for us to benefit from future growth in the CPI market, both organically and through new account sales.
Geographic Distribution
The following table sets forth the distribution of our Lender Services gross premium written by state as a percent of total gross premium written for the years ended December 31, 2016, 2015 and 2014:
Reinsurance
We use quota share reinsurance in both Program Services and Lender Services segments. “Quota share reinsurance” refers to reinsurance under which the insurer transfers, or cedes, a fixed percentage of liabilities, premium and related losses for each policy covered on a pro rata basis in accordance with the terms and conditions of the relevant agreement. In our Lender Services business, we use quota share reinsurance only in connection with our alliance with CUNA Mutual.
In our Program Services business, we have developed standardized forms of agreements, including our quota share reinsurance agreement, which we use in substantially all of our fronting arrangements. Under our fronting arrangements, we generally enter into a 100% quota share reinsurance agreement whereby we cede to the reinsurer substantially all of our gross liability under all policies issued by and on behalf of us by the general agent. The reinsurer is generally entitled to 100% of the net premiums received on policies reinsured, less the ceding fee to us, the commission paid to the general agent and premium taxes on the policies. The reinsurer assumes and is liable for substantially all losses incurred in connection with the risks under the reinsurance agreement, including judgments and settlements. See “Risk Factors-Risks Relating to Our Program Services Segment- Some of our fronting arrangements contain limits on the reinsurer’s obligations to us.” in Item 1A
Item 1A:Risk Factors
You should carefully consider the following risks and all of the other information set forth in this report, including our consolidated financial statements and the notes thereto. The following discussion of risk factors includes forward-looking statements and our actual results may differ substantially from those discussed in such forward-looking statements. See “Note on Forward-Looking Statements” in Item 1 of this report.
Risks Relating to Our Program Services Segment
We may not be able to recover amounts due from our reinsurers, which would adversely affect our financial condition.
Our Program Services segment offers fronting arrangements to domestic and foreign insurers that want to access specific U.S. property and casualty insurance business, which we collectively refer to as “capacity providers,” and generally reinsure on a quota share basis 100% of the risk under these policies with these carriers in exchange for ceding fees. Because we cede substantially all of these risks to capacity providers, we generally hold no net reserves for losses or LAE that might arise as a result of claims made under these policies. However, as the issuer of the policies, we remain directly liable to these policyholders.
We reinsure substantially all of the underwriting and operating risks in connection with our fronting arrangements to our capacity providers. We take the risk of insolvency or other failure to pay by a capacity provider. We generally select either well capitalized, highly rated authorized capacity providers or we require the capacity providers to post substantial collateral to secure the reinsured risks. However, if any of our capacity providers becomes insolvent, or otherwise refuses to reimburse losses paid to these policyholders (or us, to the extent we reimburse or pay policyholders or pay
other claims directly) in a timely manner, the corresponding impact to our liability for these claims could materially and adversely affect our financial condition and results of operations. We often hold collateral to protect us against a capacity provider’s failure to pay claims. However, collateral may not be sufficient to cover our liability for these claims, and we may not be able to cause the capacity provider to deliver additional collateral.
As of December 31, 2016, we held $2.2 billion in collateral securing $1.7 billion in reinsurance recoverables. The remaining unsecured reinsurance recoverables of $664.6 are ceded to highly-rated, well capitalized reinsurers. Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our capacity providers or any collateral securing the liabilities. This could occur because the loss experience is higher than expected or due to litigation, regulatory or other extra-contractual liabilities.
If we fail to realize a reinsurance recoverable owed under these arrangements due to insolvency, dispute or other unwillingness or inability of any of our reinsurers to meet their obligations to us, or due to our inability to access sufficient collateral to cover our liabilities, our business, financial condition, results of operations or prospects could be materially and adversely affected. For additional information, see “Business-Reinsurance” in Item 1 of this report.
If market conditions cause our reinsurance to be more costly or difficult to obtain, we may be required to bear increased risks or reduce the level of our underwriting commitments.
In our Program Services segment, we provide access to the U.S. property and casualty markets in exchange for ceding fees through our fronting business by providing access to our “A” (Excellent) A.M. Best rating, expansive licensing and reputation. As part of our business strategy for our Program Services segment, we reinsure substantially all underwriting risk, credit risk and business risk related to our fronting business. We may be unable to maintain our current reinsurance arrangements or to obtain other reinsurance in adequate amounts and at favorable rates, particularly if reinsurers become unwilling or unable to support our specialized fronting model in the future. In recent years, our Program Services segment has benefitted from favorable market conditions, including growth in the role of general agents (“GAs”) and of non-U.S. and other alternative sources of reinsurance. A decline in the availability of reinsurance, increases in the cost of reinsurance or a decreased level of activity by GAs could limit the amount of fronting business we could write and materially and adversely affect our business, financial condition, results of operations and prospects.
Regulators may challenge our use of fronting arrangements in states in which our capacity providers are not licensed.
We enter into fronting arrangements with GAs and domestic and foreign insurers that want to access specific U.S. property and casualty insurance business in states in which such capacity provider is not licensed or is not authorized to write particular lines of insurance. The capacity provider or the GA administers the business, settles all claims and reinsures substantially all of the risks. We receive ceding fees, but generally do not share in the profits or losses of the business we write for the capacity provider. Some state insurance regulators may object to our fronting arrangements. In certain states, including Florida, the Insurance Commissioner has the authority to prohibit an authorized insurer from acting as an issuing carrier for an unauthorized insurer. In addition, insurance departments in states in which there is no statutory or regulatory prohibition against an authorized insurer acting as an issuing carrier for an unauthorized insurer, such as New York, could deem the assuming insurer to be transacting insurance business without a license and the issuing carrier to be aiding and abetting the unauthorized sale of insurance.
If regulators in any of the states where we conduct our fronting business were to prohibit or limit the arrangement, we would be prevented or limited from conducting that business for which a capacity provider is not authorized in those states, unless and until the capacity provider is able to obtain the necessary licenses. This could have a material and adverse effect on our business, financial condition results of operations and prospects. In particular, we do significant business in Florida. See “-We write at least half of our Program Services business in several key states and adverse developments in these key states could have a material and adverse effect on our business, financial condition, results of operations and prospects.”
Notwithstanding these state law restrictions on ceding insurers, the Nonadmitted and Reinsurance Reform Act (“NRRA”) contained in The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)
provides that all laws of a ceding insurer’s nondomestic state (except those with respect to taxes and assessments on insurers or insurance income) are preempted to the extent that they otherwise apply the laws of the state to reinsurance agreements of nondomestic ceding insurers. The NRRA places the power to regulate reinsurer financial solvency primarily with the reinsurer’s domiciliary state and requires credit for reinsurance to be recognized for a nondomestic ceding company if it is allowed by the ceding company’s domiciliary state. A state insurance regulator might not view the NRRA as preempting a state regulator’s determination that an unauthorized reinsurer must obtain a license or that a statute prohibited our doing a fronting business. However, such a determination or a conflict between state law and the NRRA could cause regulatory uncertainty about our fronting business, which could have a material and adverse effect on our business, financial condition, results of operations and prospects.
Changes in state insurance regulation could materially and adversely affect our business.
Some states have adopted changes to their insurance laws and regulations that permit insurers to obtain credit for reinsurance from reinsurers who are able to post reduced collateral if they satisfy certain requirements, including specific rating criteria. We require many of our capacity providers to post collateral to secure their reinsurance obligations. If regulatory changes are adopted in the states in which our insurance subsidiaries are domiciled that permit non-admitted reinsurers to post reduced or no collateral in order for the insurer to obtain credit for that reinsurance, it may become more difficult for us to obtain collateral from our capacity providers who meet the applicable rating agency requirements, which could materially and adversely affect the amount of business that we can write.
We depend on a limited number of capacity providers and general agents for a large portion of our gross written premium in our Program Services segment, and the loss of business provided by any one of them could materially and adversely affect us.
Our Program Services segment offers fronting arrangements to both GAs and capacity providers. Capacity providers may be under common control with a particular GA or they be independent. An independent capacity provider may reinsure a single book or multiple books with various GAs. A single GA may control a single book with one capacity provider or multiple books with various capacity providers.
Other insurance companies compete with us for this business. These capacity providers and GAs may choose to enter into fronting arrangements with our competitors or GAs, or capacity providers may terminate fronting arrangements with us if they no longer need access to our fronting capacity or for other reasons.
Our top five GAs measured by ceding fees for the year ended December 31, 2016 accounted for approximately 21%, 19%, 10%, 9% and 5% of our ceding fees in our Program Services segment, respectively. For the years ended December 31, 2016, 2015 and 2014 approximately 40%, 43% and 48% of our ceding fees in our Program Services segment was derived from our top two fronting arrangements. Our top GA, controlled by a single capacity provider, for the year ended December 31, 2016, was Meadowbrook at 21% of Program Services ceding fees and 7.1% of total consolidated revenues.
Our top five capacity providers measured by premium volume for the year ended December 31, 2016 accounted for approximately 23%, 22%, 19%, 7%, and 5% of our gross written premium in our Program Services segment. For the years ended December 31, 2016, 2015 and 2014 approximately 45%, 53% and 57% of our gross written premium in our Program Services segment was derived from our top two capacity providers. Much of the business concentrated with these capacity providers is also included in the business concentrated with the GAs noted above.
A significant decrease in business from, or the entire loss of, our largest capacity provider or GA or several of our other large capacity providers or GAs would cause us to lose premium and require us to seek additional capacity providers or GAs or to replace the lost premium. In the event that we are unable to do so, our business, financial condition, results of operations and prospects would be materially and adversely affected.
Failure of capacity providers or GAs to properly market, underwrite or administer policies could adversely affect us.
The marketing, underwriting, claims administration and other administration of policies in our Program Services segment are the responsibility of our capacity providers or our GAs. Any failure by them to properly handle these functions could result in liability to us. Even though they may be required to compensate us for any such liability, there are risks that any such failures could create regulatory or reputational issues for us and that they do not pay us, either of which could materially and adversely affect our business, financial condition, results of operations and prospects.
We write at least half of our Program Services business in several key states and adverse developments in these key states could have a material and adverse effect on our business, financial condition, results of operations and prospects.
For the years ended December 31, 2016, 2015 and 2014 we derived approximately 56%, 60% and 56% of our gross written premium in our Program Services segment in the states of California, Texas, Florida, and New York. As a result, our financial results are subject to prevailing regulatory, legal, economic, demographic, competitive, and other conditions in these states. Adverse developments relating to any of these conditions could have a material and adverse impact on our business, financial condition, results of operations and prospects. See “Business-Program Services Segment-Geographic Distribution.”
We may not be successful in building more direct relationships with GAs and capacity providers through a direct marketing campaign.
Historically, our fronting capacity has been constrained by the size of our capital base, and we have relied on our relationship-driven channels to generate new fronting business with only a modest sales and marketing effort. In addition, we have historically relied on brokers to identify GAs in need of fronting. Although we continue to build direct relationships with GAs and capacity providers and have hired additional fully-dedicated sales staff, we may not be successful in our efforts to further expand our fronting business.
We may face increased competition in our Program Services segment.
We believe there are relatively few active competitors in our Program Services segment. We compete primarily on the basis of price, customer service, geographic coverage, financial strength ratings, licenses, reputation, business model, experience and generally not offering State National’s products for our own account. Our principal competitors are companies such as James River Group Holdings, Ltd., Clear Blue Financial Holdings, LLC., Spinnaker Insurance Company, AmTrust Financial Services, Inc. and Argo Group. Unlike us, some of our competitors may offer policy administration or other services or be willing to take on significant underwriting risk. Any increase in competition in this segment, especially by one or more substantial companies, could materially and adversely affect our business, financial condition, results of operations and prospects.
Some of our fronting arrangements contain limits on the reinsurer’s obligations to us.
While we reinsure substantially all of the risks inherent in our fronting programs, we have in certain cases entered into programs that contain limits on our reinsurers’ obligations to us, including loss ratio caps, aggregate reinsurance limits or exclusion of the credit risk of GAs. For example, under our program with Nephila Capital Ltd., we bear no business or insurance risk except for annual aggregate agreement year losses in excess of a limit that we believe is highly unlikely to be exceeded. To the extent losses under these programs exceed the prescribed limits, we will be liable to pay the losses in excess of such limits, which could materially and adversely affect our business, financial condition, results of operations and prospects.
Our losses resulting from the run-off of the retained business may exceed our reserves.
In the past, we have participated on a quota share basis to a limited extent in certain programs in the Program Services segment. In early 2012, we reinsured to inception the retained business under most of the active contracts, but others continue to run-off. See “Management’s Discussion and Analysis of Financial Condition and Results of
Operations-Factors Affecting Our Operating Results-Run-off of the Retained Business” in Item 7 of this report. As of December 31, 2016, we had reserves of $3.5 million related to this business. In the event our losses resulting from this business exceeds our reserves, the excess losses could materially and adversely affect our business, financial condition, results of operations and prospects.
Risks Relating to Our Lender Services Segment
Lender-placed residential hazard insurance is under increased regulatory scrutiny and has been subject to regulatory changes at both the federal and state levels. If lender-placed automobile insurance becomes subject to similar regulatory scrutiny and is affected by regulatory changes, our business, financial condition, results of operations and prospects could be materially and adversely affected.
Through our Lender Services segment, we provide collateral protection insurance, or CPI, to financial institutions. Other companies provide similar products to home lenders. Under certain circumstances, when borrowers fail to provide hazard insurance on their residences, the owner or servicer of the loan may place such insurance to protect the collateral and pass on the premium to the borrower. This lender-placed residential hazard insurance has come under increased regulatory scrutiny and has been subject to regulatory changes. For example, Fannie Mae and Freddie Mac mortgage servicers and their affiliates may not receive commissions or other forms of compensation with lender-placed insurance on government-sponsored enterprise (“GSE”) loans or ceding premiums to a reinsurer affiliated with the servicers. In addition, state regulators have also taken action to restrict insurance practices related to lender-placed residential hazard insurance.
In the future, states or the federal government may subject lender-placed automobile insurance to similar regulatory scrutiny or propose regulatory changes to related laws. For example, the United States Governmental Accountability Office’s (“GAO”) September 2015 Report on Lender-Placed Insurance examined both residential and personal property lender-placed insurance. The GAO recommended the NAIC gather additional information on the lender-placed insurance market. In particular, CPI’s higher expense ratios and lower loss ratios, as compared to other insurance products, presents a risk that regulatory requirements such as minimum loss ratios could be proposed in the future. Any future proposed or adopted rules relating to automobile CPI could materially and adversely affect our business, financial condition, results of operation and prospects.
The NAIC Creditor-Placed Insurance Model Act (“Creditor-Placed Model Act”) applies to insurance placed in connection with automobile loans and creates a legal framework within which creditor-placed insurance may be written and helps to maintain the separation between creditors and insurers. It also serves to minimize the possibilities of unfair competitive practices in the sale of creditor-placed insurance. The Creditor-Placed Model Act has only been adopted by a few states, including Arkansas, Michigan, Mississippi, and Tennessee, but other states have also adopted laws and regulations that cover creditor-placed insurance. There could be an effort, especially from consumer groups, to expand the protections and breadth of the Creditor-Placed Model Act. The NAIC Property and Casualty Insurance Committee is currently reviewing the Model Act and is tentatively scheduled to provide its proposed revisions (if any) in 2017.
The CPI market is highly competitive, and we may not be able to compete effectively against larger companies.
The CPI market is highly competitive. We compete on the bases of price, coverages offered, claims handling, customer service, geographic coverage, financial strength ratings, licenses, reputation, technology, relationships with business partners and experience. Some of our competitors have substantially more capital, comparable or higher ratings and greater resources than we have, and offer a broader range of products than we offer. Many of our competitors invest heavily in advertising and marketing efforts and/or expanding their online service offerings. Some of these competitors may have better brand recognition than we have and have a larger market share than we do. As a result, these larger competitors may be better able to offer lower rates to customers, to withstand larger losses, and to more effectively take advantage of new marketing opportunities. Our ability to compete against these larger competitors depends on our ability to deliver superior service and maintain our relationships with our clients.
We may undertake strategic marketing and operating initiatives to improve our competitive position and drive growth. If we are unable to successfully implement new strategic initiatives or if our marketing campaigns do not attract
new customers, our competitive position may be harmed, which could materially and adversely affect our business, financial condition, results of operations and prospects.
The termination of our alliance with CUNA Mutual could materially and adversely affect our growth prospects for our CPI business and our liquidity.
Our alliance with CUNA Mutual has allowed us to significantly increase the amount of CPI business we write due to the business that is generated by CUNA Mutual’s sales and marketing efforts. For the years ended December 31, 2016, 2015 and 2014, the CPI gross premiums written through our alliance with CUNA Mutual represented 63.0%, 60.0% and 56.3% of our total CPI business, respectively. During 2014, we amended the alliance agreement to increase our retention of the business subject to the alliance to 70% from 50% for business written on or after July 1, 2014, and in exchange have made payments to CUNA Mutual totaling $17.8 million. In addition, the term of the alliance has been extended at least through July 31, 2018. Thereafter, the agreement will be automatically renewed for consecutive three year terms unless either party provides notice of nonrenewal at least twelve months prior to the expiration date.
If the alliance were to terminate and we no longer had access to those extensive sales and marketing efforts, our ability to continue to grow our CPI business could materially and adversely affected. CUNA Mutual has the right to terminate its alliance agreement with us upon a change in control of State National or certain of its subsidiaries, which is defined to include any substantial change in the senior management team. See “Business-Lender Services Segment-Business Overview-Relationship with CUNA Mutual” in Item 1 of this report. In addition, if and when the alliance agreement terminates, depending upon the reason for the termination and subject to certain exceptions, we may be required to buy out CUNA Mutual’s right to participate in future alliance business at a price equal to the previous 12 months net premium times a percentage based on the loss ratio of the business during that period. We estimate that the amount of this payment as of December 31, 2016 would be approximately $25.3 million.
Changes affecting the automobile loan business generally and the CPI business in particular could materially and adversely affect our business, financial condition, results of operations and prospects.
A number of economic and market conditions affect vehicle sales volume and product mix, the amount of automobile loans and the CPI market, including levels of unemployment, consumer confidence, average age of vehicles on the road, availability and cost of credit, cost of fuel, credit profiles of borrowers and amounts sought to be financed. Our CPI business has benefitted in recent periods from a strong overall automobile loan environment, including increases in vehicle sales and average amounts financed. Any negative changes in market conditions could materially and adversely affect demand for our CPI product offerings and, consequently, our business, financial condition, results of operations and prospects.
If we are unable to establish and maintain accurate allowance for policy cancellations, our business, financial condition, results of operations and prospects may be materially and adversely affected.
Our financial statements include an allowance for policy cancellations, which represents our best estimate of the amounts that our insurance subsidiaries will ultimately refund for CPI polices that cancel (net of applicable offsetting expenses) as of the date of the financial statements. There is inherent uncertainty in the process of establishing the allowance.
As a result of these uncertainties, the ultimate refunds paid may deviate, perhaps substantially, from the point-in-time estimates of such refunds and expenses, as reflected in the allowance for policy cancellations included in our financial statements. To the extent that premium refunds exceed our estimates, we will be required to immediately recognize the unfavorable development and increase our allowance for policy cancellations, with a corresponding reduction in our net income in the period in which the allowance is increased. Consequently, ultimate refunds paid could materially exceed the reported allowance for policy cancellations and have a material and adverse effect on our business, financial condition, results of operations and prospects.
Risks Relating to Our Business Generally
A downgrade in the A.M. Best rating of our insurance subsidiaries would reduce the amount of business we are able to write and could materially adversely impact the competitive positions of our insurance subsidiaries.
Rating agencies evaluate insurance companies based on their ability to pay claims. Our insurance subsidiaries have been assigned an “A” (Excellent) rating by A.M. Best Company, Inc. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time. Our competitive position relative to other companies is determined in part by the A.M. Best rating of our insurance subsidiaries. A.M. Best ratings are directed toward the concerns of policyholders and insurance agencies and are not intended for the protection of investors or as a recommendation to buy, hold or sell securities.
We rely on our “A” rating from A.M. Best to operate our Program Services business and our Lender Services business. There can be no assurances that our insurance subsidiaries will be able to maintain this rating. Any downgrade in ratings would likely materially adversely affect our business through the loss of certain existing and potential policyholders and the loss of relationships with clients that might move to other companies with higher ratings. If we lost our “A” rating, our capacity providers would likely seek a higher rated issuing carrier to write their business.
Our Lender Services segment would also be adversely affected if a large number of our accounts were to require an insurer with an “A” rating. In addition, pursuant to the arrangement with CUNA Mutual, if our A.M. Best rating falls below “A-” for more than 180 consecutive days, CUNA Mutual will be entitled to terminate the arrangement with us and thereafter CUNA Mutual will have the option to purchase our right to participate in the future business of the alliance. We are not able to quantify the percentage of our business, in terms of premiums or otherwise, that would be affected by a downgrade in our A.M. Best ratings.
If we are unable to accurately underwrite risks and charge competitive yet profitable rates to our clients and policyholders, our business, financial condition, results of operations and prospects may be materially and adversely affected.
In general, the premiums for our insurance policies are established at the time a policy is issued and, therefore, before all of our underlying costs are known. Like other insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate premiums is necessary, together with investment income, to generate sufficient revenue to offset losses, loss adjustment expenses (“LAE”) and other underwriting costs and to earn a profit. If we do not accurately assess the risks that we assume, we may not charge adequate premiums to cover our losses and expenses, which would negatively affect our results of operations and our financial condition. Alternatively, we could set our premiums too high, which could reduce our competitiveness and lead to lower revenues. In addition, a variety of economic factors can affect losses in our CPI business. For example, difficult economic conditions could lead to increased losses as a result of increased premium deficiency and conversion/skip claims.
Pricing involves the acquisition and analysis of historical loss data, and the projection of future trends, loss costs and expenses, and inflation trends, among other factors, for each of our products in multiple risk tiers and many different markets. In order to accurately price our policies, we:
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collect and properly analyze a substantial volume of data from our insureds;
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develop, test and apply appropriate projections and rating formulas;
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closely monitor and timely recognize changes in trends; and
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project expected losses for our insureds with reasonable accuracy.
We seek to implement our pricing accurately in accordance with our assumptions. Our ability to undertake these efforts successfully and, as a result, accurately price our policies, is subject to a number of risks and uncertainties, including:
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insufficient or unreliable data;
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incorrect or incomplete analysis of available data;
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uncertainties generally inherent in estimates and assumptions;
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our failure to implement appropriate actuarial projections and rating formulas or other pricing methodologies;
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regulatory constraints on rate increases;
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our failure to accurately estimate investment yields and the duration of our liability for loss and LAE; and
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unanticipated court decisions, legislation or regulatory action.
Our failure to accurately and timely pay claims could materially and adversely affect our business, financial condition, results of operations and prospects.
We must accurately and timely evaluate and pay claims that are made under our CPI and other policies. Many factors affect our ability to pay claims accurately and timely, including the training and experience of our claims representatives, our claims organization’s culture and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors. Our failure to pay claims accurately and timely could lead to regulatory and administrative actions, material litigation, undermining our reputation in the marketplace and materially and adversely affecting our business, financial condition, results of operations and prospects.
In addition, if we do not train new claims employees effectively or lose a significant number of experienced claims employees, our claims department’s ability to handle an increasing workload could be adversely affected. In addition to potentially requiring that growth be slowed in the affected markets, our business could suffer from decreased quality of claims work which, in turn, could lower our operating margins.
Our insurance subsidiaries are subject to minimum capital and surplus requirements. Our failure to meet these requirements could subject us to regulatory action.
The laws of the states of domicile of our insurance subsidiaries impose risk-based capital standards and other minimum capital and surplus requirements. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do.
If we are unable to establish and maintain accurate loss reserves, our business, financial condition, results of operations and prospects may be materially and adversely affected.
Our financial statements include loss reserves, which represent our best estimate of the amounts that our insurance subsidiaries ultimately will pay on claims that have been incurred, and the related costs of adjusting those claims, as of the date of the financial statements. There is inherent uncertainty in the process of establishing insurance loss reserves.
As a result of these uncertainties, the ultimate paid loss and LAE may deviate, perhaps substantially, from the point-in-time estimates of such losses and expenses, as reflected in the loss reserves included in our financial statements. To the extent that loss and LAE exceed our estimates, we will be required to immediately recognize the unfavorable
development and increase loss reserves, with a corresponding reduction in our net income in the period in which the reserve levels are increased. Consequently, ultimate losses paid could materially exceed reported loss reserves and have a material and adverse effect on our business, financial condition, results of operations and prospects.
Catastrophic losses or the frequency of smaller insured losses may exceed our expectations, which could materially and adversely affect our business, financial condition, results of operations and prospects.
Our insurance business is subject to claims arising from catastrophes, such as hurricanes, tornadoes, windstorms, floods, earthquakes, hailstorms, severe winter weather, and fires, or other events, such as explosions, terrorist attacks, riots, and hazardous material releases. The incidence and severity of such events are inherently unpredictable, and our losses from catastrophes could be substantial. In our Program Services business, although we reinsure substantially all of the underwriting risk through our fronting arrangements, a catastrophe loss could impair the ability of one or more of our reinsurers to pay all of the reinsured claims, in which case we would be responsible for paying any claims not paid by our reinsurer(s). In our Lender Services business, it is possible that we may experience an unusual frequency of smaller losses in a particular period. In either case, the consequences could be substantial volatility in our financial condition or results of operations for any fiscal quarter or year, which could have a material and adverse effect on our business, financial condition, results of operations and prospects or our ability to write new business.
Ongoing economic uncertainty could materially and adversely affect our business, financial condition, results of operations and prospects.
Global economies and financial markets have experienced significant weakness and volatility since 2008, although the most extreme of these circumstances have abated since that time. Despite improved financial market performance since 2009, near-term U.S. economic prospects have only very gradually improved. In addition, U.S. federal and state governments continue to experience significant structural fiscal deficits, creating uncertainty as to levels of taxation, inflation, regulation and other economic fundamentals that may impact future growth prospects. Significantly greater economic, fiscal and monetary uncertainty remains in Europe, due to the combination of poor economic growth, high unemployment and significant sovereign deficits. Continuation of these conditions may potentially affect (among other aspects of our business) the demand for and claims made under our products, the ability of clients, counterparties and others to establish or maintain their relationships with us, our ability to access and efficiently use internal and external capital resources and our investment performance. In the event that these conditions persist and result in a prolonged period of economic uncertainty, our business, financial condition, results of operations, our prospects and competitor landscape could be materially and adversely affected.
Our business is dependent on the efforts of our executive officers and other personnel. If we are unsuccessful in our efforts to attract, train and retain qualified personnel, our business, financial condition, results of operations and prospects may be materially and adversely affected.
Our success is dependent on the efforts of our executive officers because of their industry expertise, knowledge of our markets, and relationships with our clients. Our executive officers are:
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Terry Ledbetter, Chairman and Chief Executive Officer;
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Matthew Freeman, President;
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David Hale, Executive Vice President, Chief Operating Officer and Chief Financial Officer;
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John Pearson, Executive Vice President and National Sales Manager;
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Trace Ledbetter, Executive Vice President of Service;
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David Cleff, Executive Vice President of Business Affairs, General Counsel and Secretary; and
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Luke Ledbetter, Executive Vice President and Chief Underwriting Officer of Program Services.
We have agreements with our executive officers that contain certain non-compete and non-solicit provisions. Nonetheless, should any of our executive officers cease working for us, we may be unable to find acceptable replacements with comparable skills and experience in the niche markets that we target. In addition, our business is also dependent on other skilled employees. We cannot assure you that we will be able to attract, train and retain, on a timely basis and on anticipated economic and other terms, experienced and capable senior management, underwriters and support staff. We intend to pay competitive salaries, bonuses and equity-based rewards in order to attract and retain such personnel, but there can be no assurance that we will be successful in such endeavors. The loss of key personnel, or the inability to recruit and retain qualified personnel in the future, could have a material adverse effect on our business, financial condition or operating results. We do not currently maintain life insurance policies with respect to our executive officers or other employees.
If we are unable to maintain our technology platform or our technology platform fails to operate properly, or meet the technological demands of our clients with respect to the products and services we offer, our business, financial condition, results of operations and prospects could be materially and adversely affected.
If we are unable to properly maintain our InsurTrak system and the remainder of our technology systems or if our technology systems otherwise fail to perform in the manner we currently contemplate, our ability to effectively underwrite and issue policies, process claims and perform other business functions, and our CPI clients’ ability to track and manage their CPI programs, could be significantly impaired and our business, reputation and financial performance could be materially and adversely affected. In addition, the success of our business is dependent on our ability to resolve any issues identified with our technology arrangements during operations and make any necessary improvements in a timely manner. Further, we will need to match or exceed the technological capabilities of our competitors over time. We cannot predict with certainty the cost of such maintenance and improvements, but failure to make such improvements could have a material and adverse effect on our business, financial condition, results of operations and prospects. See “Business-Technology.”
Also, we use e-commerce and other technology to provide, expand and market our products and services. Accordingly, we believe that it will be essential to continue to invest resources in maintaining electronic connectivity with clients and, more generally, in e-commerce and technology. Our business may suffer if we do not maintain these arrangements or keep pace with the technological demands of our clients.
If we experience security breaches or other disruptions involving our technology, our ability to conduct our business could be adversely affected, we could be liable to third parties and our reputation could suffer, which could have a material and adverse effect on our business, financial condition, results of operations and prospects.
Our business is dependent upon the uninterrupted functioning of our information technology and telecommunication systems. We rely upon our systems, as well as the systems of our vendors, for all our business operations, including underwriting and issuing policies, processing claims, providing customer service, complying with insurance regulatory requirements and performing actuarial and other analytical functions necessary for underwriting, pricing and product development. Our operations are dependent upon our ability to timely and efficiently maintain and improve our information and telecommunications systems and protect them from physical loss, telecommunications failure or other similar catastrophic events, as well as from security breaches. A shut-down of, or inability to access, one or more of our facilities; a power outage; or a failure of one or more of our information technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis. In the event of a disaster such as a natural catastrophe, terrorist attack or industrial accident, or due to a computer virus, our systems could be inaccessible for an extended period of time. While we have implemented business contingency plans and other reasonable and appropriate internal controls to protect our systems from interruption, loss or security breaches, a sustained business interruption or system failure could adversely impact our ability to process our business, provide customer service, pay claims in a timely manner or perform other necessary business functions.
Our operations depend on the reliable and secure processing, storage and transmission of confidential and other information in our computer systems and networks. Computer viruses, hackers, employee misconduct and other external hazards could expose our data systems to security breaches, cyber-attacks or other disruptions. In addition, we routinely transmit and receive personal, confidential and proprietary information by electronic means. We have implemented security measures designed to protect against breaches of security and other interference with our systems and networks resulting from attacks by third parties, including hackers, and from employee or advisor error or malfeasance. Despite these measures, we cannot assure that our systems and networks will not be subject to breaches or interference. Any such event may result in operational disruptions as well as unauthorized access to or the disclosure or loss of our proprietary information or our clients’ or insureds’ information, which in turn may result in legal claims, regulatory scrutiny and liability, reputational damage, the incurrence of costs to eliminate or mitigate further exposure, the loss of clients or affiliated advisors or other damage to our business. In addition, the trend toward broad consumer and general public notification of such incidents could exacerbate the harm to our business, financial condition and results of operations. Even if we successfully protect our technology infrastructure and the confidentiality of sensitive data, we could suffer harm to our business and reputation if attempted security breaches are publicized. We cannot be certain that advances in criminal capabilities, discovery of new vulnerabilities, attempts to exploit vulnerabilities in our systems, data thefts, physical system or network break-ins or inappropriate access, or other developments will not compromise or breach the technology or other security measures protecting the networks and systems used in connection with our business.
If we cannot sustain our business relationships, including our relationships with GAs, capacity providers and with clients in our Lender Service segment, we may be unable to compete effectively and operate profitably.
Our relationships with our clients are generally governed by agreements that may be terminated on short notice. In our Program Services segment, our standard reinsurance agreement provides several events of termination, including among others that the agreement may be terminated by any party (us, the reinsurer or general agent) by providing at least 90 days written notice to the other parties; immediately upon written notice by the reinsurer or us in the event of the cancellation or non-renewal of the general agent’s insurance license; by the reinsurer after 30 days written notice of the general agent’s failure to pay the reinsurer the premium due; by us if the reinsurer is insolvent or credit for reinsurance is disallowed or if the reinsurer is required to increase the amount of collateral or is required to secure its obligations under the agreement in specified situations; and by any party in the event of a change in control of our insurance subsidiary, the reinsurer or general agent.
Our ability to compete and remain profitable depends, in part, on our maintaining business relationships with our clients, the marketing efforts of our sales professionals, the servicing efforts of our relationship managers and on our ability to offer insurance products and maintain financial strength ratings that meet the requirements and preferences of
our clients. Any failure on our part to be effective in any of these areas may have a material and adverse effect on our business, financial condition, results of operations and prospects.
Performance of our investment portfolio is subject to a variety of investment risks that may materially and adversely affect our business, financial condition, results of operations and prospects.
Our results are affected, in part, by the performance of our investment portfolio. Our investment portfolio contains interest rate sensitive investments, such as fixed-income securities. As of December 31, 2016, our investment in fixed-income securities was approximately $332.1 million, or 99.0% of our total investment portfolio. Increases in market interest rates may have an adverse impact on the value of our investment portfolio by decreasing the value of fixed-income securities. Conversely, declining market interest rates could have an adverse impact on our investment income as we invest positive cash flows from operations and as we reinvest proceeds from maturing and called investments in new investments that could yield lower rates than our investments have historically generated. Defaults in our investment portfolio may produce operating losses and materially and adversely impact our business, financial condition, results of operations and prospects.
Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and non-U.S. economic and political conditions, and other factors beyond our control. Although we take measures to manage the risks of investing in a changing interest rate environment, we may not be able to mitigate interest rate sensitivity effectively. Our mitigation efforts include maintaining a high quality portfolio and managing the duration of the portfolio to reduce the effect of interest rate changes. Despite our mitigation efforts, a significant change in interest rates could have a material and adverse effect on our business, financial condition, results of operations and prospects.
In addition, the performance of our investment portfolio generally is subject to other risks, including the following:
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the risk of decrease in value due to a deterioration in the financial condition, operating performance or business prospects of one or more issuers of our fixed-income securities;
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the risk that our portfolio may be too heavily concentrated in the securities of one or more issuers, sectors or industries;
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the risk that we will not be able to convert investment securities into cash on favorable terms and on a timely basis; and
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general movements in the values of securities markets.
If our investment portfolio were to suffer a substantial decrease in value due to market, sector or issuer-specific conditions, our business, financial condition, results of operations and prospects could be materially and adversely affected. A decrease in value of an insurance subsidiary’s investment portfolio could also put the subsidiary at risk of failing to satisfy regulatory minimum capital requirements and could limit the subsidiary’s ability to write new business.
The insurance industry is subject to extensive regulation, which may affect our ability to execute our business plan and grow our business.
We are subject to comprehensive regulation and supervision by government agencies in Texas and Delaware, states in which our insurance subsidiaries are domiciled, as well as all states in which they are licensed, sell insurance products, issue policies, or handle claims. Some states impose restrictions or require prior regulatory approval of specific corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policyholders and are not intended to protect the interests of shareholders. Our ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner is, and will continue to be, critical to our success. Some of these regulations include:
·
Required Licensing. We operate under licenses issued by the insurance departments in the states in which we sell insurance. If a regulatory authority denies or delays granting a new license, our ability to enter that market
quickly or offer new insurance products in that market may be substantially impaired. In addition, if the insurance department in any state in which we currently operate suspends, non-renews, or revokes an existing license, we would not be able to offer affected products in that state.
·
Transactions between Insurance Companies and Their Affiliates. Transactions between us or any of our affiliates and our insurance companies generally must be disclosed, and prior approval is required before any material or extraordinary transaction may be consummated. Approval may be refused or the time required to obtain approval may delay some transactions, which may adversely affect our ability to innovate or operate efficiently. Our unregulated entities receive substantial payments for services rendered to our insurance company subsidiaries pursuant to arrangements approved by insurance regulators. Changes in insurance regulation could materially and adversely affect the amount of cash flow we are able to generate outside of our insurance company subsidiaries.
·
Regulation of Insurance Rates and Approval of Policy Forms. The insurance laws of most states in which we conduct business require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. If, as permitted in some states, we begin using new rates before they are approved, we may be required to issue refunds or credits to the policyholders if the new rates are ultimately deemed excessive or unfair and disapproved by the applicable insurance department. In other states, prior approval of rate changes is required and there may be long delays in the approval process or the rates may not be approved. Accordingly, our ability to respond to market developments or increased costs in that state could be adversely affected.
·
Other Regulations. We must also comply with regulations involving, among other matters:
·
the use of non-public consumer information and related privacy issues;
·
the use of credit history in underwriting and rating policies;
·
limitations on the ability to charge policy fees;
·
limitations on types and amounts of investments;
·
restrictions on the payment of dividends;
·
the acquisition or disposition of an insurance company or of any company controlling an insurance company;
·
involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;
·
reporting with respect to financial condition;
·
periodic financial and market conduct examinations performed by state insurance department examiners;
·
reporting with respect to ORSA; and
·
reporting with respect to the NAIC model audit rule.
The failure to comply with these laws and regulations may also result in regulatory actions, fines and penalties, and in extreme cases, revocation of our ability to do business in a particular jurisdiction. In the past we have been fined by state insurance departments for failing to comply with certain laws and regulations. In addition, we may face individual and class action lawsuits by insured and other parties for alleged violations of certain of these laws or regulations.
Regulation may become more extensive in the future, which may materially and adversely affect our business, financial condition, results of operations and prospects.
Compliance with applicable laws and regulations is time-consuming and personnel-intensive, and changes in these laws and regulations may materially increase our direct and indirect compliance and other expenses of doing business, thus materially and adversely affecting our business, financial condition, results of operations and prospects.
In the future, states may make existing insurance laws and regulation more restrictive or enact new restrictive laws. In such event, we may seek to reduce our business in, or withdraw entirely from, these states. Additionally, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. Currently, the U.S. federal government does not directly regulate the property and casualty insurance business. However, Dodd-Frank Act established a Federal Insurance Office (“FIO”) within the Department of the Treasury. The FIO initially is charged with monitoring all aspects of the insurance industry (other than health insurance, certain long-term care insurance and crop insurance), gathering data, and conducting a study on methods to modernize and improve the insurance regulatory system in the United States. On December 12, 2013, the FIO issued a report (as required under the Dodd-Frank Act) entitled “How to Modernize and Improve the System of Insurance Regulation in the United States” (the “Report”), which stated that, given the “uneven” progress the states have made with several near-term state reforms, should the states fail to accomplish the necessary modernization reforms in the near term, “Congress should strongly consider direct federal involvement.” The FIO continues to support the current state-based regulatory regime, but will consider federal regulation should the states fail to take steps to greater uniformity (e.g., federal licensing of insurers). The Report also appears to signal greater activity by the federal government in dealing with non-U.S. regulators and regulatory regimes, using the authority expressly given by the Dodd-Frank Act to the U.S. Department of the Treasury and the United States Trade Representative to negotiate “covered agreements” with foreign authorities. Each year the FIO also releases an annual report on the insurance industry (“Annual Report”), with its latest Annual Report released in September of 2016. The Annual Report provided a set of recommendations along with providing an overview of the financial performance and condition of the U.S. insurance industry and outlining a number of insurance industry and regulatory developments from the past year. We cannot predict what impact, if any, this guidance or any new legislation would have on our business, financial condition and results of operations. See “Business-Regulation-Federal and State Legislative and Regulatory Changes” in Item 1 of this report.
Our holding company structure and certain regulatory and other constraints, including adverse business performance, could affect our ability to satisfy our obligations.
We are a holding company and conduct our business operations through our various subsidiaries. Our principal sources of funds are payments from our subsidiaries, income from our investment portfolio and funds that may be raised from time to time in the capital markets. We will be largely dependent on amounts from our subsidiaries to pay principal and interest on any indebtedness that we may incur, to pay holding company operating expenses, to make capital investments in our other subsidiaries, repurchase shares and to pay dividends on our common stock.
Our insurance subsidiaries are subject to statutory requirements as to maintenance of policyholders’ surplus and payment of dividends, including in their states of domicile, Texas and Delaware. In general, the maximum amount of dividends that the insurance subsidiaries may pay in any 12-month period without regulatory approval is the greater of adjusted statutory net income or 10% of statutory policyholders’ surplus as of the preceding calendar year end. Adjusted statutory net income is generally defined for this purpose to be statutory net income, net of realized capital gains, for the calendar year preceding the date of the dividend. In addition, other states may limit or restrict our insurance subsidiaries’ ability to pay shareholder dividends generally or as a condition to issuance of a certificate of authority. See “Business-Regulation-State Insurance Regulation” in Item 1 of this report.
We may require additional capital in the future and such additional capital may not be available to us, or only available to us on unfavorable terms.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. To the extent that the funds generated by our
ongoing operations and capitalization are insufficient to fund future operating requirements, we may need to raise additional funds through financings or curtail our growth and reduce our assets. We cannot be sure that we will be able to raise equity or debt financing on terms favorable to us and our shareholders and in the amounts that we require, or at all. If we cannot obtain adequate capital, our business, financial condition, results of operations and prospects could be materially and adversely affected.
In addition, the terms of a capital raising transaction could require us to agree to stringent financial and operating covenants and to grant security interests on our assets to lenders or holders of our debt securities that could limit our flexibility in operating our business or our ability to pay dividends on our common stock and could make it more difficult for us to obtain capital in the future.
The rates we charge under the policies we write in our Program Services segment and our Lender Services segment are subject to prior regulatory approval in most of the states in which we operate.
In most of the states in which we operate through our admitted carriers, we must obtain prior regulatory approval of insurance rates charged to our insureds and our clients’ insureds, including any increases in those rates. If we are unable to receive approval for the rate changes we request, or if such approval were delayed, our ability to operate our business in a profitable manner may be limited and our financial condition, results of operations, and liquidity may be adversely affected.
The effects of emerging claim and coverage issues on our business are uncertain and negative developments in this area could have a material and adverse effect on our business, financial condition, results of operations and prospects.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may materially and adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until after we have issued insurance policies that are affected by the changes. As a result, the full extent of our liability under an insurance policy may not be known until many years after the policy is issued. Changes of this nature may expose us to higher claims than we anticipated when we wrote the underlying policy. Unexpected increases in our claim costs many years after policies are issued may also result in our inability to recover from certain of our reinsurers the full amount that they would otherwise owe us for such claims costs because certain of the reinsurance agreements covering our business include commutation clauses that permit the reinsurers to terminate their obligations by making a final payment to us based on an estimate of their remaining liabilities. In addition, the potential passage of new legislation designed to expand the right to sue, to remove limitations on recovery, to deem by statute the existence of a covered occurrence, to extend the statutes of limitations or otherwise repeal or weaken tort reforms could have an adverse impact on our business. The effects of these and other unforeseen emerging claim and coverage issues are extremely hard to predict and could be harmful to our business and have a material adverse effect on our results of operations.
We may rely on the use of credit scoring in pricing and underwriting certain of our insurance policies and any legal or regulatory requirements that restrict our ability to access credit score information could decrease the accuracy of our pricing and underwriting process and thus decrease our ability to be profitable.
We use credit scoring as a factor in pricing and underwriting decisions where allowed by state law. Consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against some groups of people and are calling for laws and regulations to prohibit or restrict the use of credit scoring in underwriting and pricing. Laws or regulations that significantly curtail or regulate the use of credit scoring, if enacted in a large number of states in which we operate, could impact the integrity of our pricing and underwriting process, which could, in turn, materially and adversely affect our business, financial condition, results of operations and prospects, and make it harder for us to be profitable over time.
Assessments and other surcharges for guaranty funds, second-injury funds, catastrophe funds, and other mandatory pooling arrangements for insurers may reduce our profitability.
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insured parties as the result of impaired or insolvent insurance companies. In addition, as a condition to the ability to conduct business in various states, our insurance subsidiaries must participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various types of insurance coverage to individuals or entities that otherwise are unable to purchase that coverage from private insurers. The effect of these assessments and mandatory shared-market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
The effects of litigation on our business are uncertain and could have a material and adverse effect on our business, financial condition, results of operation and prospects.
Although we are not currently involved in any material litigation with our clients or insureds, other members of the insurance industry are the target of class action lawsuits and other types of litigation, some of which involve claims for substantial or indeterminate amounts. These lawsuits may have outcomes that are unpredictable. This litigation is based on a variety of issues, including claim settlement and insurance practices. We cannot predict with any certainty whether we will be involved in such litigation in the future or what impact such litigation would have on our business.
Risks Related to Our Common Stock
Our revenues and results of operations may fluctuate due to the factors beyond our control, which could cause the price of our common stock to be volatile.
Our common stock is listed on the NASDAQ Global Select Market under the symbol “SNC”. Our performance, as well as government regulatory action, interest rates and general market conditions, could have a significant impact on the future market price of our common stock. Some of the factors that could negatively affect our share price or result in fluctuations in the price of our common stock include:
·
our operating results in any future quarter not meeting the expectations of market analysts or investors;
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reductions in our earnings estimates by us or market analysts;
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publication of negative research or other unfavorable publicity or speculation in the press or investment community about our company or the insurance industry in general;
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increases in interest rates causing investors to demand a higher yield or return on investment than an investment in our common stock may be projected to provide;
·
changes in market valuations of similar companies;
·
additions or departures of key personnel;
·
changes in the economic or regulatory environment in the markets in which we operate;
·
the occurrence of any of the other risk factors presented in this report; and
·
general market, economic and political conditions.
Prior to the completion of the private placement, we were treated for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code, and claims of taxing authorities related to our prior status as an “S” corporation could harm us.
Upon completion of the private placement in 2014, our parent company’s “S” corporation status terminated, and State National became treated as a “C” corporation under “Subchapter C” of the income tax provisions of the Internal Revenue Code of 1986, as amended (the “Code”), which is applicable to most corporations and treats the corporation as an entity that is separate and distinct from its shareholders. If the open tax years in which State National was treated as an “S” corporation were audited by the Internal Revenue Service, and we are determined not to have qualified for, or to have violated, our “S” corporation status, we will be obligated to pay back taxes, interest and penalties, and we do not have the right to reclaim tax distributions that we have made to our shareholders during those periods. These amounts could include taxes on all of our taxable income while State National was treated as an “S” corporation. Any such claims could result in additional costs to us and could have a material adverse effect on our results of operations and financial condition.
We have entered into a tax indemnification agreement with our former “S” corporation shareholders and could become obligated to make payments to them for any additional federal, state or local income taxes assessed against them for fiscal periods prior to the completion of the private placement.
In the event of an adjustment to our reported taxable income for a period or periods prior to termination of our “S” corporation status, persons who held shares of our common stock during the time in which it was treated as an “S” corporation could be liable for additional income taxes for those prior periods. Therefore, prior to the completion of the private placement in 2014 we entered into a tax indemnification agreement with our shareholders, who we refer to as our former “S” Corporation Shareholders. Pursuant to the tax indemnification agreement, we will pay each such shareholder on an after-tax (or grossed-up) basis the amount of additional income taxes plus interest and penalties due as a result of adjustments (pursuant to a determination by, or a settlement with, a taxing authority or court, or pursuant to the filing of an amended tax return) to the taxable income of our parent company with respect to taxable periods during which it filed as an “S” corporation. The payments we could be required to make will be reduced by certain tax benefits that may be available to our former “S” Corporation Shareholders as a result of such adjustments. Such payments will also include any reasonable out-of-pocket expenses incurred by the former “S” Corporation Shareholders arising out of a claim for such tax liability.
Compliance with the laws, rules and regulations of being a public company requires significant company resources and management attention.
As a public company with listed equity securities, we need to comply with laws, regulations and requirements, certain corporate governance provisions of The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), periodic reporting requirements of the Exchange Act and other regulations of the SEC and the requirements of the NASDAQ Global Select Market, with which we were not required to comply as a private company. Complying with these laws, rules and regulations, requires us to incur significant legal, accounting and other expenses. These efforts require a significant amount of time from our board of directors and management, possibly diverting their attention from the implementation of our business plan and growth strategy.
We have made, and will continue to make, changes to our corporate governance standards, disclosure controls, financial reporting and accounting systems to meet our obligations as a public company. We cannot assure you that the changes we have made and will continue to make to satisfy our obligations as a public company will be successful, and any failure on our part to satisfy these obligations could subject us to delisting of our common stock, fines, sanctions and other regulatory action and potential litigation.
Failure to maintain an effective system of internal control over financial reporting may have an adverse effect on the Company’s stock price.
Section 404 of Sarbanes-Oxley and the related rules and regulations of the SEC require an annual management assessment of the effectiveness of our internal control over financial reporting. If we fail to maintain the adequacy of our
internal control over financial reporting, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 of Sarbanes-Oxley and the related rules and regulations of the SEC. If we cannot in the future favorably assess the effectiveness of our internal control over financial reporting, investor confidence in the reliability of our financial reports may be adversely affected, which could have a material adverse effect on the price of our common stock.
As an “emerging growth company”, our shareholders likely will not have the benefit of certain protective provisions that would otherwise apply to most public companies.
The Jumpstart Our Business Startups (“JOBS”) Act became law in 2012. The JOBS Act “IPO On-Ramp” provisions provide that companies with less than $1 billion of total annual gross revenues (“emerging growth companies”) will be exempted from certain disclosure requirements for up to five years following their initial public offerings. An emerging growth company is subject to reduced disclosure requirements during this period, including:
·
fewer years of required financial statements in its registration statement (two years compared to three years by non-emerging growth companies);
·
no requirement to present selected financial data for periods preceding the earliest audited period required to be presented in the registration statement for a company’s initial public offering;
·
exemption from the requirements under Section 404(b) of the Sarbanes-Oxley Act for auditor attestation relating to internal control over financial reporting;
·
grandfather provisions allowing a company to forgo compliance with new or revised financial statement or auditing requirements; and
·
reduced executive compensation disclosure, including reduction of the number of executive officers whose compensation is required to be described, fewer years of required disclosure, exemption from the requirement to include a compensation disclosure and analysis section and exemption from certain provisions of the Dodd-Frank Act relating to “say-on-pay,” “pay-for-performance,” comparative pay and golden parachutes.
As a result, our shareholders likely will not have the benefit of certain protective provisions and additional disclosures that would otherwise apply to most public companies. Unless earlier terminated, our status as an emerging growth company will end on December 31, 2019.
Future sales and issuances of shares of our capital stock may depress our share price.
We may in the future issue our previously authorized and unissued securities. We have an authorized capitalization of 150 million shares of our common stock and 10 million shares of preferred stock with such designations, preferences and rights as are contained in our charter or bylaws and as determined by our board of directors. Issuances of stock may result in dilution of our existing shareholders or a decrease in the per share price of our common stock. It is not possible to state the actual effect of the issuance of any shares of our preferred stock on the rights of holders of our common stock until our board of directors determines the specific rights attached to that class or series of preferred stock.
We cannot predict what effect, if any, future sales of our common stock, or the availability of shares for future sale, will have on the price prospective buyers are willing to pay for our common stock. Sales of a substantial number of shares of our common stock by us or our shareholders, or the perception that such sales could occur, may adversely affect the price prospective buyers are willing to pay for our common stock and may make it more difficult for you to sell your shares at a time and price that you determine appropriate. See “Shares Available for Future Sale” for further information regarding circumstances under which additional shares of our common stock may be sold.
Provisions contained in our organizational documents, as well as provisions of Delaware law, contractual agreements and compensation arrangements, could delay or prevent a change of control of us, which could adversely affect the price of shares of our common stock.
Our bylaws and Delaware law contain provisions that could have the effect of rendering more difficult or discouraging an acquisition deemed undesirable by our board of directors. Our corporate governance documents include provisions that:
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provide that special meetings of our shareholders generally can only be called by the chairman of the board of directors, the chief executive officer, the president or by a resolution approved by our board of directors;
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provide our board of directors the ability to issue undesignated preferred stock, the terms of which may be established and the shares of which may be issued without shareholder approval, and which may grant preferred holders super voting, special approval, dividend or other rights or preferences superior to the rights of the holder of common stock;
·
eliminate the ability of shareholders to act by written consent in lieu of a meeting;
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provide our board of directors the ability to issue common stock and warrants within the amount of authorized capital; and
·
provide that shareholders seeking to bring business before our annual meeting of shareholders, or to nominate candidates for election as directors at our annual meeting of shareholders, generally must provide timely advance notice of their intent in writing and certain other information not less than 90 days nor more than 120 days prior to the one-year anniversary of the date of the preceding year’s annual meeting of shareholders.
In addition, some of our agreements, such as our alliance agreement with CUNA Mutual, our standard reinsurance agreements and some of our incentive plans contain change of control provisions. In addition, we have certain severance agreements with executives that provide for payments following a change of control.
The provisions discussed above, alone or together, could delay hostile takeovers and changes of control of our company or changes in our management, even if such transactions would be beneficial to our shareholders.
As a Delaware corporation, we will also be subject to anti-takeover provisions of Delaware law. The Delaware General Corporation Law (“DGCL”) provides that shareholders are not entitled to cumulative voting rights in the election of directors unless a corporation’s certificate of incorporation provides otherwise. Our certificate of incorporation does not provide for cumulative voting in the election of directors.
In addition, we are subject to Section 203 of the DGCL, which, subject to certain exceptions, prohibits a public Delaware corporation from engaging in a business combination (as defined in such section) with an “interested shareholder” (defined generally as any person who beneficially owns 15% or more of the outstanding voting stock of such corporation or any person affiliated with such person) for a period of three years following the time that such shareholder became an interested shareholder, unless: (1) prior to such time, the board of directors of such corporation approved either the business combination or the transaction that resulted in the shareholder becoming an interested shareholder; (2) upon consummation of the transaction that resulted in the shareholder becoming an interested shareholder, the interested shareholder owned at least 85% of the voting stock of such corporation at the time the transaction commenced (excluding for purposes of determining the voting stock outstanding (but not the outstanding voting stock owned by the interested shareholder) the voting stock owned by directors who are also officers or held in employee benefit plans in which the employees do not have a confidential right to tender or vote stock held by the plan); or (3) on or subsequent to such time the business combination is approved by the board of directors of such corporation and authorized at a meeting of shareholders by the affirmative vote of at least two-thirds of the outstanding voting stock of such corporation not owned by the interested shareholder.
Any provision of our certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our shareholders to receive a premium for their shares of common stock, and could also affect the price that some investors are willing to pay for shares of our common stock. See “Description of Capital Stock-Certain Anti-Takeover Effects of Provisions of Our Organizational Documents and Delaware Law.”
Applicable insurance laws may make it difficult to effect a change of control of our company.
State insurance holding company laws require prior approval by the respective state insurance departments of any change of control of an insurer. “Control” is generally defined as the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the Company, whether through the ownership of voting securities, by contract or otherwise. Control is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or any entity that controls a domestic insurance company. Any person wishing to acquire control of us or of any substantial portion of our outstanding shares would first be required to obtain the approval of the domestic regulators (including those asserting “commercial domicile”) of our insurance subsidiaries or file appropriate disclaimers.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our shareholders might consider to be desirable. See “Regulation-Holding Company Regulation-Change of Control.”
Future issuance of debt or preferred stock, which would rank senior to our common stock upon our liquidation, and future offerings of equity securities, which would dilute our existing shareholders, may adversely affect the market value of our common stock.
In the future, we may attempt to increase our capital resources by issuing debt or making additional offerings of equity securities, including bank debt, commercial paper, medium-term notes, senior or subordinated notes and classes of shares of preferred stock. Upon liquidation, holders of our debt securities and preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of shares of our common stock. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market value of our common stock, or both. Our preferred stock, if issued, could have a preference on liquidating distributions or a preference on dividend payments that would limit amounts available for distribution to holders of shares of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, holders of shares of our common stock bear the risk of our future offerings reducing the market value of our common stock and diluting their stockholdings in us.
Item 1B:
Item 1B:Unresolved Staff Comments
None.
Item 2:
Item 2:Properties
We own the headquarters building and land at 1900 L. Don Dodson Drive in Bedford, Texas, which includes approximately 200,000 square feet of office space.
Item 3:
Item 3:Legal Proceedings
We are routinely involved in legal proceedings arising in the ordinary course of business, in particular in connection with claims adjudication with respect to our policies. We believe that there is no individual case pending that is likely to have a material adverse effect on our financial condition or results of operations.
Item 4:
Item 4:Mine Safety Disclosures
Not applicable.
Executive Officers of the Registrant
All executive officers are elected by the board of directors and hold office until the board meeting held following the next annual meeting of shareholders, and until his or her successor is elected and qualified or until his or her earlier death, resignation or removal.
PART II
Item 5:
Item 5:Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock began trading on the NASDAQ Global Select Market under the symbol “SNC” on November 3, 2014. As of March 1, 2017 there were approximately 320 holders of record of our common stock. This figure does not include beneficial owners who hold shares in the name of nominees.
The following table presents high and low sales prices for our common stock on the NASDAQ Global Select Market for the periods indicated.
Dividend Policy
The following table shows quarterly dividends that were paid on our common stock with respect to the periods indicated. The per share amounts are not representative of the amount of any future dividends we may pay.
The Company is a holding company and has no direct operations. Our ability to pay dividends in the future depends on the ability of our operating subsidiaries, including our insurance subsidiaries, to pay dividends to us. The laws of the jurisdictions in which our insurance subsidiaries are organized regulate and restrict, under certain circumstances, their ability to pay dividends to us. However, our agency, T.B.A. Insurance Group, Ltd. (“TBA”), is not statutorily restricted from paying dividends to us. In addition, future debt agreements may contain certain prohibitions or limitations on the payment of dividends. Any declaration and payment of dividends that may be approved by our board of directors will depend on many other factors, including general economic and business conditions, our strategic plans, our financial results and condition, legal and regulatory requirements and other factors that our board of directors deems relevant. Our board of directors may eliminate the payment of future dividends at its discretion, without notice to our shareholders. Subject to approval by our board of directors and the other factors referenced above, we currently intend to continue to provide for the payment of comparable cash dividends during 2017.
Equity Compensation Plan Information
As of December 31, 2016, the 2014 Long-Term Incentive Plan (the “Plan”) was the only compensation plan under which securities of the Company were authorized for issuance. The Plan was approved by the Company’s shareholders prior to the completion of the private placement in 2014. The Company has no equity compensation plans that have not been approved by its shareholders. The table below provides information as of December 31, 2016 with respect to the Plan.
Purchases of Equity Securities
On October 12, 2015, the Company announced a share repurchase program authorizing the repurchase up to $50 million in shares of the Company's common stock through December 31, 2016. The repurchase program was extended through December 31, 2017. Repurchases are made in accordance with the guidelines specified under Rule 10b-18 and may be made under Rule 10b5-1, under the Securities Exchange Act of 1934. The following table presents information related to our repurchases of common stock for the periods indicated:
Item 6:
Item 6:Selected Financial Data
The following tables set forth our selected historical consolidated financial information for the periods ended and as of the dates indicated. These selected historical consolidated results are not necessarily indicative of results to be expected in any future period. You should read the following selected consolidated financial information together with the other information contained in this report, including the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this report.
The income statement data for the years ended December 31, 2016, 2015 and 2014 and the balance sheet data as of December 31, 2016 and 2015 are derived from our audited financial statements included elsewhere in this report. The income statement data for the years ended December 31, 2013 and 2012 and the balance sheet data as of December 31, 2014, 2013 and 2012 are derived from our audited financial statements that are not included in this report.
(1)
The CPI premiums written presented in this document reflect the effects of the allowance for policy cancellations, including any adjustments related to re-estimation of the allowance. As such, the CPI premiums written are those that we expect to earn, which we refer to as “stick premiums,” while those that are expected to cancel are included in the allowance for policy cancellations.
(2)
Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross earned premium on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured. Typically, the reinsured policies have a term of one year. Minimum capacity fees, which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium that we estimate will be written in the contract year, are earned over the contract year. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Principal Revenue and Expense Items-Minimum ceding fees.” Ceding commissions earned on Lender Services business are not included as ceding fees. CUNA Mutual’s ceding commission is included as a partial offset to commission expense.
(3)
Upon the completion of the private placement in 2014, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes. This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.5%, 38.1% and 37.2% for the years ended December 31, 2014, 2013 and 2012, respectively.
(4)
As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.3 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions.
(5)
Prior to the completion of the private placement in June 2014, we made special compensation payments to our co-founders in recognition of their service to our Company. We refer to these payments as “founder special compensation.” Following the completion of the private placement in 2014, we ceased paying founder special compensation.
(6)
In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million.
(7)
Represents the tax effect of non-GAAP expense adjustments for founder special compensation, offering-related expenses, and contract modification expense for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.5%, 38.1% and 37.2% for the years ended December 31, 2014, 2013 and 2012, respectively.
(8)
Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring, infrequent or unusual offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.
(9)
Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our reinsurers or any collateral securing the liabilities. This could occur because the loss
experience based on the policy terms is higher than expected or due to litigation, regulatory or other extra-contractual liabilities. Our insurance subsidiaries remain liable for unearned premiums and unpaid losses and loss adjustment expenses with respect to reinsurance ceded should the reinsurer be unable to meet its obligations. Management considers the possibility of a reinsurer becoming unable to meet its obligations as remote due to the reinsurers’ financial stability, A.M. Best Company rating, size, security funds available, and other factors as appropriate.
Following is a summary of these balances as of:
(10)
An allowance for policy cancellations is provided for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes that will be incurred on expected future policy cancellations associated with the Company’s CPI business. Premiums and cancellation data are accumulated by accounting month (month in which the premium was written/collected), lending institution and at the corporate level. The estimation methodology utilizes actual cancellation rates (premium refunds divided by premiums written by accounting month) to determine expected future cancellations for that accounting month. The estimate for each accounting month decreases each subsequent month as actual refunds emerge. While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are reviewed quarterly by management, and any changes are reflected in current operations.
Item 7.
Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking and Other Statements
This discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. See “Note on Forward-Looking Statements” in Part I of this report.
Overview
We are a leading specialty provider of property and casualty insurance services operating in two niche markets across the United States. In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for ceding fees. In our Lender Services segment, we specialize in providing collateral protection insurance (“CPI”), which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.
Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier (“fronting”) capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. These reinsurers are domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business. Issuing carrier arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. We reinsure substantially all of the underwriting risks in connection with our fronting arrangements to our capacity providers. As such, this segment generates very large gross premiums with no net
premiums (except for the run-off of the retained business as described below). In many cases, we hold significant collateral to secure the associated reinsurance recoverables. Furthermore, to the extent funds related to settling balances (premiums, commissions and losses) between the GAs and the reinsurers are not the obligation of the Company, no receivables or payables are reflected in the Company’s financial statements for these amounts. In exchange for providing our insurance capacity, licensing and rating to our GA and insurer clients, we receive ceding fees averaging in excess of 5% of gross written premiums.
Our Lender Services segment generates premiums primarily from providing collateral protection insurance or CPI to our credit union, bank and specialty finance company clients. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.
Recent Developments
Effective January 1, 2017, the Company acquired 100% of the outstanding common shares of Fireman’s Fund Insurance Company of Ohio, an excess and surplus lines, or non-admitted, shell company. The company was subsequently renamed Independent Specialty Insurance Company (“ISIC”). The purpose of these acquisitions is to provide exclusive capacity for one of our programs.
Factors Affecting Our Operating Results
Trending Market Opportunities. We believe that macroeconomic conditions will provide us with growth opportunities in each of our business segments. Increasing automobile sales should expand lenders’ loan portfolios to improve our Lender Services results. Over the past decade, alternative capital has been entering the reinsurance market at an accelerating pace. This influx of capital has had the effect of compressing rates for reinsurance, which in the past was primarily written to reinsure catastrophe-exposed property insurance. These lower reinsurance rates are now driving industry capital to seek opportunity in U.S. primary insurance markets for both property and casualty lines. These market dynamics should provide growth opportunities in our Program Services segment.
In our Lender Services business, we believe that organic growth from our existing lender clients will be driven by overall growth in lenders’ portfolios as a result of rising automobile sales, higher average auto loan balances and an aging U.S. automobile fleet. We also expect that new sales from our alliance with CUNA Mutual will produce additional premiums.
We believe that the increased role of capital market alternatives to reinsurance, including the capitalization of hedge fund-backed reinsurers and the availability of capital in the non-U.S. reinsurance market, is driving demand for our Program Services, as these firms typically do not have direct access to the U.S. insurance market. We are well positioned to meet this demand due to our highly rated and broadly licensed insurance subsidiaries in addition to our proven model to provide fronting for a fee.
We currently have a significant program with Nephila Capital, Ltd. (“Nephila”) under which we granted Nephila the exclusive right to utilize the Company as issuing carrier for U.S. catastrophe exposed property insurance from 2015 through 2019. Nephila is a hedge fund with approximately $11 billion in assets under management that participates in the market for catastrophe exposed property business. In exchange for this exclusive right, Nephila has agreed to pay State National contractual minimum ceding fees totaling $51.5 million for 2016 through 2019. The minimum ceding fees are subject to State National maintaining its “A” A.M. Best rating and potential reductions to the extent that State National is unable to provide production year capacity or is otherwise constrained from writing premium. Also, under certain circumstances, Nephila may terminate the exclusivity, which would reduce the contractual minimum ceding fees to a total of $32.5 million for 2016 through 2019. In the event of such a termination, State National would have the ability to write the catastrophe exposed property business for other capacity providers. The timing and actual amount of gross premiums written for Nephila will impact the timing and amount of ceding fees earned each period under this program. See “-Principal Revenue and Expense Items-Minimum ceding fees.” In addition, State National and
Nephila have an alliance under which State National acquired City National Insurance Company (“CNIC”), an admitted property and casualty insurance shell company and ISIC, a non-admitted property and casualty insurance shell company, which will be used exclusively to write business produced by Nephila. Nephila will have a three year option to purchase these companies beginning three years after the shell companies first write premium. In the event that the option is exercised, contractual minimum payments to State National will extend for an additional two years.
Alliance with CUNA Mutual. The Company’s alliance with CUNA Mutual that began in 2009 provides us access to a wider array of clients and added significant additional scale to our CPI business. For the years ended December 31, 2016, 2015 and 2014, we have generated net premiums earned of $69.6 million, $59.5 million and $40.7 million, respectively, through the alliance with CUNA Mutual. Prior to July 1, 2014, this business was subject to a 50% quota share agreement with CUNA Mutual. Effective July 1, 2014, we amended the alliance agreement to increase our retention of the business subject to the alliance to 70% in exchange for payments made to CUNA Mutual totaling $17.8 million. The Company’s net premiums earned increased $18.6 million, $15.8 million and $5.4 million related to the amendment of the alliance agreement for the years ended December 31, 2016, 2015 and 2014, respectively. In addition, the term of the alliance has been extended at least through July 31, 2018.
Run-off of the Retained Business. In the past, the Company has participated to a limited extent on a quota share basis in certain programs in the Program Services segment. From 2007 until 2011, California had required USIC to retain 10% of the risks written. After this requirement was lifted in early 2012, the Company reinsured to inception the retained business under most of the active contracts, but others continue to run-off. The Company has no active retained contracts and has no present intention of participating in future contracts. We refer to this business as “the run-off of the retained business.” As of December 31, 2016, we had net reserves of $3.5 million related to this business.
Subchapter S Corporation Status. Prior to the completion of the private placement in 2014, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and intermediate holding company) to be pass-through entities for federal income tax purposes. As a result, prior to the completion of the private placement, the income for our parent company and pass-through subsidiaries was not subject to, and we did not pay, U.S. federal income taxes, and no provision or liability for federal or state income tax for our parent company and pass-through subsidiaries has been included in our consolidated financial statements. The tax provision, assets and liabilities that are reflected in our consolidated financial statements for periods prior to the completion of the private placement represent those for our insurance subsidiaries and their intermediate holding company, State National Intermediate Holdings, Inc. (“SNIH”), as those entities were “C” Corporations. Despite the Subchapter S corporation status, the impact of taxes on our parent company are included in the financial statements in that our shareholders were provided with the cash to pay the taxes that passed through to the shareholders. Prior to the completion of the private placement, we made periodic cash distributions to our shareholders that have included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses that pass through to them. Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our parent company became a “C” Corporation for U.S. tax purposes and became subject to a combined federal and state corporate income tax rate between 35% and 38%. We invest a portion of our investment portfolio in tax-exempt municipal securities, which investment may have the effect of lowering our effective tax rate.
Founder Special Compensation. Prior to the completion of the private placement in 2014, we paid special compensation to our co-founders in recognition of their service to our Company. We refer to these payments as “founder special compensation.” Founder special compensation payments were discretionary and determined by the Company’s owners in the first or second quarter of the year in which they were made, based on current period considerations including capital position, estimated capital needs and liquidity, and earnings for the prior year. We paid founder special compensation in the aggregate amount of $17.9 million for the year ended December 31, 2014. Following the completion of the private placement in 2014, we ceased paying founder special compensation.
Seasonality of Our Business. Our Lender Services segment typically experiences seasonal fluctuations in written premium. The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least. We believe this trend follows loan delinquency patterns for the industry. We generally do not experience seasonality in our Program Services segment.
Principal Revenue and Expense Items
Premiums earned. Premiums earned are the earned portion of our net premiums written, which are predominately CPI premiums. As the CPI product is not a traditional insurance product, the premium recognition is likewise different. We do not record premiums until we collect them from our accounts since they have the right to waive the placement of insurance on any of their loans. There is a high level of policy cancellations since borrowers often purchase insurance at the traditional rates that provides protection for them in addition to their lender. Due to this high level of policy cancellations, we split the premium into two pieces: (1) an allowance for future cancellations and (2) premiums that we expect to earn, which we refer to as “stick premiums.” We earn stick premiums on a pro rata basis over the terms of the policies. The CPI premiums written as presented in this document reflect the effects of the allowance for policy cancellations including any adjustments related to re-estimation of the allowance. As such, our recorded CPI premiums written are those that we expect to earn while those that are expected to cancel are included in the allowance for policy cancellations. At the end of each reporting period, stick premium written that is not earned is classified as unearned premium, which is earned in subsequent periods over the remaining terms of the policies. Our policies typically have a term of one year, although the average duration of our CPI policies is typically less than six months due to policy cancellations.
Ceding fees. Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross premiums earned on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured, which policies often have a one year term.
Minimum ceding fees. Minimum ceding fees are fees we receive pursuant to contractual minimum premium requirements for certain of our programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces (1) “premium-related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium that we estimate will be written in the contract year, which fees are earned over the contract year.
At the end of each quarter during the program contract year, we adjust the capacity fee based upon the re-estimated or actual amount of gross premiums that we expect will be written or that were written for that program for the full contract year. If the estimated annual gross written premiums fall below the minimum contract level in a given period, capacity fees associated with the estimated premium shortfall for that period are earned in that period. If the estimated annual gross written premiums equal or exceed the required minimum level for a given period, no capacity fees are recognized for that period, and the premium-related fees are earned as the associated gross written premium is earned. In connection with our re-estimation process, if in a subsequent period we increase our estimate of the amount of gross premiums that we expect will be written under a program for the full contract year, we will reverse a portion of the capacity fees earned in a prior period. Conversely, to the extent that we decrease our estimate of gross premiums, we will recognize capacity fees associated with the additional shortfall in the current period.
Losses and loss adjustment expenses. Losses and loss adjustment expenses (“LAE”) include claims paid, estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing claims. We record loss and LAE related to estimates of future claim payments based on historical experience. We seek to establish all reserves at the most likely ultimate exposure based on our historical claims experience. We revise our estimates as we receive additional information about claims and the total costs of settlement.
Commissions. Substantially all commission expenses are related to our Lender Services segment. A significant portion of these amounts are paid to financial institutions as a means to reimburse the financial institution for costs associated with operating a CPI program. These commissions are partially offset by a 21% ceding commission received under our quota reinsurance agreement with CUNA Mutual and the reimbursement we received from CUNA Mutual for 30% of direct commissions and other reimbursable expenses paid to accounts. The ceding commission compensates us
for expenses, such as underwriting and policy acquisition expenses, that we incur in connection with the writing of the ceded business.
General and administrative expense. General and administrative expense is composed of all other operating expenses, including various departmental salaries and benefits expense for employees. General and administrative expense also includes expenses related to our office space, postage, telephone and information technology charges, as well as legal and auditing fees and corporate travel. In addition, general and administrative expense includes those charges that are related to the amortization of tangible and intangible assets.
Stock-based compensation expense. Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for restricted stock grants and stock option awards that contain a service condition are recognized on a straight line pro rata basis over the vesting period. For restricted stock awards that contain a performance condition, the expense is recognized based on the awards expected to vest and the cumulative expense is adjusted whenever the estimate of the number of awards to vest changes.
Other Measures and Ratios
Non-GAAP Measures
Adjusted pre-tax income. Our financial statements are presented in conformity with generally accepted accounting principles in the U.S. (“GAAP”). Adjusted pre-tax income is considered a non-GAAP financial measure because it reflects adjustments to pre-tax income, which is the most directly comparable measure calculated in accordance with GAAP, for the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance with CUNA Mutual, as applicable. The Company’s management (“Management”) believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. Management uses adjusted pre-tax income to evaluate core financial performance against historical results without the effect of these items.
Adjusted net income. Adjusted net income is considered a non-GAAP financial measure because it reflects adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP for the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented and the exclusion of the increase in the Company’s deferred tax asset as a result of the conversion to the C Corporation status, for the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance with CUNA Mutual, as applicable. Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods before and after the completion of our private placement in June 2014. Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.
For a reconciliation of these non-GAAP financial measures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Results of Operations-Consolidated Results of Operations.” These adjustments to the GAAP measures are only applicable to 2014 and prior periods.
Program Services Ratios
Gross leverage. Gross leverage for the Company is the ratio of gross written premiums and gross liabilities to surplus. A significant portion of our capital is used to support the gross premium and insurance liabilities in our Program Services segment. Because we retain virtually no risk other than the credit risk of the capacity providers, and we maintain strict credit underwriting standards, broad indemnification agreements and collateral requirements, we are able to maintain significant ceded reinsurance business on a relatively small amount of capital compared to our peers. For the year ended December 31, 2016, our gross leverage ratio was 14.7 to 1. Our objective is to produce a total company gross leverage ratio of between 13 to 1 and 17 to 1.
Lender Services Insurance Ratios
Net loss ratio. The net loss ratio is a measure of the underwriting profitability of our Lender Services segment. Expressed as a percentage, this is the ratio of net losses and LAE incurred to net premiums earned. For the years ended December 31, 2016, 2015 and 2014, our net loss ratio was 44.5%, 45.5% and 42.0%, respectively. This decrease is primarily due to an increase in premiums earned, resulting in part from active account management on our CPI product.
Net expense ratio. The net expense ratio is a component of our operational efficiency in administering our Lender Services segment. Expressed as a percentage, this is the ratio of net expenses (commissions, taxes, licenses, and fees and general and administrative) to net premiums earned. Our expense ratio is higher than that for most traditional insurance products due to the labor and systems intensive processes involved in monitoring the insurance statuses for the loan portfolios of our Lender Services clients. For the years ended December 31, 2016, 2015 and 2014, our net expense ratio was 39.5%, 41.0% and 47.3%, respectively.
Net combined ratio. The net combined ratio is a measure of the overall profitability of our Lender Services segment. This is the sum of the net loss ratio and the net expense ratio. For the years ended December 31, 2016, 2015 and 2014, our net combined ratio was 84.0%, 86.5% and 89.3%, respectively. Our objective is to price our products to achieve a net combined ratio between 85% to 90%.
Financial Ratios
Return on equity. One of the key financial measures that we use to evaluate our operating performance is return on equity. We calculate return on equity by dividing net income by the average GAAP equity. Our return on equity at December 31, 2016 was 17.5%. Our overall financial objective is to produce a return on equity of at least 15% over the long-term.
Financial leverage ratio. Our financial leverage ratio at December 31, 2016 was 14.8%, as compared to 16.6% at December 31, 2015. Our objective is to maintain a financial leverage ratio in the range of 20% to 40% over the long-term.
Critical Accounting Estimates
Our consolidated financial statements include amounts that, either by their nature or due to the requirements of GAAP, are determined using estimates and assumptions. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances. While we believe that the amounts included in our consolidated financial statements reflect our best judgment, actual amounts could ultimately materially differ from those currently presented. We believe the items that require the most subjective and complex estimates are: unpaid losses and LAE reserves, allowance for policy cancellations, unearned premium reserve, reinsurance recoverable, valuation of our investment portfolio, assessment of other-than-temporary impairments (“OTTI”) and minimum ceding fees.
We believe our accounting policies for these items are of critical importance to our consolidated financial statements. The following discussion provides more information regarding the estimates and assumptions required to arrive at these amounts. For a complete summary of our significant accounting policies, see the notes to the consolidated financial statements.
Unpaid losses and loss adjustment expenses
The liability for unpaid losses and LAE includes an estimate for claims reported and an additional liability for claims incurred but not reported at the balance sheet date, as well as estimates of the expenses associated with processing and settling all reported and unreported claims, less estimates of anticipated salvage and subrogation recoveries. Estimates are based upon past loss experience modified for current trends as well as economic, legal and social conditions. Loss reserves are not discounted to present value, which would involve recognizing the time value of money and offsetting estimates of future payments by future expected investment income.
In establishing these estimates, we make various assumptions regarding a number of factors, including frequency and severity of claims, the length of time needed to achieve ultimate settlement of claims, inflation of medical costs, insurance policy coverage interpretations, jury determinations and legislative changes. Due to the inherent uncertainty associated with these estimates, and the cost of incurred but unreported claims, our actual liabilities may be different from our original estimates. On a quarterly basis, we review our reserves for losses and LAE to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s results. Additional information regarding the judgments and uncertainties surrounding our estimated reserves for losses and LAE can be found in “Business-Loss Reserves” in Item 1 of this report.
Allowance for policy cancellations
An allowance for policy cancellations is provided for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes that will be incurred on expected future policy cancellations associated with the Company’s business. Premiums and cancellation data are accumulated by accounting month (month in which the premium was written/collected). The estimation methodology utilizes actual cancellation rates (premium refunds divided by premiums written by accounting month) to determine expected future cancellations for that accounting month. The balance for each accounting month decreases each subsequent month as actual refunds emerge.
While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are continually reviewed by management, and any changes are reflected in current operations.
Unearned premium
Unearned premium reserves represent the portion of premiums written applicable to the unexpired terms of the policies. The Lender Services segment calculates this reserve after adjusting for anticipated policy cancellations.
Reinsurance recoverable
The recoverable for ceded unpaid losses and LAE includes an estimate for claims reported and an additional liability for claims incurred but not reported, based on the Company’s historical loss experience. While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amount ultimately paid when the claims are settled. These estimates are reviewed and adjusted on a continuing basis, as necessary, as experience develops or as new information becomes known and such adjustments are included in current operations. The recoverable for ceded premium reserves represent the portion of premiums written applicable to the unexpired terms of the policies. The Lender Services segment calculates this reserve after adjusting for anticipated policy cancellations.
Investments
Investments are considered available-for-sale and are carried at fair value. The Company measures the fair value of the investments based upon quoted market prices from an independent pricing service and its third-party investment managers, using observable market information. The cost of securities sold is based on the specific identification method. Unrealized gains and losses associated with the available-for-sale portfolio, as a result of temporary changes in fair value during the period such investments are held, are reflected net of income taxes and reported in other comprehensive income as a separate component of shareholders’ equity. Unrealized losses associated with the available-for-sale portfolio that are deemed to be other-than-temporary are charged to income in the period in which the other-than-temporary impairment is determined. Debt security premiums and discounts are amortized into earnings using the effective-interest method.
The Company evaluates its investment portfolio for impairments of individual securities that are deemed to be other-than-temporary. Fixed maturity securities that are determined to have other-than-temporary impairment and it is more likely than not the Company will sell before recovery of their amortized cost, are written down to fair value and the entire amount of the write-down is included in net income, net of realized investment gains. For all other impaired fixed-
maturity securities, the impairment loss is separated into the amount representing the credit loss and the amount representing all other factors. The amount of impairment loss that represents the credit loss is included in net income, net of realized investment gains. The amount of the impairment loss that relates to all other factors is included in other comprehensive income. Equity securities that are determined to have other-than-temporary impairment are recognized in net income, net of realized investment gains.
The process for identifying other-than-temporary declines in fair value involves the consideration of several factors, including, but not limited to, whether the issuer has been downgraded to below investment-grade, the length of time in which there has been a significant decline in value, the liquidity and overall financial condition of the issuer, the nature and performance of the collateral or other credit support backing the security, the significance of the decline in value, and whether the Company has the intent to sell the security or may be required to sell the security prior to its anticipated recovery. The Company reviews securities for other-than-temporary impairment internally and with its investment advisors.
The Company invests in convertible securities that have embedded derivatives. Derivatives embedded within non-derivative instruments, such as options embedded in convertible fixed maturity securities, are bifurcated from the host instrument when the embedded derivative meets the criteria for bifurcation. However, for reporting purposes, these embedded derivatives are presented together with the host contract and carried at estimated fair value. Changes in the estimated fair value of the embedded derivatives are reflected in “Realized net investment gains” in the consolidated statements of income, while changes in the estimated fair value of the underlying fixed maturity securities are reflected in “Unrealized holding gains (losses)” in the consolidated statements of comprehensive income.
Minimum ceding fees
Minimum ceding fees are fees the Company receives pursuant to contractual minimum premium requirements for certain programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces: (1) “premium-related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium estimated to be written in the contract year, which fees are earned over the contract year.
Minimum ceding fees earned are based on estimates of annual premiums to be written for those programs that are subject to a minimum premium levels and related ceding fees. These estimates are based upon various assumptions made regarding the production plans for the underlying program. These assumptions are reviewed by management and the amount of annual premiums expected to be written are re-estimated each quarter. As actual premiums emerge and revisions are made to earlier estimates, minimum ceding fees are earned or reversed and are reflected in current operations.
(1)
Prior to the completion of the private placement in June 2014, we made special compensation payments to our co-founders in recognition of their service to our Company. We refer to these payments as “founder special compensation.” Following the completion of the private placement in 2014, we ceased paying founder special compensation.
(2)
Offering-related expenses are non-recurring expenses related to the Company’s private placement of common stock.
(3)
In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million. As a result, we recorded non-recurring contract modification expense of $17.8 million.
(4)
Upon the completion of the private placement in 2014, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes. This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rate of 37.5% for the period ended December 31, 2014.
(5)
As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.3 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions.
(6)
Represents the tax effect of non-GAAP expense adjustments for founder special compensation, offering-related expenses, and contract modification expense. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rate of 37.5% for the period ended December 31, 2014.
Consolidated Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
Premiums earned. Premiums earned increased by $11.6 million, or 9.8%, from $118.1 million for the year ended December 31, 2015 to $129.7 million for the year ended December 31, 2016. This increase was due to an increase in Lender Services premiums earned. Factors contributing to this increase are new sales, active account management and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Ceding fees. Ceding fees increased by $5.3 million, or 7.9%, from $68.0 million for the year ended December 31, 2015 to $73.3 million for the year ended December 31, 2016, due to an increase in Program Services gross earned premium. Program Services gross earned premiums increased from $1.0 billion for the year ended December 31, 2015 to $1.2 billion for the year ended December 31, 2016, resulting in an increase in premium-related ceding fees of $8.3 million. Capacity fees decreased $3.0 million for the year ended December 31, 2016 compared to the year ended December 31, 2015, due to an increase in premium-related fees and a decrease in minimum contractual fees for 2016 compared to 2015.
Realized net investment gains. Realized net investment gains increased by $0.8 million, or 44.9%, from a gain of $1.9 million for the year ended December 31, 2015 to a gain of $2.7 million for the year ended December 31, 2016. This increase was partially the result of the liquidation of fixed maturity securities for the purchase of CNIC in September 2016 and acquisition of ISIC in January 2017, and was partially offset by a decrease in the change in fair value of embedded derivatives on the Company’s convertible securities.
Losses and loss adjustment expenses. Losses and LAE increased by $3.0 million, or 5.4%, from $55.8 million for the year ended December 31, 2015 to $58.8 million for the year ended December 31, 2016, which was primarily the result of increased exposure due to higher earned premiums. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense. General and administrative expense increased by $7.0 million, or 11.2%, from $63.0 million for the year ended December 31, 2015 to $70.0 million for the year ended December 31, 2016, primarily due to investment in strategic growth, increased public company expenses, professional fees and stock-based compensation.
Income tax expense (benefit). Income tax expense increased by $2.8 million, or 11.4%, from $24.9 million for the year ended December 31, 2015 to $27.7 million for the year ended December 31, 2016, primarily resulting from the increase in income before income taxes. Our effective tax rate for financial reporting purposes was 36.1% and 35.8% for 2016 and 2015, respectively.
Consolidated Results of Operations for the Year Ended December 31, 2015 compared to the Year Ended December 31, 2014
Premiums earned. Premiums earned increased by $21.4 million, or 22.2%, from $96.7 million for the year ended December 31, 2014 to $118.1 million for the year ended December 31, 2015. This increase was due to an increase in Lender Services premiums earned, $10.4 million of which is related to the amendment of the CUNA Mutual alliance agreement. Factors contributing to this increase in premiums earned are new sales and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan sizes.
Ceding fees. Ceding fees increased by $22.3 million, or 48.6%, from $45.7 million for the year ended December 31, 2014 to $68.0 million for the year ended December 31, 2015, due to an increase in Program gross earned premium and capacity fees. Program Services gross earned premiums increased from $815.2 million for the year ended December 31, 2014 to $1.0 billion for the year ended December 31, 2015 resulting in an increase in premium-related ceding fees of $11.1 million. Capacity fees increased $11.2 million for the year ended December 31, 2015 compared to the year ended December 31, 2014.
Investment income. Investment income increased by $3.1 million, from $4.8 million for the year ended December 31, 2014 to $7.9 million for the year ended December 31, 2015, in part due to an increase in investment holdings as a result of the net proceeds of the private placement and investing operating cash flows.
Other income. Other income decreased by $2.8 million, from $4.4 million for the year ended December 31, 2014 to $1.6 million for the year ended December 31, 2015. This decrease is primarily related to termination of a tenant lease in November 2014.
Losses and loss adjustment expenses. Losses and LAE increased by $15.0 million, or 36.6%, from $40.8 million for the year ended December 31, 2014 to $55.8 million for the year ended December 31, 2015, which is partly the result of increased exposure due to higher earned premiums and an increase in claim frequency and severity. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
Commissions. Commission expense increased by $1.6 million from $3.9 million for the year ended December 31, 2014 to $5.5 million for the year ended December 31, 2015, primarily due to the increase in Lender Services premiums earned and a reduction to ceding commissions as a result of the amendment to the CUNA Mutual alliance agreement.
General and administrative expense. General and administrative expense increased by $4.1 million, or 6.9%, from $58.9 million for the year ended December 31, 2014 to $63.0 million for the year ended December 31, 2015, primarily due to stock-based compensation, employee group insurance and expenses associated with being a public company.
Founder special compensation. We ceased paying founder special compensation following the completion of the private placement in June 2014.
Offering-related expenses. We incurred $8.8 million of non-recurring offering-related expenses related to the private offering of the Company’s stock in 2014. We incurred no offering-related expenses in 2015.
Contract modification expense. Contract modification expense decreased by $17.8 million. In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million. As a result, we recorded non-recurring contract modification expense of $17.8 million for the year ended December 31, 2014.
Income tax expense (benefit). Income tax expense increased by $34.6 million, from a benefit of $9.7 million for the year ended December 31, 2014 to an expense of $24.9 million for the year ended December 31, 2015, primarily resulting from the conversion of the Company’s tax status from a Subchapter S Corporation to a C Corporation.
Program Services Segment - Results of Operations
Program Services Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
Ceding fees. Ceding fees increased by $5.3 million, or 7.9%, from $68.0 million for the year ended December 31, 2015 to $73.3 million for the year ended December 31, 2016, due to an increase in Program Services gross earned premium. Program Services gross earned premiums increased from $1.0 billion for the year ended December 31, 2015 to $1.2 billion for the year ended December 31, 2016, resulting in an increase in premium-related ceding fees of $8.3 million. Capacity fees decreased $3.0 million for the year ended December 31, 2016 compared to the year ended December 31, 2015, due to an increase in premium-related fees and a decrease in minimum contractual fees for 2016 compared to 2015.
Losses and loss adjustment expenses. Losses and LAE incurred in the run-off of the retained business decreased by $1.0 million from $2.0 million for the year ended December 31, 2015 to $1.0 million for the year ended December 31, 2016, which is due to less adverse development than in prior year on the run-off of the retained business.
General and administrative expense. General and administrative expense increased by $2.2 million, or 17.3%, from $12.4 million for the year ended December 31, 2015 to $14.6 million for the year ended December 31, 2016. The increase was primarily due to investment in strategic growth and professional fees.
Program Services Segment Results of Operations for the Year Ended December 31, 2015 compared to the Year Ended December 31, 2014
Ceding fees. Ceding fees increased by $22.3 million, or 48.6%, from $45.7 million for the year ended December 31, 2014 to $68.0 million for the year ended December 31, 2015, due to an increase in Program gross earned premium and
capacity fees. Program Services gross earned premiums increased from $815.2 million for the year ended December 31, 2014 to $1.0 billion for the year ended December 31, 2015 resulting in an increase in premium-related ceding fees of $11.1 million. Capacity fees increased $11.2 million for the year ended December 31, 2015 compared to the year ended December 31, 2014.
Losses and loss adjustment expenses. Losses and LAE incurred in the run-off of the retained business increased by $1.8 million from $0.2 million for the year ended December 31, 2014 to $2.0 million for the year ended December 31, 2015. The increase in losses and LAE for the year ended December 31, 2015, was primarily related to reserve strengthening on run-off programs.
General and administrative expense. General and administrative expense increased by $1.6 million, or 14.7%, from $10.8 million for the year ended December 31, 2014 to $12.4 million for the year ended December 31, 2015. The increase was primarily related to stock-based compensation and consulting fees.
Lender Services Segment - Results of Operations
(1)
In connection with the amendment to the alliance agreements with CUNA Mutual, we paid CUNA Mutual $17.8 million. As a result, we recorded non-recurring contract modification expense of $17.8 million.
Lender Services Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
Premiums earned. Premiums earned increased by $11.6 million, or 9.8%, from $118.1 million for the year ended December 31, 2015 to $129.7 million for the year ended December 31, 2016. Factors contributing to this increase included new sales, active account management and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan balances.
Losses and loss adjustment expenses. Losses and LAE increased by $3.9 million, or 7.3%, from $53.8 million for the year ended December 31, 2015 to $57.7 million for the year ended December 31, 2016, primarily as a result of increased exposure due to higher earned premiums. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
General and administrative expense. General and administrative expense increased by $2.2 million, or 5.4%, from $39.8 million for the year ended December 31, 2015 to $42.0 million for the year ended December 31, 2016, primarily due to investment in strategic growth and stock-based compensation.
Lender Services Segment Results of Operations for the Year Ended December 31, 2015 compared to the Year Ended December 31, 2014
Premiums earned. Premiums earned increased by $21.4 million, or 22.2%, from $96.7 million for the year ended December 31, 2014 to $118.1 million for the year ended December 31, 2015, $10.4 million of which is related to the amendment of the CUNA Mutual alliance agreement. Factors contributing to this increase in premiums earned are new sales and growth in the loan portfolios of existing accounts driven by rising automobile sales and higher average auto loan sizes.
Losses and loss adjustment expenses. Losses and LAE increased by $13.2 million, or 32.4%, from $40.6 million for the year ended December 31, 2014 to $53.8 million for the year ended December 31, 2015, which is partly the result of increased exposure due to higher earned premiums and an increase in claim frequency and severity. The net loss ratio increased from 42.0% to 45.5% for the years ended December 31, 2014 and December 31, 2015, respectively. A strengthening economy, an aging automobile fleet, and easier access to credit have contributed to an increase in vehicle sales, resulting in higher loan balances which are the bases upon which we pay claims.
Commissions. Commission expense increased by $1.6 million from $3.9 million for the year ended December 31, 2014 to $5.5 million for the year ended December 31, 2015, primarily due to the increase in Lender Services premiums earned and a reduction to ceding commissions as a result of the amendment to the CUNA Mutual alliance agreement.
General and administrative expense. General and administrative expense increased by $0.8 million, or 2.2%, from $39.0 million for the year ended December 31, 2014 to $39.8 million for the year ended December 31, 2015. The increase in general and administrative expenses was minimal in relation to our increased premium retention from the Alliance quota share agreement due to our ability to effectively leverage our fixed costs. This contributed to a decrease in our net expense ratio to 41.0% in 2015 compared to 47.3% in 2014.
Contract modification expense. Contract modification expense decreased by $17.8 million. In connection with the 2014 amendment to the alliance agreement with CUNA Mutual, we paid CUNA Mutual $17.8 million. As a result, we recorded non-recurring contract modification expense of $17.8 million for the period ended December 31, 2014.
Corporate Segment - Results of Operations
(1)
Prior to the completion of the private placement in June 2014, we made special compensation payments to our co-founders in recognition of their service to our Company. We refer to these payments as “Founder special compensation.” Following the completion of the private placement, we ceased paying Founder special compensation.
(2)
Offering-related expenses are non-recurring expenses related to the Company’s private placement of common stock.
Corporate Segment Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015
Realized net investment gains. Realized net investment gains increased by $0.8 million, or 44.9%, from a gain of $1.9 million for the year ended December 31, 2015 to a gain of $2.7 million for the year ended December 31, 2016. This increase was partially the result of the liquidation of fixed maturity securities for the purchase of CNIC in September 2016 and acquisition of ISIC in January 2017, and was partially offset by a decrease in the change in fair value of embedded derivatives on the Company’s convertible securities.
General and administrative expense. General and administrative expense increased by $2.7 million, or 25.5%, from $10.7 million for the year ended December 31, 2015 to $13.4 million for the year ended December 31, 2016, primarily due to investment in strategic growth, professional fees and an increase in stock-based compensation.
Income tax expense (benefit). Income tax expense increased by $2.8 million, from $24.9 million for the year ended December 31, 2015 to $27.7 million for the year ended December 31, 2016, primarily resulting from the increase in income before income taxes. Our effective tax rate for financial reporting purposes was 36.1% and 35.8% for 2016 and 2015, respectively.
Corporate Segment Results of Operations for the Year Ended December 31, 2015 compared to the Year Ended December 31, 2014
Investment income. Investment income increased by $3.1 million, from $4.8 million for the year ended December 31, 2014 to $7.9 million for the year ended December 31, 2015, in part due to an increase in investment holdings as a result of the net proceeds of the private placement and investing operating cash flows.
Other income. Other income decreased by $3.1 million, from $3.2 million for the year ended December 31, 2014 to $0.1 million for the year ended December 31, 2015. This decrease is primarily related to termination of a tenant lease in November 2014.
General and administrative expense. General and administrative expense increased by $1.7 million, from $9.0 million for the year ended December 31, 2014 to $10.7 million for the year ended December 31, 2015, primarily due to an increase in stock-based compensation.
Founder special compensation. We ceased paying founder special compensation following the completion of the private placement in June 2014.
Offering-related expenses. We incurred $8.8 million of non-recurring offering-related expenses related to the private offering of the Company’s stock in 2014. We incurred no offering-related expenses in 2015.
Income tax expense (benefit). Income tax expense increased by $34.6 million, from a benefit of $9.7 million for the year ended December 31, 2014 to an expense of $24.9 million for the year ended December 31, 2015, primarily resulting from the conversion of the Company’s tax status from a Subchapter S Corporation to a C Corporation.
Investment Portfolio
Our investment strategy emphasizes, first, the preservation of capital and, second, the generation of an appropriate risk-adjusted return. We seek to generate investment returns using investment guidelines that stress prudent allocation among cash and cash equivalents, fixed-maturity securities and, to a lesser extent, equity securities. Cash and cash equivalents include cash on deposit and short-term money market funds. As of December 31, 2016, the tax adjusted yield on our fixed maturity and equity securities was 2.7%. Convertible securities represent 13.9% of the portfolio at December 31, 2016. The average duration, excluding convertible securities, was 4 years and included obligations of the U.S. Treasury or U.S. government agencies, obligations of U.S. and Canadian corporations, mortgages guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association, the Federal Home Loan Mortgage Corporation, Federal Farm Credit entities, and asset-backed securities and commercial mortgage obligations. Our equity securities include preferred stock and common stock of U.S. corporations. Our investment portfolio is managed by Asset Allocation & Management Company, LLC and AAM Advisors, Inc. (collectively, “AAM”). AAM operates under written investment guidelines approved by our board of directors. We pay AAM an investment management fee based on the market value of assets under management.
For each period specified below, the cost, fair value, and gross unrealized gains and losses on available-for-sale securities were as follows:
The table below summarizes the credit quality of our fixed-maturity securities as of December 31, 2016, as rated by Standard and Poor’s.
The amortized cost and fair value of available-for-sale debt securities held as of December 31, 2016, by contractual maturity, are shown in the table below. Actual maturities may differ from contractual maturities because some borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The tables below summarize the gross unrealized losses of fixed-maturity and preferred securities by the length of time the security had continuously been in an unrealized loss position for each year or shorter period specified below:
There were 270 and 237 securities at December 31, 2016 and December 31, 2015, respectively, that account for the gross unrealized loss, none of which we deemed to be other-than-temporarily impaired. Management believes that the temporary impairments are primarily the result of a combination of widening credit spreads and higher underlying Treasury rates, and that despite the wider credit spreads and higher rates, the securities are only temporarily impaired due to the strength of the issuing companies’ balance sheets, as well as their available liquidity options. For structured securities, future cash flow projections were used to determine potential impairment. For those securities where cash flow projections showed less than 100% principal recovery, a net present value test was done to determine any credit related losses. We do not intend to sell or believe we will be required to sell any of our temporarily-impaired fixed maturities before recovery of their amortized cost basis. Management has the intent and ability to hold the equity securities in an unrealized loss position until the recovery of their fair value. Therefore, Management does not consider these investments to be other-than-temporarily impaired.
We are required to maintain deposits in various states where the insurance subsidiaries are licensed to operate. These deposits are fixed maturity securities at fair values totaling $77.0 million and $53.5 million at December 31, 2016 and December 31, 2015, respectively. The increase in the amounts on deposit at December 31, 2016 is due to an increase in the required deposits for workers’ compensation business and required deposits acquired in the acquisition of CNIC.
Fair value of financial instruments. ASC 820, “Fair Value Measurements and Disclosures”, provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. The standard applies when GAAP requires or allows assets or liabilities to be measured at fair value; therefore, it does not expand the use of fair value in any new circumstance. Investments measured at fair value on a recurring basis at December 31, 2016 and December 31, 2015 are all considered level 2 investments.
Liquidity
We are organized as a holding company with four domestic insurance company subsidiaries, as well as a wholly-owned subsidiary that operates in an agency capacity. Our principal sources of operating funds are premiums, ceding fees, investment income and proceeds from sales and maturities of investments. Our primary uses of operating funds include payments of claims and operating expenses. We pay claims using cash flow from operations and invest our excess cash primarily in fixed-income securities. We expect that projected cash flows from operations and our revolving credit facility will provide us with sufficient liquidity to fund our anticipated growth and to pay claims and operating expenses, interest on debt facilities and other holding company expenses for the foreseeable future. However, if our growth attributable to potential acquisitions, internally generated growth, or a combination of these factors, exceeds our expectations, we may have to raise additional capital in the near term. If we cannot obtain adequate capital on favorable
terms or at all, we may be unable to support future growth or operating requirements and, as a result, our business, financial condition and results of operations could be adversely affected. We may generate liquidity through the issuance of debt or equity securities or financing through borrowings under credit facilities, or a combination thereof.
Our insurance subsidiaries are subject to statutory and regulatory restrictions imposed on insurance companies by their states of domicile which limit the amount of cash dividends or distributions that they may pay to us unless special permission is received from the insurance regulator of the relevant domiciliary state. The aggregate limit imposed by the various domiciliary states of our insurance subsidiaries was approximately $26.9 million and $23.0 million as of December 31, 2016 and 2015, respectively. In addition, we are able to generate substantial cash flow outside of our regulated insurance company subsidiaries through intercompany agency and management agreements between our insurance subsidiaries and our agency, TBA. TBA functions as a managing general agent for SNIC, NSIC and USIC in connection with the Lender Services segment. In addition, under the management agreement TBA provides business development, financial monitoring and other oversight functions to our insurance subsidiaries.
The following table is a summary of our consolidated statements of cash flows:
Comparison of Years Ended December 31, 2016 and 2015
Net cash provided by operating activities was $10.2 million higher for the year ended December 31, 2016 compared to the year ended December 31, 2015, primarily due to an increase in Lender Services and Program Services operating results.
Net cash used in in investing activities decreased $18.7 million for year ended December 31, 2015 to the year ended December 31, 2016, primarily due to the liquidation of investments related to the acquisition of CNIC and acquisition of ISIC in January 2017. These decreases were largely offset by the purchase of CNIC on September 30, 2016 in the amount of $17.4 million.
Net cash used in financing activities increased $2.4 million for the year ended December 13, 2016 compared to the year ended December 31, 2015, primarily due to the settlement of $3.9 million in stock repurchases in 2016.
Comparison of Years Ended December 31, 2015 and 2014
Net cash provided by operating activities was $37.8 million higher for the year ended December 31, 2015 compared to the year ended December 31, 2014. The increase is primarily due to nonrecurring cash expenditures for the year ended December 31, 2014 related to founder special compensation, amendment to the CUNA Mutual alliance agreement and offering-related expenses. Also, contributing to the increase is an increase in ceding fees and the change to the Company’s retention related to the CUNA Mutual Alliance agreement to 70% from 50%.
Net cash used in in investing activities decreased $101 million from $128 million for year ended December 31, 2014 to $27 million for the year ended December 31, 2015. This decrease is primarily due to investing cash received from the private placement in 2014.
Net cash from financing activities decreased $94.3 million for the year ended December 31, 2015 compared to the year ended December 31, 2014. The decrease is primarily due to proceeds of $97 million received from the private
placement in 2014. Other activity impacting cashflows was a decrease in dividends paid of $10.5 million, $14.4 million stock repurchase in 2015 and $6.8 million subordinated debenture repurchase in 2014.
Other Material Changes in Financial Position
Accounts receivable from agents, net. This balance reflects ceding fees, premiums and premium taxes receivable. During the year ending December 31, 2016, accounts receivable from agents increased $12.1 million from December 31, 2015, primarily as a result of an increase in Program Services receivables. The increase primarily relates to one of our arrangements under which we are responsible to certain reinsurers for the collection and payment of premiums. As a result, the related premiums receivable and payable are reflected in our balance sheet. The remainder partially relates to an agreement with Nephila we entered into effective January 1, 2016. For Nephila, we will, at Nephila’s request, transfer certain exposures that are otherwise reinsured by Nephila’s quota share reinsurer to excess reinsurers. In instances where this agreement is utilized, State National enters into an agreement directly with excess reinsurers, and Nephila guarantees the obligation of those excess reinsurers and pays the premiums on our behalf on a quarterly basis in arrears. We purchased one excess reinsurance policy under this agreement during 2016.
Goodwill and intangible assets, net. As of December 31, 2016, goodwill and intangible assets increased $6.6 million compared to December 31, 2015, primarily due to an increase in indefinite-lived intangible assets of $7.4 million related to the CNIC acquisition.
Deferred income taxes, net. Deferred income taxes, net, increased $2.7 million compared to December 31, 2015, primarily due to increases in Deferred ceding fees and the Allowance for policy cancellations related to growth in Program Services and Lender Services revenues.
Reinsurance recoverables, unpaid losses and loss adjustment expenses and unearned premiums. As of December 31, 2016, we held $2.2 billion in collateral securing $1.7 billion in reinsurance recoverables. The remaining unsecured reinsurance recoverables of $664.6 are ceded to highly-rated, well capitalized reinsurers. During the year ended December 31, 2016, reinsurance recoverables increased $431.2 million from December 31, 2015, which was primarily a result of the increase in gross premiums written for Program Services business due to the addition of new programs and expansion of existing programs and gross loss development for prior year claims. These factors also caused an increase in the corresponding unearned premiums and the unpaid losses and loss adjustment expenses of $95.2 million and $338.9 million, respectively.
Allowance for policy cancellations. As of December 31, 2016, the allowance for policy cancellations increased by $6.8 million from December 31, 2015, primarily due to the volume and timing of CPI premiums (gross of cancellations) written in 2016 compared to 2015. The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least. On a quarterly basis, we review our estimates for allowance for policy cancellations to determine whether further adjustments are appropriate. Any resulting adjustments are included in
the current period’s operating results. The allowance for policy cancellations for the year ended December 31, 2016 and December 31, 2015 included upward revisions to prior year estimates of $1.4 million and $0.6 million, respectively. Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers. After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net impact to the balance sheet and the corresponding reduction in net income from the revised estimates for the year ended December 31, 2016 and 2015 was approximately $0.6 million and $0.2 million, respectively.
Capital Resources
The Company has three statutory business trusts that were formed between 2002 and 2004, for the sole purpose of issuing $44.5 million of trust preferred securities in private offering transactions. The trusts used the proceeds from these offerings, together with the equity proceeds received upon their initial formation from TBA, an indirect wholly-owned subsidiary of State National, to purchase variable-rate subordinated debentures issued by TBA. All voting securities of the trusts are owned by TBA, and the debentures are the sole assets of the trusts. The trusts meet the obligations of the trust preferred securities with the interest and principal paid on the debentures. These trusts’ interest rates range from 3.80% to 4.10% plus the three-month LIBOR. The three-month LIBOR at December 31, 2016, was 1.0%. All of the debentures mature between 2032 and 2034.
On March 31, 2016, the Company, through TBA, entered into a loan agreement, which provides for a secured revolving credit facility in an aggregate principal amount of $15 million. The credit agreement matures on April 30, 2018. Under the credit agreement, TBA may request advances up to the aggregate amount of the unused commitment under the credit facility, on a revolving basis, prior to the maturity of the credit agreement. Borrowings under the credit agreement will bear interest at a variable rate equal to LIBOR plus 1.85% per annum; provided, however, that LIBOR shall be subject to a floor of 0.15%. TBA shall also pay a commitment fee on the daily average unused commitment amount for the period running from the closing date to the maturity date at a rate of 0.125% per annum. The credit agreement contains customary representations, warranties, covenants, and events of default, as well as a financial covenant requiring TBA and the Company to maintain a consolidated tangible net worth of at least $150 million.
Contractual Obligations and Commitments
The following table sets forth certain of our contractual obligations as of December 31, 2016:
(1)
The loss and LAE payments due by period in the table above are based upon the loss and LAE estimates as of December 31, 2016 and actuarial estimates of expected payout patterns and are not contractual liabilities with finite maturities. Our contractual liability is to provide benefits under the policy. As a result, our calculation of loss and LAE payments due by period is subject to the same uncertainties associated with determining the level of loss and LAE generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our loss and LAE estimation process, see “Business-Loss Reserves” in Item 1 of this report. Actual payments of loss and LAE by period will vary, perhaps materially, from the table above to the extent that current estimates of loss and LAE vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors-Risks Relating to Our Business-If we are unable to establish and maintain accurate loss reserves, our business, financial condition, results of operations and prospects may be materially and adversely affected” in Item
1A of this report for a discussion of the uncertainties associated with estimating loss and LAE.
(2)
The interest related to the debt by period as of December 31, 2016 was as follows: $2.2 million-less than 1 year, $4.5 million-1 - 3 years, $4.5 million-3 - 5 years and $ 26.3 million-more than 5 years.
Item 7A.
Item 7A.Quantitative and Qualitative Disclosures About Market Risk
Liquidity Risk
Liquidity risk represents our potential inability to meet all payment obligations when they become due. We maintain sufficient cash and marketable securities to fund claim payments and operations.
Credit Risk
We are exposed to credit risk from potential losses arising principally from the financial condition of our third party reinsurers, and also from potential losses in our investment portfolio. Although our third party reinsurers are obligated to reimburse us to the extent we cede risk to them, we are ultimately liable to our policyholders on all risks we have ceded. As a result, reinsurance contracts do not limit our ultimate obligations to pay claims covered under the insurance policies we issue and we might not collect amounts recoverable from our reinsurers. We generally address this credit risk by either (1) selecting reinsurers that have an A.M. Best rating of “A-” (Excellent) or better, have $300 million in equity and/or capital and surplus and are a Texas or Delaware (for USIC) authorized reinsurer at the time we enter into the agreement, or (2) requiring that the reinsurer post substantial collateral to secure the reinsured risks. Security can take the form of collateral (in the form of security posted with a trustee pursuant to a related agreement, or evergreen letter of credit), or guaranty by a related third party that we believe has the ability to pay. The security amount is a function of the policyholder liabilities (unearned premiums, losses and LAE reserves) or other amounts that are more representative of the amounts at risk. Excess security is required when a reinsurer does not meet the above financial requirements to provide a “cushion” for inadequate estimates of policyholder liabilities. Unless there is some mitigating factor, we control the ability to set policyholder liability amounts for security purposes.
Security is also immediately required if a reinsurer falls below the benchmark rating during the term of a reinsurance agreement. Existing security may be increased if a reinsurer is downgraded during the term of a reinsurance agreement or experiences a significant loss in policyholder equity and/or capital and surplus.
Collateral levels are reviewed weekly, on each reinsurer on which security is required. Collateral calculations are adjusted as monthly activity reports are received on individual programs and collateral account balance information is available. Collateral is generally obtained a quarter in advance at the end of each calendar quarter.
We also evaluate the credit risk of our investment portfolio. The primary measure we utilize to mitigate credit risk (the risk of principal default on the securities we invested in) involves the credit quality of our portfolio. Approximately 65% of our portfolio is rated AA- or higher (rated by Standard & Poor’s), which is consistent with the guidelines provided to our asset managers. Additionally, our Investment Committee reviews the portfolio on a quarterly basis and discusses any securities which have been downgraded in the previous quarter.
Market Risk
The risk of underperformance in the market is addressed by having a quality asset manager administering our portfolio. Additionally, our portfolio is diversified to eliminate exposure to any one particular segment. Finally, as the bulk of our assets support either our surplus or short tailed lines of business, investment performance is a relatively small portion of our profits relative to other property and casualty companies.
Our investment policy is reviewed periodically and updated to meet current needs. However, the primary goal and philosophy of the policy is to be conservative in nature to provide preservation of principal and provide necessary liquidity.
Interest Rate Risk
This is a two-fold risk involving loss of market value due to a rising interest rate environment coupled with a need to liquidate those securities to provide liquidity for operations. Our exposure to extreme shifts in interest rates is mitigated to some extent by selecting a duration target for the portfolio which is relatively short (i.e., approximately four years). The exposure to actually selling underwater securities to gain liquidity is managed by maintaining a laddered portfolio whereby we have securities maturing over the next few years. Further mitigation is provided by maintaining the convexity (i.e., how the duration of a bond changes as the interest rate changes) of the portfolio at relatively low levels.
We had fixed-maturity securities with a fair value of $332.1 million and an amortized cost of $330.0 million as of December 31, 2016 that are subject to interest rate risk. Interest rate risk is the risk that we may incur losses due to adverse changes in interest rates. Fluctuations in interest rates have a direct impact on the market valuation of our fixed-maturity securities. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements.
The table below summarizes the interest rate risk associated with our fixed-maturity securities by illustrating the sensitivity of the fair value of our fixed-maturity securities as of December 31, 2016 to selected hypothetical changes in interest rates, and the associated impact on our shareholders’ equity. We anticipate that we will continue to meet our obligations from operating cash flows. We classify our fixed-maturity securities and equity securities as available-for-sale. Temporary changes in the fair value of our fixed-maturity securities impact the carrying value of these securities and are reported in our shareholders’ equity as a component of other comprehensive income, net of deferred taxes. The selected scenarios in the table below are not predictions of future events, but rather are intended to illustrate the effect such events may have on the fair value and carrying value of our fixed-maturity securities and on our shareholders’ equity, each as of December 31, 2016.
Changes in interest rates would affect the fair market value of our fixed-rate debt instruments but would not have an impact on our earnings or cash flow. As of December 31, 2016, we had $44.5 million of debt instruments, gross of debt issuance costs. A fluctuation of 100 basis points in interest on our variable-rate debt instruments, which are tied to LIBOR, would affect our earnings and cash flows by $0.4 million before income tax, on an annual basis, but would not affect the fair value of the variable-rate debt.
Item 8.
Item 8.Financial Statements and Supplementary Data
The financial statements and financial statement schedules required to be filed pursuant to this Item 8 are listed in the accompanying Index to Consolidated Financial Statements and Schedules at page and are filed as part of this report.
Item 9.
Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A:
Item 9A:Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to provide reasonable assurance that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. We note that the design of any system of controls is based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving the stated goals under all potential future conditions.
Management Report on Internal Control over Financial Reporting
We, as management of the Company, are responsible for establishing and maintaining adequate internal control over financial reporting. Pursuant to the rules and regulations of the SEC, internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, or persons performing similar functions, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
·
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
·
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are made only in accordance with authorizations of management and directors of the Company; and
·
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate. Management has evaluated the effectiveness of our internal control over financial reporting as of December 31, 2016, based on the control criteria established in a report entitled Internal Control-Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, we have concluded that our internal control over financial reporting is effective as of December 31, 2016.
This annual report does not include an attestation report of the Company's registered public accounting firm due to the exemption provided by the JOBS Act for emerging growth companies.
Changes in Internal Controls over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B.Other Information.
None.
PART III
Item 10.
Item 10.Directors, Executive Officers and Corporate Governance
Information regarding our executive officers is included in Part I of this Form 10-K.
Information regarding our directors is incorporated by reference from the information included under the caption “Proposal 1 Election of Directors” in our Proxy Statement for our Annual Meeting of Shareholders to be held May 18, 2017 (the “Proxy Statement”). We plan to file the Proxy Statement within 120 days after December 31, 2016.
Information regarding family relationships between directors and executive officers is incorporated by reference from the information included under the caption “Certain Relationships and Related Transactions” in the Proxy Statement.
Information required regarding compliance with Section 16(a) of the Exchange Act is incorporated by reference from the information included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.
Information regarding our audit committee and our audit committee financial expert is incorporated by reference from the information included under the caption “The Board, Its Committees and Its Compensation-Corporate Governance-Committees of the Board-Audit Committee” in the Proxy Statement.
Information regarding our Code of Business Conduct and Ethics for executive and financial officers and directors is incorporated by reference from the information included under the caption “The Board, Its Committees and Its Compensation-Corporate Governance-Code of Business Conduct and Ethics” in the Proxy Statement.
Item 11.
Item 11.Executive Compensation
Information regarding our executive compensation is incorporated by reference from the information included under the captions “Compensation Discussion and Analysis” and “Executive Compensation” in the Proxy Statement.
Information regarding Compensation Committee interlocks is incorporated by reference from the information included under the caption “Compensation Committee Interlocks and Insider Participation” in the Proxy Statement.
Information regarding the report of our Compensation Committee is incorporated by reference from the information included under the caption “Compensation Committee Report” in the Proxy Statement.
Item 12.
Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
Information regarding our security ownership is incorporated by reference from the information included under the caption “Security Ownership of Management and Certain Beneficial Holders” in the Proxy Statement.
Item 13.
Item 13.Certain Relationships and Related Transactions, and Director Independence
Information regarding certain relationships and related transaction is incorporated by reference from the information included under the caption “Certain Relationships and Related Transactions” in the Proxy Statement.
Information regarding the independence of our directors is incorporated by reference from the information included under the caption “The Board, Its Committees and Its Compensation-Corporate Governance-Director Independence” in the Proxy Statement.
Item 14.
Item 14.Principal Accountant Fees and Services
Information regarding our principal accountant and its fees is incorporated by reference from the information included under the caption “Independent Registered Public Accounting Firm” in the Proxy Statement.
PART IV
Item 15.
Item 15.Exhibits and Financial Statement Schedules
The following documents are filed as part of this report:
(a)
The financial statements and financial schedules listed in the accompanying Index to Financial Statements are filed as part of this report. The exhibits listed in the accompanying Index to Exhibits are filed as part of this report.
(b)
Exhibits: See Item 15(a).
(c)
Schedules: See Item 15(a).
INDEX TO EXHIBITS
101 CAL
XBRL Taxonomy Extension Calculation Linkbase Document (filed herewith)
101 LAB
XBRL Taxonomy Extension Label Linkbase Document (filed herewith)
101 PRE
XBRL Taxonomy Extension Presentation Linkbase Document (filed herewith)
101 DEF
XBRL Taxonomy Extension Definition Linkbase Document (filed herewith)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
			 		
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of State National Companies, Inc.
We have audited the accompanying consolidated balance sheets of State National Companies, Inc. as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedules listed in the Index to Consolidated Financial Statements. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of State National Companies, Inc. at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
Dallas, Texas
March 14, 2017
STATE NATIONAL COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
($ in thousands, except for share and per share information)
The accompanying notes are an integral part of these consolidated financial statements.
STATE NATIONAL COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS (continued)
($ in thousands, except for share and per share information)
The accompanying notes are an integral part of these consolidated financial statements.
			 		
STATE NATIONAL COMPANIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
($ in thousands, except for per share information)
The accompanying notes are an integral part of these consolidated financial statements.
STATE NATIONAL COMPANIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
($ in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
			 		
STATE NATIONAL COMPANIES, INC.
Consolidated Statements of Shareholders’ Equity
($ in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
STATE NATIONAL COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
			 		
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
			
		
1. Summary of Significant Accounting Policies
Description of Business
State National Companies, Inc. (the “Company”) refers to a group of companies that conducts insurance-related activities along two major segments. The Company’s Program Services segment generates fee income, in the form of ceding fees, by offering issuing carrier capacity to both specialty general agents and other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk. Substantially all of the underwriting risk associated with the Program Services segment is ceded to unaffiliated, highly rated reinsurance companies or other reinsurers that provide collateral. The Company’s Lender Services segment generates premiums primarily from the sale of collateral protection insurance (“CPI”), which insures automobiles or other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. The Company includes the results of operations of an acquired business in its consolidated financial statements from the date of the acquisition.
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), which, as to our insurance company subsidiaries, differ from statutory accounting practices prescribed or permitted for insurance companies by insurance regulatory authorities.
Estimates
The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from these estimates.
Fair Value of Financial Instruments
Cash and Cash Equivalents: The carrying amounts reported in the consolidated balance sheets approximate fair value.
Restricted Cash and Investments: The carrying amounts reported in the consolidated balance sheets approximate fair value.
Short-term Investments: The carrying amounts reported in the consolidated balance sheets approximate fair value.
Investments: See Note 9 - “Fair Value Measurements”
Land held for sale: The land held for sale is carried at fair value less expected selling costs.
Payables and Receivables: Reinsurance recoverable on paid losses, reinsurance recoverables, agents’ balances receivable and payable, and payable to insurance companies are carried at cost, which approximates fair value.
Subordinated Debentures: The amounts reported in the consolidated balance sheets are carried at par, which approximates their estimated fair value due to the floating interest rate provisions of the debt instruments.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
Income taxes receivable/payable: The carrying amounts reported in the consolidated balance sheets approximate fair value.
Other assets/liabilities: The carrying amounts reported in the consolidated balance sheets approximate fair value.
Cash and Cash Equivalents
All highly liquid investments with an original maturity of three months or less are considered cash equivalents.
Short-Term Investments
Short-term investments represent liquid investments with original maturities of more than three months but less than one year.
Restricted Cash and Investments
Restricted cash and investments are primarily comprised of deposits made by a reinsurer that cover losses for a program up to the contractual threshold. These fiduciary cash and investment balances are invested at the direction of the reinsurer for this program; accordingly, income earned on these balances inures to the benefit of the reinsurer.
Investments
Investments are considered available-for-sale and are carried at fair value. The Company measures the fair value of the investments based upon quoted market prices from an independent pricing service and its third-party investment managers, using observable market information. The cost of securities sold is based on the specific identification method. Unrealized gains and losses associated with the available-for-sale portfolio, as a result of temporary changes in fair value during the period such investments are held, are reflected net of income taxes and reported in other comprehensive income as a separate component of shareholders’ equity. Unrealized losses associated with the available-for-sale portfolio that are deemed to be other-than-temporary are charged to income in the period in which the other-than-temporary impairment is determined. Debt security premiums and discounts are amortized into earnings using the effective-interest method.
The Company evaluates its investment portfolio for impairments of individual securities that are deemed to be other-than-temporary. Fixed maturity securities that are determined to have other-than-temporary impairment and it is more likely than not the Company will sell before recovery of their amortized cost, are written down to fair value and the entire amount of the write-down is included in net income, net of realized investment gains. For all other impaired fixed-maturity securities, the impairment loss is separated into the amount representing the credit loss and the amount representing all other factors. The amount of impairment loss that represents the credit loss is included in net income, net of realized investment gains. The amount of the impairment loss that relates to all other factors is included in other comprehensive income. Equity securities that are determined to have other-than-temporary impairment are recognized in net income, net of realized investment gains.
The process for identifying other-than-temporary declines in fair value involves the consideration of several factors, including, but not limited to, whether the issuer has been downgraded to below investment-grade, the length of time in which there has been a significant decline in value, the liquidity and overall financial condition of the issuer, the nature and performance of the collateral or other credit support backing the security, the significance of the decline in value, and whether the Company has the intent to sell the security or may be required to sell the security prior to its anticipated recovery. The Company reviews securities for other-than-temporary impairment internally and with its investment advisors.
The Company invests in convertible securities that have embedded derivatives. Derivatives embedded within non-derivative instruments, such as options embedded in convertible fixed maturity securities, are bifurcated from the host instrument when the embedded derivative meets the criteria for bifurcation. However, for reporting purposes,
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
these embedded derivatives are presented together with the host contract and carried at estimated fair value. Changes in the estimated fair value of the embedded derivatives are reflected in “Realized net investment gains” in the consolidated statements of income, while changes in the estimated fair value of the underlying fixed maturity securities are reflected in “Unrealized holding gains (losses)” in the consolidated statements of comprehensive income.
Deferred Acquisition Costs
Certain costs, primarily premium taxes, commissions, and general expenses that are directly related to the successful acquisition of new or renewal business are deferred to the extent recoverable from future premiums earned. Deferred acquisition costs are amortized in proportion to the related unearned premium reserve over the terms of the related policies. Investment income is not included in the Company’s recoverability analysis of deferred acquisition costs.
Deferred Ceding Fees
Ceding fees that are associated with unearned premiums are established as a liability and earned pro rata over the life of the underlying business.
Property, Equipment, and Depreciation
Property and equipment are recorded at cost and depreciated. Depreciation is computed using the straight-line method over the estimated useful lives of the assets (ranging from three to twenty years). Gains and losses on the disposition of fixed assets are determined on a specific asset identification basis and are included in net income. Land held for sale is carried at fair value less expected selling costs.
Goodwill and Intangible Assets
Goodwill is the difference between the purchase price in a business combination and the fair value of assets acquired and liabilities assumed, and is not amortized. Intangible assets include assets with an indefinite life, primarily insurance licenses, and are not amortized. Intangible assets also include assets with a finite life, primarily customer relationships/lists, and are amortized over the estimated useful life of the asset in proportion to the expected benefit.
Goodwill is tested for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the carrying amount may not be recoverable. The impairment test is performed using a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the second step of the impairment test is performed for purposes of measuring the impairment.
In the second step, the fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit to determine an implied goodwill value. If the carrying amount of the reporting unit goodwill exceeds the implied goodwill value, an impairment loss is recognized in an amount equal to that excess.
As of December 31, 2016, the Company performed the first step of its annual goodwill assessment for the individual reporting units to which goodwill is allocated and determined there is no impairment of goodwill.
The Company periodically evaluates the recoverability of intangible assets and takes into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. No impairments were recognized in 2016, 2015 or 2014.
Unpaid Losses and Loss Adjustment Expenses
The liability for unpaid losses and loss adjustment expenses (“LAE”) includes an estimate for claims reported and an additional liability for claims incurred but not reported, based on the Company’s historical loss experience. While
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
Management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amount ultimately paid when the claims are settled. These estimates are continually reviewed and adjusted, as necessary, as experience develops or as new information becomes known; such adjustments are included in current operations.
Allowance for Policy Cancellations
An allowance for policy cancellations is provided for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes that will be incurred on expected future policy cancellations associated with the Company’s CPI business. The allowance is based on the Company’s historical cancellation experience.
While Management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are continually reviewed by Management, and any changes are reflected in current operations.
Reinsurance
Reinsurance premiums, losses, and loss adjustment expenses are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
Earnings Per Share
The computation of earnings per share is based upon the weighted average number of common shares outstanding during the period plus the effect of common shares potentially issuable (in periods in which they have a dilutive effect). Earnings per share have been adjusted to reflect a 736 for 1 stock split in the form of a stock dividend on June 23, 2014.
Income Taxes
Prior to June 25, 2014, the Company had elected for its parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code. On June 25, 2014, the Company completed a private placement of common stock, which resulted in the termination of its Subchapter S corporation status. Prior to this change in tax status, deferred income taxes were recorded only on the Company’s insurance subsidiaries (and their immediate parent) to reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Prior to June 25, 2014 all other entities included in the consolidated group filed under Subchapter S Corporation status; therefore, no provision for income taxes had been recorded for these entities. On June 25, 2014 the Company recorded a net deferred income tax benefit related to this change in tax status to reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts.
For any uncertain tax positions not meeting the “more likely than not” recognition threshold, accounting standards require recognition, measurement, and disclosure in the financial statements. There were no uncertain tax positions at December 31, 2016 and December 31, 2015.
Income Recognition
Premiums on CPI business are earned on a pro rata basis over the terms of the policies after taking into consideration the allowance for policy cancellations. Premiums on Program Services business are earned on a pro rata basis over the terms of the policies. Ceding fees are earned on the same basis as the underlying premiums.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
Program Services
In connection with writing Program Services business, the Company enters into contractual agreements with both the producing general agents and the reinsurers, whereby the general agents and reinsurers are typically obligated to each other for payment of insurance amounts, including premiums, commissions, and losses. To the extent these funds are not the obligation of the Company and are settled directly between the general agent and the reinsurer, no receivables or payables are recorded for these amounts. All obligations of the Company’s insurance subsidiaries owed to or on behalf of their policyholders are recorded by the Company and, to the extent appropriate, offsetting reinsurance recoverables are recorded.
Minimum Ceding Fees
Minimum ceding fees are fees the Company receives pursuant to contractual minimum premium requirements for certain programs where either significant premium capacity is reserved for that program or where the expected premium volume is not reasonably assured. For those programs where a minimum applies, the ceding fees are considered as two distinct pieces: (1) “premium-related fees,” which are earned as the associated gross written premium is earned, typically pro rata on an annual basis; and (2) “capacity fees,” which are determined based on the shortfall, if any, between the program’s contractual annual premium minimum and the amount of premium estimated to be written in the contract year, which fees are earned over the contract year.
Minimum ceding fees earned are based on estimates of annual premiums to be written for those programs that are subject to minimum premium levels and related ceding fees. These estimates are based upon various assumptions made regarding the production plans for the underlying program. These assumptions are reviewed by Management and the amount of annual premiums expected to be written are re-estimated as needed. As actual premiums emerge and revisions are made to earlier estimates, minimum ceding fees are earned or reversed and are reflected in current operations.
Stock-Based Compensation
Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for restricted stock grants and stock option awards that contain a service condition are recognized on a straight line pro rata basis over the vesting period. For restricted stock awards that contain a performance condition, the expense is recognized based on the awards expected to vest and the cumulative expense is adjusted whenever the estimate of the number of awards to vest changes. An estimation of future forfeitures of stock-based awards is incorporated into the determination of compensation expense. See Note 15 - “Stock-Based Payments” for related disclosures.
Recent Accounting Pronouncements
In May 2014, the FASB issued an accounting standards update (ASU 2014-09), “Revenue from Contracts with Customers” (Topic 606). The core guidance of the ASU presents a comprehensive revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. The ASU provides a five-step analysis of transactions to determine when and how revenue is recognized and requires additional disclosures sufficient to describe the nature, amount, timing and uncertainty of revenue and cash flows for these transactions. In August 2015, the FASB issued ASU 2015-14 to defer the effective date to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. An entity can choose to apply the guidance using either the full retrospective or a modified retrospective approach. The Company is currently evaluating which approach to apply at adoption. The Company has assessed its revenue streams to identify those contracts that are clearly excluded from the scope of the standard and those that may be subject to the new standard. Insurance contracts within the scope of Topic 944, “Financial
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
Services - Insurance” are excluded from the scope of Topic 606. The Company does not plan to early adopt and expects the impact of this pronouncement to be minimal.
In August 2014, the FASB issued an accounting standards update (ASU 2014-15), “Presentation of Financial Statements - Going Concern (Sub-Topic 205-40). The ASU requires management to perform a two-step evaluation to assess an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Management must first evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern. If management concludes that substantial doubt is raised, management also is required to consider whether its plans alleviate that doubt. Disclosures in the notes to the financial statements are required if management concludes that substantial doubt exists or that its plans alleviate substantial doubt that was raised. This ASU is effective for annual periods ending after December 15, 2016 and for annual periods and interim periods thereafter. The Company adopted the provisions of this ASU as of December 31, 2016.
In May 2015, the FASB issued an accounting standards update (ASU 2015-09), “Disclosures about Short-Duration Contracts” (Topic 944) intended to make targeted improvements to disclosure requirements for insurance companies that issue short-duration contracts. The amendments in this update are expected to increase transparency of significant estimates made in measuring those liabilities, improve comparability by requiring consistent disclosure of information, and provide financial statement users with additional information to facilitate analysis of the amount, timing, and uncertainty of cash flows arising from contracts issued by insurance entities and the development of loss reserve estimates. This ASU is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. The Company adopted the provisions of this ASU on December 31, 2016. See Note 11 - “Losses and Loss Adjustment Expenses” for related disclosures.
In September 2015, the FASB issued an accounting standards update (ASU 2015-16), “Business Combinations - Simplifying the Accounting for Measurement-Period Adjustments” (Topic 805) which applies to all entities that have reported provisional amounts for items in a business combination for which the accounting is incomplete by the end of the reporting period in which the combination occurs and during the measurement period have an adjustment to provisional amounts recognized. The amendments in this update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments in this update require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. This ASU is effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years, and should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. The only disclosures required at transition are the nature of and reason for the change in accounting principle. An entity should disclose that information in the first annual period of adoption and in the interim periods within the first annual period if there is a measurement-period adjustment during the first annual period in which the changes are effective. The Company adopted the provisions of this ASU on January 1, 2016.
In January 2016, the FASB issued an accounting standards update (ASU 2016-01), “Recognition and Measurement of Financial Assets and Financial Liabilities” (Sub-Topic 825-10). The amendments in this update supersede the guidance to classify equity securities with readily determinable fair values into different categories (that is, trading or available-for-sale) and require equity securities to be measured at fair value with changes in the fair value recognized through net income. The amendments are expected to improve financial reporting by providing relevant information about an entity’s equity investments and reducing the number of items that are recognized in other comprehensive income. This ASU is effective for annual and interim periods beginning after December 15, 2017. The Company is currently evaluating what impact this ASU will have on financial results and disclosures.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
In February 2016, the FASB issued an accounting standards update (ASU 2016-02), “Leases” (Topic 842) that requires lessees to put most leases on their balance sheets but recognize expenses on their income statements. The FASB is issuing this update to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This ASU is effective for annual and interim periods beginning after December 15, 2018. Early adoption is permitted. The Company does not plan to early adopt and is currently evaluating what impact this ASU will have on financial results and disclosures.
In March 2016, the FASB issued an accounting standards update (ASU 2016-08), “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net).” The new standard requires an entity to determine whether it is a principal or an agent in a transaction in which another party is involved in providing goods or services to a customer by evaluating the nature of its promise to the customer. An entity is a principal and therefore records revenue on a gross basis if it controls the promised good or service before transferring the good or service to the customer. An entity is an agent and records as revenue the net amount it retains for its agency services if its role is to arrange for another entity to provide the goods or services. The amendments clarify how an entity should identify the unit of accounting for the principal versus agent evaluation, and how it should apply the control principle to certain types of arrangements, such as service transactions, by explaining what a principal controls before the specified good or service is transferred to the customer. This ASU’s effective date and transition requirements are the same as those of the new revenue recognition standard which is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that period. An entity can choose to apply the guidance using either the full retrospective or a modified retrospective approach. The Company is currently evaluating which approach to apply at adoption. The Company has assessed its revenue streams to identify those contracts that are clearly excluded from the scope of the standard and those that may be subject to the new standard. Insurance contracts within the scope of Topic 944, “Financial Services - Insurance” are excluded from the scope of Topic 606. The Company expects the impact of this pronouncement to be minimal.
In March 2016, the FASB issued an accounting standards update (ASU 2016-09), “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” Under the new guidance, companies will no longer record excess tax benefits and certain tax deficiencies in additional paid-in capital (APIC). Instead, companies will record all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement, and APIC pools will be eliminated. For interim reporting purposes, companies will account for excess tax benefits and tax deficiencies as discrete items in the period in which they occur. In addition, the guidance eliminates the requirement that excess tax benefits be realized before companies can recognize them. The guidance requires companies to present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity. This ASU is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company prospectively adopted the provisions of this ASU on January 1, 2016 and the impact was immaterial to financial results. There would have been no impact to prior periods.
In May 2016, the FASB issued an accounting standards update (ASU 2016-12), “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients.” The amendments clarify that, for a contract to be considered completed at transition, all (or substantially all) of the revenue must have been recognized under legacy GAAP. The amendments also clarify how an entity should evaluate the collectability threshold and when an entity can recognize nonrefundable consideration received as revenue if an arrangement does not meet the standard’s contract criteria. This ASU’s effective date and transition requirements are the same as those of the new revenue recognition standard which is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that period. An entity can choose to apply the guidance using either the full retrospective or a modified retrospective approach. The Company is currently evaluating which approach to apply at adoption. The Company has assessed its revenue streams to identify those contracts that are clearly excluded from the scope of the standard and those that may be subject to the new standard. Insurance contracts within the scope of Topic 944, “Financial Services - Insurance” are excluded from the scope of Topic 606. The Company expects the impact of this pronouncement to be minimal.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
In June 2016, the FASB issued an accounting standards update (ASU 2016-13), “Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The standard will replace today’s “incurred loss” approach with an “expected loss” model for instruments measured at amortized cost and require entities to record allowances for available-for-sale (AFS) debt securities rather than reduce the carrying amount, as they do today under the other-than-temporary impairment (OTTI) model. It also simplifies the accounting model for purchased credit-impaired debt securities and loans. This ASU is effective for annual and interim periods beginning after December 15, 2019. The Company will be evaluating what impact this ASU will have on financial results and disclosures.
In August 2016, the FASB issued an accounting standards update (ASU 2016-14), “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” This ASU amends guidance related to debt prepayment or extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims and corporate-owned life insurance, distributions received from equity method investees and beneficial interests in securitization transactions. The guidance will generally be applied retrospectively and is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those years. The Company does not expect financial results and disclosures to be significantly impacted by this ASU.
In November 2016, the FASB issued an accounting standards update (ASU 2016-18), “Statement of Cash Flows (Topic 230): Restricted Cash.” The amendments require entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. As a result, entities will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the statement of cash flows. This ASU is effective for annual and interim periods beginning after December 15, 2017. The Company will be evaluating what impact this ASU will have on disclosures.
Reclassifications
The Company adopted ASU 2015-03, “Interest - Imputation of Interest” on January 1, 2016. Presentation of “Other Assets” and “Debt, net” on the prior year balance sheet have been retrospectively adjusted to reflect the adoption of this ASU. The 2015 presentation of each line was adjusted by $760 thousand to reflect the netting of unamortized debt issuance costs.
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2. Investments
The following table summarizes information on the amortized cost, gross unrealized gains and losses, and the fair value of investment securities by class:
Investment securities are exposed to various risks such as interest rate, market, and credit risk. Fair values of securities fluctuate based on the magnitude of changing market conditions; significant changes in market conditions could materially affect the portfolio fair value in the near term.
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The following tables show the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
The determination that a security has incurred an other-than-temporary decline in fair value and the associated amount of any loss recognition requires the judgment of Management and a regular review of the Company’s investments. Management reviewed all securities with unrealized losses in accordance with the Company’s impairment policy described in Note 1 - “Summary of Significant Accounting Policies” in the consolidated financial statements for the years ended December 31, 2016, 2015 and 2014. Management believes that the temporary impairments are primarily the result of a combination of widening credit spreads, and higher underlying Treasury rates, and that despite the wider credit spreads and higher rates, the securities are only temporarily impaired due to the strength of the issuing companies’ balance sheets, as well as their available liquidity options. For structured securities, future cash flow projections were used to determine potential impairment. For those securities where cash flow projections showed less than 100% principal recovery, a net present value test was done
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to determine any credit related losses. There are 270 securities in an unrealized loss position at December 31, 2016. Over 95% of these investments are investment-grade at December 31, 2016. We do not intend to sell or believe we will be required to sell any of our temporarily-impaired fixed maturities before recovery of their amortized cost basis. Management has the intent and ability to hold the equity securities in an unrealized loss position until the recovery of their fair value. Therefore, Management does not consider these investments to be other-than-temporarily impaired at December 31, 2016.
Proceeds from sales of investments in fixed-maturity, equity and short-term securities during 2016, 2015, and 2014 were $64.5 million, $39.1 million, and $14.8 million respectively.
The Company holds convertible securities with embedded derivatives. The embedded derivative is bifurcated from the host contract if all of the following criteria are met: the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings; the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract; and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. These embedded derivatives are presented together with the host contract and carried at estimated fair value. Changes in the estimated fair value of the embedded derivatives are reflected in “Realized net investment gains” in the consolidated statements of income, while changes in the estimated fair value of the underlying fixed maturity securities are reflected in “Unrealized holding gains (losses)” in the consolidated statements of comprehensive income.
The following table presents the Company’s gross realized gains (losses) for the periods ended December 31:
The Company had one and eleven non-cash exchanges of investment securities for each of the periods ending December 31, 2016 and December 31, 2015, respectively. Non-cash consideration received for these exchanges was $533 thousand and $4.9 million in 2016 and 2015, respectively. Gains of $153 thousand and $33 thousand were recognized on these exchanges and are reflected in the “Realized net investment gains” balance shown on the consolidated statements of income.
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The following schedule details the maturities of the Company’s fixed-maturity securities, available-for-sale, as of December 31, 2016:
Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The Company’s investment portfolio includes approximately $0.8 million of mortgage-backed securities collateralized by subprime residential loans, which represent approximately 0.24% of the Company’s total investments as of December 31, 2016. The Company does not own mortgage derivatives.
Net investment income for the periods ended December 31, consists of the following:
The Company’s insurance subsidiaries are required to maintain deposits in various states where they are licensed to operate. These deposits consist of fixed-maturity securities at fair values totaling $77.0 million and $53.5 million at December 31, 2016 and December 31, 2015, respectively.
3. Deferred Acquisition Costs
Certain costs, primarily premium taxes, commissions, and general expenses that are directly related to the successful acquisition of new or renewal business are deferred to the extent recoverable from future premiums earned. Deferred acquisition costs are amortized in proportion to the related unearned premium reserve over the terms of the related policies. Deferred acquisition costs are as follows for the years ended December 31:
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4. Property, Equipment, and Depreciation
The following is a summary of property, equipment, and depreciation at December 31:
Depreciation and amortization expense for 2016, 2015 and 2014 was $1.7 million, $1.8 million and $1.8 million, respectively.
The Company purchased a tract of land in 2007 with a plan to build a new home office building for its own use. During 2009, the Company classified this land as held for sale, since it had abandoned its plan to build a new home office and purchased an existing building for its own use. Gains of $3 thousand, $107 thousand and $454 thousand were recognized at December 31, 2016, 2015 and 2014, respectively, from the sale of property and equipment.
5. Goodwill and Intangible Assets
As of December 31, 2016 and 2015, goodwill of $2.1 million is attributable to our Program Services segment and $450 thousand is attributable to the Lender Services segment. Definite-lived intangible assets total $2.7 million and $3.4 million, net of amortization, as of December 31, 2016 and 2015, respectively, and are fully attributable to our Lender Services segment. Indefinite-lived intangible assets, insurance licenses, total $7.4 million as of December 31, 2016, and are fully attributable to our Program Services segment.
Customer relationships/lists are amortized based on discounted cash flow estimates over their expected useful lives of 15 years. Amortization expense related to the customer relationships/lists was $720 thousand, $725 thousand, and $765 thousand for the years ended December 31, 2016, 2015, and 2014, respectively. The non-compete agreements were amortized based on the discounted cash flow estimates over their expected useful lives of five to nine years. Amortization expense related to the non-compete agreements was zero, zero and $458 thousand for the years ended December 31, 2016, 2015, and 2014, respectively.
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Expected amortization expense over the next five years for the Company’s definite-lived intangible assets is as follows: 2017 - $699 thousand; 2018 -$644 thousand; 2019 - $260 thousand; 2020 - $244 thousand; and 2021 - $228 thousand.
6. Debt
Between 2002 and 2004, the Company formed four business trusts (the “Trusts”) for the sole purpose of issuing, in private placement transactions, $52 million of trust preferred securities (“TPS”). In turn, the Trusts then used the proceeds thereof, together with the equity proceeds received from the Company upon their initial formation, to purchase $53.6 million of variable-rate subordinated debentures (“TPS Debentures”) issued by the Company. All voting securities of the Trusts are owned by the Company, and the TPS Debentures are the sole assets of the Trusts. The Trusts meet the obligations of the TPS with the interest and principal paid on the TPS Debentures. The Company does not have a variable interest in the Trusts and therefore does not consolidate the Trusts.
Subordinated debentures with a carrying value of $7.5 million were repurchased for $6.75 million (plus accrued interest of approximately $49 thousand) on October 8, 2014. The debentures were issued on May 15, 2003 with an original maturity of May 15, 2033. This transaction resulted in a gain of approximately $610 thousand after deducting the unamortized portion of the initial issuance costs from the difference in the par value and the purchase price.
The following is a summary of the TPS Debentures at December 31:
The TPS Debentures and the TPS are uncollateralized, do not require maintenance of minimum financial covenants, and carry nearly identical terms. The TPS mature based on the schedule above, but early redemption is allowed beginning five years after issue date. If the Company chooses to redeem before the stated maturity date, it must redeem on a normal quarterly interest payment date and in multiples of $1 thousand (and include accrued interest).
Interest is payable quarterly (see rates above) and set and paid quarterly. The three-month LIBOR rate at December 31, 2016, was 1.0%. Payment of interest may be deferred for up to 20 consecutive quarters; however, the Company may not declare or pay any dividends or distributions, nor make any guarantee payments or payments on fixed-maturity securities, unless senior in interest to the TPS Debentures. These same limitations apply during an event of default.
Debt is reflected in the consolidated financial statements net of debt issuance costs paid to placement agents with an initial cost of $1.3 million, net of accumulated amortization of $572 thousand and $529 thousand at December 31, 2016 and 2015, respectively. The debt issuance costs are being amortized over 30 years using the straight-line method, which approximates the effective interest method.
The Company, through a subsidiary, has guaranteed that amounts paid to the Trusts under the TPS Debentures will be remitted to the holders of the TPS. These guarantees, when taken together with the obligations of the Company under the TPS Debentures, the indentures pursuant to which those debentures were issued, and the related trust agreements (including obligations to pay related trust costs, fees, expenses, debt, and other obligations for the Trusts
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other than with respect to the common and trust preferred securities of the Trusts), provide a full and unconditional guarantee of amounts due on the TPS.
On March 31, 2016, the Company, through its subsidiary T.B.A. Insurance Group, Ltd. (“TBA”), entered into a loan agreement (“credit agreement”), which provides for a secured revolving credit facility in an aggregate principal amount of $15 million. The credit agreement matures on April 30, 2018. Under the credit agreement, TBA may request advances up to the aggregate amount of the unused commitment under the credit facility, on a revolving basis, prior to the maturity of the credit agreement. Borrowings under the credit agreement will bear interest at a variable rate equal to LIBOR plus 1.85% per annum; provided, however, that LIBOR shall be subject to a floor of 0.15%. TBA shall also pay a commitment fee on the daily average unused commitment amount for the period running from the closing date to the maturity date at a rate of 0.125% per annum. The credit agreement contains customary representations, warranties, covenants, and events of default, as well as a financial covenant requiring TBA and the Company to maintain a consolidated tangible net worth of at least $150 million. TBA’s obligations under the credit agreement are guaranteed by the Company and are secured by a securities account in the name of TBA and maintained with the creditor, in which TBA must maintain assets with a market value of at least $25 million.
7. Income Tax Provision
The shareholders previously consented to elections for certain entities in the Company to be treated as S Corporations under Internal Revenue Code Section 1362(a). As a result of these elections, federal income taxes prior to June 25, 2014 are recorded only for State National Intermediate Holdings, Inc. (“SNIH”), State National Insurance Company, Inc. (“SNIC”), National Specialty Insurance Company (“NSIC”) and United Specialty Insurance Company (“USIC”), as they remained C Corporations and filed a consolidated federal income tax return. On June 25, 2014, the Company completed a private placement of common stock which resulted in termination of its S Corporation status. As a result, the Company is taxed as a C Corporation and filed a consolidated short period federal income tax return with its subsidiaries for the period June 26 through December 31, 2014. Income for the Company’s pass-through entities was taxed (for federal purposes) to the individual owners during the short period January 1 through June 25, 2014. The Company recorded a net deferred income tax benefit of $19.3 million related to this change in tax status.
The components of income tax expense for the years ended December 31 are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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Deferred income taxes reflect the effect of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The components of the net deferred income tax asset are as follows at December 31:
No valuation allowance was recorded at December 31, 2016 and 2015, as the temporary differences disclosed above relate to deferred income tax assets that are more-likely-than-not to be realized in future years.
In the second quarter of 2014, the Company revised its provision for income taxes to reflect a change in the federal statutory rate from 34.3% to 35.0%, effective January 1, 2014. A reconciliation of federal income tax expense
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computed by applying the federal statutory tax rate to income before federal income tax expense for the periods ended December 31 follows:
The Company recognizes interest and penalties related to uncertain tax positions in general and administrative expenses. There were no uncertain tax positions at December 31, 2016.
The Company had no net operating loss or capital loss carry-forwards at December 31, 2016.
As of December 31, 2016, the Company’s U.S. federal income tax returns for tax years that ended December 31, 2013 through December 31, 2015, remain open under the normal three year statute of limitations and, therefore, are subject to examination by the Internal Revenue Service.
8. Reinsurance
Through unaffiliated general agents, the Company’s insurance subsidiaries write property and casualty lines of business in the Program Services segment. This business is written and reinsured pursuant to quota share and excess of loss reinsurance contracts and general agency agreements that are typically tripartite agreements executed by the Company’s insurance subsidiaries, the reinsurer, and the general agent. Substantially all of the underwriting risk associated with this business is borne by the reinsurer. As compensation for writing this business, the Company’s insurance subsidiaries receive ceding fees from the producers and, accordingly, the related ceding fees receivable are reflected as accounts receivable from agents. In most instances, if the producer defaults on its obligation to pay these fees (or any other amount due), the reinsurer is obligated to make the payment under the guarantee contained in the contracts.
Certain insurance subsidiaries write business in the Lender Services segment through an affiliated general agent. The Company is party to a reinsurance agreement in which it cedes 30% of certain CPI policies to CUMIS Insurance Society, Inc. (“CUNA Mutual”) and receives a ceding commission related to these policies.
The Company’s insurance subsidiaries remain liable for unearned premiums and unpaid losses and loss adjustment expenses with respect to reinsurance ceded should the reinsurer be unable to meet its obligations. Management considers the possibility of a reinsurer becoming unable to meet its obligations as remote due to the reinsurers’
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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financial stability, A.M. Best Company rating, size, security funds available, and other factors as appropriate. Following is a summary of these balances:
The fair value of all collateral held by the Company’s insurance subsidiaries for reinsurers for whom we require collateral is approximately 132% of the related reinsurance recoverables as of December 31, 2016, with the lowest ratio for any such reinsurer being 100%.
9. Fair Value Measurements
Assets and liabilities reported in the consolidated financial statements at fair value are required to be classified according to a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into three levels. The hierarchy gives the highest ranking to fair values determined using unadjusted quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest ranking to fair values determined using methodologies and models with unobservable inputs (Level 3). An asset’s or liability’s classification is based on the lowest level input that is significant to its measurement. For example, a Level 3 fair value measurement may include inputs that are both observable (Level 1 and 2) and unobservable (Level 3). The levels of the fair value hierarchy are as follows:
·
Level 1: Inputs are quoted prices for identical assets or liabilities in active markets that are accessible at the measurement date.
·
Level 2: Inputs include quoted prices for similar assets or liabilities in active markets, quoted prices from those willing to trade in markets that are not active, or other inputs that are observable or can be corroborated by market data for the term of the instrument. These inputs include market interest rates and volatilities, spreads, and yield curves.
·
Level 3: Inputs are unobservable. Unobservable inputs reflect the Company’s own assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.
A description of the Company’s valuation techniques used to measure its assets at fair value is as follows:
·
Available-for-sale, fixed-maturity securities: All fixed-maturity investments are currently reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from either an independent pricing service using quoted prices or from its third-party investment managers. These Level 2 inputs are valued by either the pricing service or the investment managers utilizing observable data that may include dealer quotes, market spreads, cash flows, yield curves, live trading levels, trade execution data, market consensus, prepayment speeds, credit information, and the security’s terms and conditions, among other things.
·
Available-for-sale equity securities: Equity securities are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service using quoted prices or from its third-party investment managers. These Level 2 inputs are valued by either the pricing service or the investment managers utilizing observable data that may include dealer quotes, market
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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spreads, cash flows, yield curves, live trading levels, trade execution data, market consensus, prepayment speeds, credit information, and the security’s terms and conditions, among other things.
·
Embedded derivatives: The Company invests in convertible securities that have embedded derivatives. Embedded derivatives are recorded at estimated fair value with changes in estimated fair value reported in the consolidated statements of net income. The estimated fair value of the embedded derivatives is calculated by the Company’s third-party investment managers using observable inputs.
Management has reviewed the processes used by the pricing services and has determined that they result in fair values consistent with requirements for Level 2 investment securities. Based on an analysis of the inputs, the Company’s investments measured at fair value on a recurring basis have been categorized as follows:
The fair value of embedded derivatives included in Level 2 securities was $9.5 million at December 31, 2016 and $8.6 million at December 31, 2015, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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There was no Level 3 activity including gains or losses recognized purchases, or sales transaction during the periods ending December 31, 2016 and December 31, 2015.
Transfers between levels are recognized at the end of the reporting period. There were no transfers between Level 1, Level 2, and Level 3 at December 31, 2016 and December 31, 2015.
10. Premiums Earned
Premiums earned consist of the following for the years ended December 31:
Premiums written for CPI include an allowance for return premiums and policy fees related to expected future policy cancellations. Original estimates are adjusted as the policies develop and additional information becomes known regarding actual cancellation rates.
11. Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses consist of the following for the years ended December 31:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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Activity in the liability for unpaid losses and loss adjustment expenses at December 31, is summarized as follows:
The estimate for ultimate losses incurred on a net basis related to prior years increased by $0.6 million in 2016, increased by $1.8 million in 2015 and decreased by $0.5 million in 2014. The unfavorable development in 2016 is primarily related to reserve strengthening in our Program Services segment ($1.1 million), partially offset by favorable development of $0.5 million in our Lender Services segment. The unfavorable development in 2015 is primarily related to reserve strengthening on run-off programs in our Program Services segment ($2.0 million). The favorable development in 2014 is primarily due to $0.7 million of favorable development in our Lender Services segment. All of these changes were the result of the re-estimation of unpaid losses and LAE due to ongoing analyses of recent loss development trends as new data becomes available. We had no significant changes in reserving assumptions or methodologies.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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The Company adopted the provisions of ASU 2015-09 “Disclosures about Short-Duration Contracts” effective December 31, 2016. The liability for “Unpaid losses and loss adjustment expenses” has been disaggregated along the Program and Lender Services segments. The incurred and paid losses by accident year information presented below for calendar years prior to 2016 for both the Program and Lender Services segments is required supplementary information and is unaudited. The following incurred and paid losses by accident year tables are for the Program Services segment:
The Lender Services segment writes business that is short-tailed due to the nature of the coverages. Therefore, two years of incurred and paid losses by accident year are presented in the tables below:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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Incurred but not reported (“IBNR”) reserve estimates are generally calculated by first projecting the ultimate cost of all claims that have occurred and then subtracting reported losses and loss expenses. Reported losses include cumulative paid losses and loss expenses plus case reserve estimates. The IBNR reserve includes a provision for claims that have occurred but have not yet been reported, some of which are not yet known to the insurer, as well as a provision for future development on reported claims. The following table presents IBNR liabilities and claims frequency, which is measured by claim event, for each accident year presented for the Program Services segment.
The following table presents IBNR liabilities and claims frequency, which is measured by claim event, for each accident year presented for the Lender Services segment:
The average annual percentage payout of incurred claims by age, net of reinsurance, is calculated using a weighted average of paid losses & loss adjustment expenses to incurred losses & loss adjustment expenses, both net of reinsurance for each age. Program claims have a longer tail, therefore the percentage payout is calculated over ten years. Lender claims have a short tail, therefore the percentage payout is calculated over two years. The following tables that present the average annual percentage payout of incurred claims by age, net of reinsurance for the Program and Lender Services segments are required supplementary information and are therefore unaudited:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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The following table reconciles the Program and Lender loss development tables to the liability for unpaid losses and loss adjustment expenses:
On September 30, 2016, the Company acquired 100% of the outstanding common shares of United National Specialty Insurance Company, which was subsequently renamed to City National Insurance Company or (“CNIC”). CNIC was acquired as a shell company with a 100% quota share reinsurance agreement. Total gross liability for “Unpaid losses and loss adjustment expenses” includes $12.5 million of gross liability acquired as a part of the acquisition.
12. Statutory Accounting
A reconciliation of the Company’s insurance subsidiaries’ shareholders’ equity and net income as of and for the years ended December 31 from Statutory Accounting Principles (SAP) to GAAP is as follows:
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At December 31, 2016 and 2015, the amount of statutory capital and surplus for the consolidated insurance subsidiaries was $269.4 million and $229.8 million, respectively. At December 31, 2016 and 2015, minimum statutory capital and surplus required was $5.0 million for the Company’s insurance subsidiaries domiciled in Texas and $750 thousand for the Company’s insurance subsidiaries domiciled in Delaware. The Texas Department of Insurance (the “Department”) requires approval for dividends from insurance subsidiaries that exceed statutory guidelines. The maximum dividend that may be paid without prior approval of the Commissioner of Insurance is limited to the greater of 10% of statutory surplus at the end of the preceding calendar year or the statutory net income of the preceding calendar year. At December 31, 2016, unrestricted net assets available for dividends were $26.9 million.
The Company is required to comply with the NAIC’s Risk-Based Capital (“RBC”) requirements. Under the RBC standards, risks specific to the Company in such areas as asset risk, insurance risk, interest rate risk, and business risk are evaluated and compared to the Company’s capital and surplus to determine solvency margins. In its calculation of risk-based capital for SNIC and NSIC, the Company has deducted amounts for which it holds collateral (either trust funds in the name of the Company or irrevocable letters of credit) for amounts recoverable from reinsurance companies. The Company believes this practice to be appropriate because the credit risk for the related reinsurance balances is virtually eliminated due to the protection provided by the collateral. This practice differs from NAIC annual statement instructions. There is no monetary effect on net income or statutory surplus from the use of this practice. If the Company had not used this practice, the RBC calculations would not have resulted in a regulatory event in 2016 or 2015.
At periodic intervals, the Department routinely examines the insurance subsidiaries’ statutory financial statements as part of its legally prescribed oversight of the insurance industry. Based on these examinations, regulators can direct that the statutory-basis financial statements be adjusted in accordance with their findings. The Texas Department of Insurance completed its examination of the December 31, 2006 through December 31, 2010, statutory-basis financial statements of NSIC and SNIC in 2012, with no significant findings reported. The Delaware Insurance Department also completed its examination of the December 31, 2006 through December 31, 2010, statutory-basis financial statements of USIC in 2012, with no significant findings reported. SNIC, NSIC and USIC are currently under examination by their respective departments of insurance for the years 2011-2015 with an anticipated completion during 2017.
13. Related-Party Transactions
The accompanying consolidated financial statements include transactions with a former affiliate, Trace Air, Inc. The Company was party to an aircraft lease with a term expiring in 2020. Pursuant to the lease agreement, the Company leased the aircraft at a rate of $1,800 per hour of use, subject to a minimum monthly lease rate of $36 thousand. In addition, the Company was responsible for operating and maintenance costs associated with the aircraft. Under this agreement, we made aggregate payments to Trace Air, Inc. of $359 thousand in 2014. This
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lease agreement was terminated following the completion of the private placement of company stock (See Note 20 - “Common Stock”).
Prior to the private placement in 2014, we entered into a one-year consulting agreement with Lonnie Ledbetter that became effective upon his resignation as a director, officer and employee of the Company. This agreement became effective upon completion of the private placement, pursuant to which we paid Lonnie Ledbetter a total of $500 thousand ($250 thousand in 2015 and 2014, respectively) in exchange for him providing certain consulting services to us during the term of the agreement. Lonnie Ledbetter completed his one-year consultancy with the Company on June 25, 2015.
In 2014, prior to the completion of the private placement, the Company transferred real estate and certain vehicles valued at $513 thousand, equally to Trace Ledbetter and Luke Ledbetter, which amounts were included in founder special compensation in the 2014 consolidated statement of income.
14. 401(k) Profit-Sharing Plan and Trust
The Company has a 401(k) profit-sharing plan for employees that covers all officers and employees who are at least 18 years of age. The Company is required to make a matching contribution of 100% of the first 1% and 50% of the next 5% of employees’ contributions. For employee contributions made prior to January 1, 2015, the Company was required to make matching contributions of 50% of employees’ contributions, limited to 6% of eligible employees’ compensation. Also, the Company may make additional matching and profit-sharing contributions that are discretionary and are determined at the end of each plan year. The employer contribution expense included in general and administrative expenses is $1.4 million, $1.2 million and $1.1 million of December 31, 2016, 2015, and 2014, respectively.
15. Stock-Based Payments
On May 29, 2014, the Company’s shareholders approved the 2014 Long-Term Incentive Plan (“2014 Plan”), which provides for an aggregate of 4.4 million shares of our common stock that may be issued to employees and non-employee directors. Awards under the 2014 Plan may be in the form of stock options (including incentive stock options that meet the requirements of Section 422 of the Internal Revenue Code and non-statutory stock options), restricted stock, restricted stock units, stock appreciation rights and performance units.
The fair value of the restricted shares granted is determined based on the most recent trading price of the stock as of the grant date. The fair value of each stock option grant is established on the grant date using the Black-Scholes option pricing model. The Company granted 575,000, zero and 2,783,873 options during the years ended December 31, 2016, 2015, and 2014 respectively. The following table summarizes the assumptions used to value these options:
The Company measures compensation cost for stock awards at fair value and recognizes it over the service period for awards expected to vest. Total stock-based compensation expense related to stock options and stock grants for the year ended December 31, 2016, 2015, and 2014 was $4.6 million, $4.1 million, and $2.0 million respectively. Total recognized tax benefit related to the stock options and stock grants was $1.6 million, $1.4 million and $688 thousand for the years ended December 31, 2016 and 2015, and 2014 respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
As of December 31, 2016, there was $3.5 million of total unrecognized compensation cost related to non-vested share-based compensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.3 years.
The total fair value of stock awards that vested during the years ended December 31, 2016 and 2015 was $3.8 million and $3.9 million respectively. No awards vested during the year ended December 31, 2014. A summary of nonvested stock activity, including stock options and restricted stock grants, for the year ended December 31, 2016 and 2015 is as follows:
A summary of stock option activity for the year ended December 31, 2016 is as follows:
As of December 31, 2016, there were approximately 575 thousand shares of common stock available for future grants under the 2014 Plan.
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16. Concentration of Risk
The Company maintains cash and cash equivalents in accounts with financial institutions in excess of the amount insured by the Federal Deposit Insurance Corporation. The Company monitors the financial stability of these institutions regularly, and Management does not believe there is significant credit risk associated with deposits in excess of federally insured amounts.
The Company’s writings in California, Texas, Florida and New York comprised 56%, 57% and 53% of gross premiums written for the years ending December 31, 2016, 2015 and 2014, respectively. Four general agents comprised 57%, 57% and 65% of gross premiums written in the Program Services segment for the years ending December 31, 2016, 2015, and 2014 respectively. The five largest reinsurers with unsecured reinsurance recoverables, all of which are rated A or higher by A.M. Best, accounted for approximately 17%, 15%, 7%, 6%, and 5% of the Company’s unsecured reinsurance recoverables at December 31, 2016.
17. Leases
The Company previously leased a portion of its home office building to an unaffiliated third party under the terms of an operating lease. Rental income for the year ended December 31, 2014 is $2.1 million.
In November 2013, the Company received an early termination notice from the unaffiliated third party relating to the operating lease between the parties. The early termination notice was in compliance with the terms of the lease. The Company recognized $1.5 million in lease termination fees in 2014 due to the early termination of the lease. The lease was considered an operating lease through the early termination date of November 30, 2014.
18. Commitments and Contingencies
The Company is involved in various legal proceedings incidental to its normal business activities. Management of the Company does not anticipate that the outcome of such legal actions will have a material effect on the Company’s consolidated financial position or results of operations.
The Company’s insurance subsidiaries are subject to assessments from various insurance regulatory agencies related to insurance company insolvencies. Management is not aware of any material assessments for which notice has not yet been received. However, to the extent that such assessments are made, the Company has the contractual right to recover these amounts from the underlying reinsurers.
The Company has a Collateral Protection Alliance (the “Alliance”) with CUMIS Insurance Society, Inc., a subsidiary of CUNA Mutual, to administer and write CPI business for CUNA Mutual’s customers. The Alliance includes an agency agreement and a reinsurance agreement whereby the Company cedes a portion of the business back to CUNA Mutual. In connection with the Alliance, the Company has a purchase option and CUNA Mutual has a put option, whereby the Company is obligated to purchase CUNA Mutual’s right to participate in future Program Services business at a specified price in the event of termination of the Alliance. The terms of the Alliance with CUNA Mutual were modified on May 19, 2014, whereby CUNA Mutual’s quota share percentage under the reinsurance agreement was reduced; the Alliance was extended through July 31, 2018 with an automatic three-year renewal (subject to the right of either party to give notice of nonrenewal); the termination rights for each party were modified, and the purchase price calculation was modified. In consideration of these changes, State National paid contract modification expense of $17.8 million.
19. Earnings Per Share
We have adopted the provisions of ASC 260, “Earnings Per Share,” requiring presentation of both basic and diluted earnings per share. Earnings per share have been adjusted to reflect a 736 for one stock split in the form of a stock
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
			
		
dividend on June 23, 2014. A reconciliation of the numerators and denominators of the basic and diluted per share calculations is presented below:
20. Common Stock
On June 25, 2014, the Company completed the sale of an aggregate of 31,050,000 shares of our common stock in a private placement exempt from registration under the Securities Act and received net proceeds of approximately $280.6 million. Of the net proceeds from the private placement, the Company used approximately (i) $190.6 million to purchase 21,030,294 shares of common stock from certain of our shareholders pursuant to a stock redemption agreement entered into prior to the private placement, (ii) $17.8 million to make pre-tax payments to CUNA Mutual pursuant to a recent amendment of the alliance agreement (See Note 18 - “Commitments and Contingencies”) and (iii) $50 million to contribute to the capital of our insurance subsidiaries.
On October 12, 2015, the Company announced a share repurchase program authorizing the repurchase up to $50 million in shares of the Company's common stock through December 31, 2016. On November 22, 2016, the Company’s Board of Directors extended the repurchase program through December 31, 2017. Repurchases are made in accordance with the guidelines specified under Rule 10b-18 and may be made under Rule 10b5-1, under the Securities Exchange Act of 1934. During the year ended December 31, 2016, the Company purchased 969,341 shares of its common stock at an aggregate purchase price including commissions of $10.0 million. The excess cost of the repurchased shares over par value was charged to retained earnings.
A summary of common stock repurchases for the years ended December 31, 2016 and 2015 is as follows:
21. Segment Information
The Company’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and business strategies. The Company operates through three business segments of which the two operating segments are Program Services and Lender Services. In the Program Services segment, the Company operates an issuing carrier (“fronting”) business that leverages our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide insurance capacity
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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access to U.S. property and casualty insurance markets. In the Lender Services segment, the Company specializes in providing collateral protection insurance, which insures automobiles held as collateral for loans made by financial institutions. The other segment is the Corporate segment. This segment consists of the investment portfolio, subordinated debentures, and includes rental income, investment income, interest expense, and corporate expenses.
The Company’s Corporate segment includes an asset for Property and equipment, net. The depreciation of this asset is allocated to all segments based on estimated usage. The depreciation allocated to the Lender Services segment was $1.3 million, $1.4 million and $1.4 million for the years ended December 31, 2016, 2015 and 2014, respectively. The depreciation allocated to the Program Services segment was $359 thousand, $343 thousand and $397 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
The following is business segment information for the twelve months ended December 31, 2016, 2015 and 2014:
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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The following tables summarize the financial position of the Company’s segments as of December 31, 2016 and 2015.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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22. Condensed Quarterly Financial Data - Unaudited
The following tables summarize our quarterly financial data:
The Company earns minimum ceding fees on certain programs based on estimates of annual premiums to be written for those programs that are subject to minimum premium levels and related ceding fees. The company re-estimated its 2015 annual projection for such programs during the second, third and fourth quarters of 2015, which resulted in $1.3 million, $1.9 million and $1.0 million of additional minimum ceding fees earned for the quarters ending June 30, 2015, September 30, 2015 and December 31, 2015, respectively. The Company re-estimated its 2016 annual projection for such programs during the third and fourth quarters of 2016, which resulted in an additional $0.6 million and $0.7 million of minimum ceding fees earned for the two quarters ending September 30, 2016 and December 31, 2016.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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23. Business Combinations
On September 30, 2016 (“the acquisition date”), the Company acquired 100% of the outstanding common shares of United National Specialty Insurance Company, which was subsequently renamed City National Insurance Company (“CNIC”). CNIC is an admitted shell company with licenses in 49 states. The purpose of the acquisition is to provide exclusive capacity for one of our programs.
The acquisition date fair value of the consideration transferred totaled $18.7 million in cash. The following table summarizes the fair values of assets acquired and liabilities assumed at the acquisition date.
CNIC was acquired as a shell company with a 100% quota share reinsurance agreement. There was no income statement impact resulting from the acquisition. There is no goodwill to assign to reporting segments. The indefinite lived intangible asset is assigned to the Program Services segment. The Company recognized $277 thousand of acquisition related costs that were expensed in the current period. These costs are included in the consolidated statements of income as “General and administrative” expenses.
STATE NATIONAL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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24. Subsequent Events
Effective January 1, 2017, the Company acquired 100% of the outstanding common shares of Fireman’s Fund Insurance Company of Ohio, which was subsequently renamed Independent Specialty Insurance Company (“ISIC”). ISIC is an excess and surplus lines, or non-admitted, shell company. The purpose of the acquisition is to provide exclusive capacity for one of our programs. The acquisition date fair value of the consideration transferred totaled $49.4 million in cash. ISIC was acquired as a shell company with a 100% quota share reinsurance agreement. There was no income statement impact resulting from the acquisition. There is no goodwill to assign to reporting segments. The indefinite lived intangible asset is assigned to the Program Services segment. The following table summarizes the fair values of assets acquired and liabilities assumed at the acquisition date.
Annual Schedules
State National Companies, Inc.
Parent Company Only
Balance Sheets
($ in thousands, except for per share information)
State National Companies, Inc.
Parent Company Only
Statements of Income
($ in thousands)
State National Companies, Inc.
Parent Company Only
Statements of Cash Flows
($ in thousands)
			 		
State National Companies, Inc.
Supplementary Insurance Information
			 		
State National Companies, Inc.
Supplementary Schedule of Allowance for Policy Cancellations
Allowance for policy cancellations is established based on estimates of expected future policy cancellations associated with new business written. Deductions are made as policy cancellations occur and return premiums are paid in subsequent months. The allowance for policy cancellations in 2016, 2015, and 2014 included upward revisions to prior year estimates of $1.4 million, $0.6 million and $4.2 million, respectively. Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers. After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net negative impact to the balance sheet and the corresponding reduction in net income from the revised estimates in each of the years ending December 31, 2016, 2015, and 2014 was approximately $0.6 million, $0.2 million and $2.2 million, respectively.