Liquidity and Capital Resources
The primary sources of our liquidity are (1) funds generated from insurance operations, including net investment income, (2) proceeds from
the sale of investments, and (3) proceeds from maturing investments.
We generally experience positive cash flow from operations. Premiums are collected on insurance policies in advance of the disbursement of
funds for payment of claims. Operating costs of our property/casualty Insurance Subsidiaries, other than loss and loss expense payments and commissions paid to related agency companies, average less than one-third of net premiums earned on a
consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided and the timing of the claim payments. Because losses are often settled in periods subsequent to
when they are incurred, operating cash flows may, at times, become negative as loss settlements on claim reserves established in prior years exceed current revenues. Our cash flow relating to premiums is significantly affected by reinsurance
programs in effect, whereby we cede both premium and risk to other insurance and reinsurance companies. These programs vary significantly among products and certain contracts call for reinsurance payment patterns, which do not coincide with the
collection of premiums by us from our insureds.
On August 31, 2017, our Board of Directors authorized the reinstatement of our share repurchase program for up to 2,464,209 shares of our
Class A or Class B Common Stock. On August 7, 2018, our Board of Directors reaffirmed our share repurchase program, but also provided that the aggregate dollar amount of shares of our common stock that may be repurchased under the share repurchase
program through August 8, 2019 may not exceed $25.0 million. The repurchases may be made in the open market or through privately negotiated transactions, from time-to-time, and in accordance with applicable laws, rules and regulations. On
September 24, 2018, we entered into a stock repurchase plan for the purpose of repurchasing up to $12.0 million of shares of our common stock, at various pricing thresholds, in accordance with guidelines specified under Rule 10b5-1 of the
Securities Exchange Act of 1934, as amended (the "Rule 10b5-1 Plan"). The Rule 10b5-1 Plan was established pursuant to, and as part of, our share repurchase program and permits shares to be repurchased in accordance with pre-determined criteria
when repurchases would otherwise be prohibited, such as during self-imposed blackout periods, or under insider trading laws. The Rule 10b5-1 plan expired on November 8, 2018. The share repurchase program may be amended, suspended or discontinued at
any time and does not commit us to repurchase any shares of our common stock. We have funded, and intend to continue to fund, the share repurchase program from cash on hand. The actual number and value of the shares to be purchased will depend on
the performance of our stock price, market volume and other market conditions. During the year ended December 31, 2018, we paid $4.6 million to repurchase 7,770 shares of Class A and 191,898 shares of Class B Common Stock under the share
repurchase program.
For several years, our investment philosophy has emphasized the purchase of short-term bonds with high quality and liquidity. Our fixed
income investment portfolio continues to emphasize shorter-duration instruments. If there was a hypothetical increase in interest rates of 100 basis points, the price of our bonds at December 31, 2018 would be expected to fall by approximately
2.8%.
The credit quality of our fixed income securities remains high with a weighted average rating of AA-, including cash. The average
contractual life of our fixed income and short-term investment portfolio increased to 5.5 years at December 31, 2018 compared to 4.9 years at December 31, 2017. The average duration of our fixed income portfolio remains much shorter than both the
contractual maturity average and the duration of our liabilities. We also remain an active participant in the equity securities market, allocating capital in excess of amounts considered necessary to fund our current operations. The long-term
horizon for our equity investments allows us to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by our domestic property/casualty Insurance Subsidiaries are regulated by
guidelines promulgated by the National Association of Insurance Commissioners (the "NAIC"), which are designed to provide protection for both policyholders and shareholders.
Net cash flows from operations increased $3.0 million to $100.7 million for 2018 from $97.7 million in 2017. The increase in operating cash
flow was primarily related to higher premium volume in 2018 compared to 2017. Net cash flows from operations increased $65.3 million to $97.7 million for 2017 compared to $32.4 million in 2016. The 2017 increase in operating cash flows was
related to higher premium volume in 2017 compared to 2016.
Net cash provided by investing activities was $23.7 million for 2018 compared to net cash used in investing activities of $74.3 million in
2017. The $98.0 million change was primarily related to higher proceeds from sales of fixed income and equity securities and lower purchases of equity securities and fixed income investments. These increases were partially offset by lower proceeds
from maturities of our fixed income securities and lower distributions from limited partnerships during 2018, in addition to the purchase of $10.0 million of company-owned life insurance in the first quarter of 2018. Net cash used in investing
activities was $74.3 million for 2017 compared to $27.4 million in 2016. The increase of $46.9 million in cash used in investing activities was primarily related to higher purchases of equity securities and fixed income investments and lower
proceeds from sales of equity and fixed income securities. These increases were partially offset by higher distributions from limited partnership investments and higher proceeds from maturities of fixed income securities in 2017.
Net cash used in financing activities for 2018 consisted of regular cash dividend payments to shareholders of $16.8 million ($1.12 per share)
and $4.6 million to repurchase 199,668 shares of our common stock. Financing activities for 2017 consisted of regular cash dividend payments to shareholders of $16.3 million ($1.08 per share) and $1.9 million to repurchase 84,960 shares of our
Class B Common Stock. Financing activities for 2016 consisted solely of the regular cash dividend payments to shareholders of $15.8 million ($1.04 per share).
Our assets at December 31, 2018 included $156.9 million of investments included within cash and cash equivalents on the consolidated balance
sheets that are readily convertible to cash without market penalty and an additional $45.9 million of fixed income investments maturing in less than one year. We believe these liquid investments, plus the expected cash flow from premium
collections, are sufficient to provide for projected claim payments and operating cost demands. In the event competitive conditions produce inadequate premium rates and we choose to further restrict volume, the liquidity of our investment
portfolio would permit us to continue paying claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time. In addition, our reinsurance program is structured to
mitigate significant cash outlays that accompany large losses.
We previously maintained a revolving line of credit with a $40.0 million limit that had an expiration date of September 23, 2018. Interest
on this line of credit was referenced to the London Interbank Offered Rate ("LIBOR") and could be fixed for periods of up to one year at our option. Outstanding drawings on this line of credit were $20.0 million at December 31, 2017. On August 9,
2018, we entered into a credit agreement providing a revolving credit facility with a $40.0 million limit, with the option for up to an additional $35.0 million in incremental loans at the discretion of the lenders. This credit agreement, which
has an expiration date of August 9, 2022, replaced our line of credit that was to expire on September 23, 2018. Interest on this credit facility is referenced to LIBOR and can be fixed for periods of up to one year at our option. Outstanding
drawings on this revolving credit facility were $20.0 million as of December 31, 2018. At December 31, 2018, the effective interest rate was 3.61%, and we had $20.0 million remaining under the revolving credit facility. The current outstanding
borrowings were used to repay the previous line of credit. Our revolving credit facility has two financial covenants, each of which were met as of December 31, 2018, requiring us to have a minimum U.S. Generally Accepted Accounting Principles
("GAAP") net worth and a maximum consolidated leverage ratio of 0.35 to 1.00.
Annualized net premiums written by our Insurance Subsidiaries for 2018 equaled approximately 112.3% of the combined statutory surplus of
these Insurance Subsidiaries, a level consistent with higher premiums written. Premium writings of 100% and in some cases up to 200% of surplus are generally considered acceptable by regulatory authorities. Further, the statutory capital of each
of our Insurance Subsidiaries substantially exceeded minimum risk-based capital requirements set by the NAIC as of December 31, 2018. Accordingly, we have the ability to significantly increase our business without seeking additional capital to
meet regulatory guidelines.
Consolidated shareholders' equity is composed largely of GAAP shareholders' equity of our Insurance Subsidiaries. As such, there are
statutory restrictions on the transfer of substantial portions of this equity to Protective. At December 31, 2018, $64.1 million may be transferred by dividend or loan to Protective without approval by, or prior notification to, regulatory
authorities. An additional $213.1 million of shareholders' equity of our Insurance Subsidiaries could be advanced or loaned to Protective with prior notification to, and approval from, regulatory authorities, although transfers of this size would
not be practical. We believe these restrictions pose no material liquidity concerns for us. We also believe the financial strength and stability of our Insurance Subsidiaries would permit access by Protective to short-term and long-term sources
of credit when needed. Protective had cash and marketable securities valued at $15.2 million at December 31, 2018.
We believe investors’ understanding of our performance is enhanced by our disclosure of underwriting income (loss), which is a measure that
is not calculated in accordance with GAAP. Underwriting income (loss) represents the pre-tax profitability of our insurance operations and is derived by subtracting net realized and unrealized gains (losses) on investments and net investment income
from income (loss) before federal income tax expense (benefit). For 2018, we also had a goodwill impairment charge, which has also been excluded from the calculation of underwriting income (loss). We use underwriting income (loss) as an internal
performance measure in the management of our operations because we believe it gives us and users of our financial information useful insight into our results of operations, our underlying business performance and our ongoing operating trends.
Underwriting income (loss) should not be viewed as a substitute for income (loss) before federal income tax expense (benefit) calculated in accordance with GAAP, and other companies may define underwriting income (loss) differently. In addition,
for 2018, the goodwill impairment charge has been excluded from other operating expenses when calculating our expense ratio and our combined ratio, as these ratios are intended to depict our underlying business performance and ongoing operating
trends. We also believe that the exclusion of this goodwill impairment charge improves the comparability of our expense ratio and our combined ratio with our ratios in prior years.
|
|
2018
|
|
|
2017
|
|
|
2016
|
|
Income (loss) before federal income tax expense (benefit)
|
|
$
|
(43,872
|
)
|
|
$
|
10,122
|
|
|
$
|
43,054
|
|
Less: Net realized and unrealized gains (losses) on investments
|
|
|
(25,691
|
)
|
|
|
19,686
|
|
|
|
23,228
|
|
Less: Net investment income
|
|
|
22,048
|
|
|
|
18,095
|
|
|
|
14,483
|
|
Less: Goodwill impairment charge included in other operating expenses (see below)
|
|
|
(3,152
|
)
|
|
|
–
|
|
|
|
–
|
|
Underwriting income (loss)
|
|
$
|
(37,077
|
)
|
|
$
|
(27,659
|
)
|
|
$
|
5,343
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other operating expenses
|
|
$
|
137,177
|
|
|
$
|
113,594
|
|
|
$
|
89,462
|
|
Less: Goodwill impairment charge
|
|
|
3,152
|
|
|
|
–
|
|
|
|
–
|
|
Other operating expenses, excluding goodwill impairment charge
|
|
$
|
134,025
|
|
|
$
|
113,594
|
|
|
$
|
89,462
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratios
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss expenses incurred
|
|
$
|
345,864
|
|
|
$
|
247,518
|
|
|
$
|
186,481
|
|
Net premiums earned
|
|
|
432,880
|
|
|
|
328,145
|
|
|
|
276,011
|
|
Loss ratio
|
|
|
79.9
|
%
|
|
|
75.4
|
%
|
|
|
67.6
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other operating expenses
|
|
$
|
137,177
|
|
|
$
|
113,594
|
|
|
$
|
89,462
|
|
Less: Commissions and other income
|
|
|
9,932
|
|
|
|
5,308
|
|
|
|
5,275
|
|
Other operating expenses, less commissions and other income
|
|
|
127,245
|
|
|
|
108,286
|
|
|
|
84,187
|
|
Net premiums earned
|
|
|
432,880
|
|
|
|
328,145
|
|
|
|
276,011
|
|
Expense ratio
|
|
|
29.4
|
%
|
|
|
33.0
|
%
|
|
|
30.5
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Impact of goodwill impairment charge
|
|
|
(0.7
|
)%
|
|
|
–
|
|
|
|
–
|
|
Expense ratio, excluding goodwill impairment charge
|
|
|
28.7
|
%
|
|
|
33.0
|
%
|
|
|
30.5
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined ratio
|
|
|
109.3
|
%
|
|
|
108.4
|
%
|
|
|
98.1
|
%
|
Combined ratio, excluding goodwill impairment charge
|
|
|
108.6
|
%
|
|
|
108.4
|
%
|
|
|
98.1
|
%
|
Results of Operations
2018 Compared to 2017
|
|
2018
|
|
|
2017
|
|
|
Change
|
|
|
% Change
|
|
Gross premiums written
|
|
$
|
582,500
|
|
|
$
|
504,737
|
|
|
$
|
77,763
|
|
|
|
15.4
|
%
|
Ceded premiums written
|
|
|
(138,102
|
)
|
|
|
(151,348
|
)
|
|
|
13,246
|
|
|
|
(8.8
|
)%
|
Net premiums written
|
|
$
|
444,398
|
|
|
$
|
353,389
|
|
|
$
|
91,009
|
|
|
|
25.8
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net premiums earned
|
|
$
|
432,880
|
|
|
$
|
328,145
|
|
|
$
|
104,735
|
|
|
|
31.9
|
%
|
Net investment income
|
|
|
22,048
|
|
|
|
18,095
|
|
|
|
3,953
|
|
|
|
21.8
|
%
|
Commissions and other income
|
|
|
9,932
|
|
|
|
5,308
|
|
|
|
4,624
|
|
|
|
87.1
|
%
|
Net realized and unrealized gains (losses) on investments
|
|
|
(25,691
|
)
|
|
|
19,686
|
|
|
|
(45,377
|
)
|
|
|
(230.5
|
)%
|
Total revenue
|
|
|
439,169
|
|
|
|
371,234
|
|
|
|
|
|
|
|
|
|
Losses and loss expenses incurred
|
|
|
345,864
|
|
|
|
247,518
|
|
|
|
98,346
|
|
|
|
39.7
|
%
|
Other operating expenses
|
|
|
137,177
|
|
|
|
113,594
|
|
|
|
23,583
|
|
|
|
20.8
|
%
|
Total expenses
|
|
|
483,041
|
|
|
|
361,112
|
|
|
|
|
|
|
|
|
|
Income (loss) before federal income tax benefit
|
|
|
(43,872
|
)
|
|
|
10,122
|
|
|
|
(53,994
|
)
|
|
|
|
|
Federal income tax benefit
|
|
|
(9,797
|
)
|
|
|
(8,201
|
)
|
|
|
(1,596
|
)
|
|
|
|
|
Net income (loss)
|
|
$
|
(34,075
|
)
|
|
$
|
18,323
|
|
|
$
|
(52,398
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross premiums written for 2018 increased $77.8 million (15.4%), while net premiums earned increased $104.7 million (31.9%), as compared to
2017. The higher gross premiums written and net premiums earned were the result of continued growth in our commercial automobile and workers' compensation products in both our retail and program distribution channels. The difference in the
percentage change for premiums written compared to earned was reflective of the normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of
business in-force.
Premiums ceded to reinsurers on our insurance business averaged 23.7% of gross premiums written for 2018 compared to 30.0% for 2017. The
percentage of premiums ceded to reinsurance decreased as a result of changes in our reinsurance structure. In the third quarter of 2017, we lowered the quota share rate on our workers' compensation premiums to reflect growing profitability and
confidence in this book of business. We also restructured our commercial automobile reinsurance treaty, moving away from variable premium ceded rates (based on loss performance) to a flat ceding arrangement with no material changes to the economic
risks taken for these products (i.e., ceded losses will decrease by a similar amount as ceded premiums). The impact of these changes to our reinsurance structure was partially offset by reserve strengthening in 2018 that resulted in ceding an
additional $17.3 million in premium from prior treaty years related to variable premium adjustment provisions in our historical reinsurance treaties. Our historical commercial automobile reinsurance treaties cause an adjustment to premiums ceded
when the ultimate loss estimate changes for a reinsurance treaty year. Reserve strengthening in 2017 also resulted in ceding an additional $13.7 million in premium related to these variable premium adjustment provisions in 2017.
Losses and loss expenses incurred during 2018 increased $98.3 million (39.7%) to $345.9 million compared to $247.5 million in 2017. The loss
ratio also increased to 79.9% for 2018 compared to a loss ratio of 75.4% for 2017. The loss ratio is calculated as the percentage of losses and loss expenses incurred to net premiums earned. The increased losses and loss expenses and loss ratio
in 2018 reflected reserve adjustments of $16.8 million related to unfavorable prior accident year loss development in commercial automobile coverages. These unfavorable loss developments were the result of increased claim severity due to a more
challenging litigation environment, as well as an unexpected increase in the time to settle claims leading to an unfavorable change in claim settlement patterns. The 2018 loss ratio also reflected an increase in current accident year losses driven
by severe commercial automobile losses, including continued emergence of severity. The 2017 loss ratio also reflected a $19.2 million reserve strengthening related to prior accident year deficiencies that developed as a result of unfavorable loss
development from commercial automobile coverages, particularly from severe transportation loss events that occurred primarily during the first six months of 2017 and higher than expected loss development for discontinued lines of business.
Commercial automobile products covered by our reinsurance treaties are subject to an aggregate stop-loss provision. Once this aggregate
stop-loss level is reached, for every $100 of additional loss, we are responsible only for our $25 retention. The following table illustrates the financial impact of a further 5% or 10% increase in ultimate losses for the five most recent
reinsurance treaty years (2013-2017) covering these commercial automobile products:
|
|
5% Increase in Ultimate Loss Ratio
|
|
|
10% Increase in Ultimate Loss Ratio
|
|
Gross loss expense from further strengthening current reserve position
|
|
$
|
34.3
|
|
|
$
|
68.7
|
|
Net financial loss
|
|
$
|
9.0
|
|
|
$
|
17.6
|
|
$/share (after tax)
|
|
$
|
0.48
|
|
|
$
|
0.94
|
|
Net investment income for 2018 increased 21.8% to $22.0 million compared to $18.1 million for 2017. The increase reflected an increase in
average funds invested resulting from positive cash flow, as well as higher interest rates, which led to higher reinvestment yields for our short-duration fixed income portfolio. After-tax investment income increased by 39.4% to $17.7 million
during 2018, compared to $12.7 million during 2017, reflecting the aforementioned higher interest rates and reinvestment yield environment.
Net realized and unrealized losses on investments of $25.7 million during 2018 were driven by $9.7 million in unrealized losses on equity
securities during the period, which are now recorded in the consolidated statements of operations in conjunction with our adoption of ASU 2016-01, a $9.3 million decrease in the value of our limited partnership investments and net realized losses
on sales of fixed income and equity securities of $6.6 million. During 2018, we sold $149.2 million in equity securities resulting in a gain on sale of $51.9 million. The majority of this gain was included in unrealized gains within other
comprehensive income (loss) at December 31, 2017 and, as a result of the adoption of ASU 2016-01, was reclassified to retained earnings as of January 1, 2018 and not recognized in the consolidated statements of operations for 2018. These equity
sales further solidified the conservative nature of our high quality, short-duration investment portfolio; opportunistically utilized the new lower corporate tax rate of 21%, which was beneficial given the low tax basis of many of these equity
positions; and were accretive to income, given the increase in yields at the shorter end of the yield curve.
Comparative 2017 net realized investment gains were
$19.7 million, consisting primarily of $12.5 million in gains reported from our investments in limited partnerships and $7.4 million in net realized gains from sales of securities. Realized investment gains and losses result from decisions
regarding overall portfolio realignment as well as the sale of individual securities, including the change in aggregate value of limited partnerships and, as such, should not be expected to be consistent from period to period.
Other operating expenses for 2018 increased $23.6 million, or 20.8%, to $137.2 million compared to 2017. The increase in other operating
expenses was primarily due to increased commission expenses as a result of increased premiums written and higher salary and benefit expense and a non-cash impairment charge of $3.2 million recorded in the fourth quarter of 2018 to write off our
entire goodwill balance. See Note M for further discussion. The ratio of consolidated other operating expenses less commissions and other income to net premiums earned (the "expense ratio") was 29.4% during 2018, or 28.7% excluding the impact of
the goodwill impairment charge, compared to 33.0% for 2017. The decrease in the expense ratio was primarily related to the leveraging effect of higher net premiums earned in 2018 compared to 2017.
Federal income tax benefit was $9.8 million for 2018 compared to income tax benefit of $8.2 million in 2017. The effective tax rate for 2018
was 22.3% compared to (81.0%) in 2017. The effective federal income tax rate in 2018 differed only slightly from the normal statutory rate primarily as a result of tax-exempt investment income. In the fourth quarter of 2017, we recorded a benefit
of $9.6 million related to the remeasurement of deferred tax assets and liabilities pursuant to the U.S. Tax Act, which impacted our effective federal income tax rate for 2017.
As a result of the factors discussed above, net loss for 2018 was $34.1 million compared to net income of $18.3 million in 2017, a change of
$52.4 million.
2017 Compared to 2016
|
|
2017
|
|
|
2016
|
|
|
Change
|
|
|
% Change
|
|
Gross premiums written
|
|
$
|
504,737
|
|
|
$
|
403,004
|
|
|
$
|
101,733
|
|
|
|
25.2
|
%
|
Ceded premiums written
|
|
|
(151,348
|
)
|
|
|
(131,252
|
)
|
|
|
(20,096
|
)
|
|
|
15.3
|
%
|
Net premiums written
|
|
$
|
353,389
|
|
|
$
|
271,752
|
|
|
$
|
81,637
|
|
|
|
30.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net premiums earned
|
|
$
|
328,145
|
|
|
$
|
276,011
|
|
|
$
|
52,134
|
|
|
|
18.9
|
%
|
Net investment income
|
|
|
18,095
|
|
|
|
14,483
|
|
|
|
3,612
|
|
|
|
24.9
|
%
|
Commissions and other income
|
|
|
5,308
|
|
|
|
5,275
|
|
|
|
33
|
|
|
|
0.6
|
%
|
Net realized and unrealized gains (losses) on investments
|
|
|
19,686
|
|
|
|
23,228
|
|
|
|
(3,542
|
)
|
|
|
(15.2
|
)%
|
Total revenue
|
|
|
371,234
|
|
|
|
318,997
|
|
|
|
|
|
|
|
|
|
Losses and loss expenses incurred
|
|
|
247,518
|
|
|
|
186,481
|
|
|
|
61,037
|
|
|
|
32.7
|
%
|
Other operating expenses
|
|
|
113,594
|
|
|
|
89,462
|
|
|
|
24,132
|
|
|
|
27.0
|
%
|
Total expenses
|
|
|
361,112
|
|
|
|
275,943
|
|
|
|
|
|
|
|
|
|
Income before federal income tax expense (benefit)
|
|
|
10,122
|
|
|
|
43,054
|
|
|
|
(32,932
|
)
|
|
|
|
|
Federal income tax expense (benefit)
|
|
|
(8,201
|
)
|
|
|
14,109
|
|
|
|
(22,310
|
)
|
|
|
|
|
Net income
|
|
$
|
18,323
|
|
|
$
|
28,945
|
|
|
$
|
(10,622
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross premiums written for 2017 increased $101.7 million (25.2%), while net premiums earned increased $52.1 million (18.9%), as compared to
2016. The increase in net premiums written and earned was primarily due to an increase of $60.8 million in net premiums earned related to commercial automobile products and $3.7 million in higher net premiums earned related to workers'
compensation products, which were consistent with our growth strategy. These increases were partially offset by $8.1 million of lower premiums generated by reinsurance products, reflective of our decision to completely withdraw from the property
catastrophe reinsurance and professional liability reinsurance markets, and a decrease of $3.9 million in premiums earned from personal automobile products. The difference in the percentage change for premiums written compared to earned is
reflective of the normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force.
Premiums ceded to reinsurers averaged 30.0% of gross premiums written for 2017, compared to 32.6% for 2016. The percentage of premiums ceded
to reinsurance decreased as a result of changes in our reinsurance structure in the third quarter of 2017. The change in net premiums earned, compared to growth in gross premiums written, was a function of premium adjustment provisions in our
historical commercial automobile reinsurance treaties. This historical reinsurance structure, which was revised in the July 2017 reinsurance renewal, causes an adjustment for ceded premiums when the ultimate loss estimate changes for a reinsurance
treaty year. This resulted in ceding an additional $13.7 million in premium in connection with our reserve strengthening in 2017.
Losses and loss expenses incurred during 2017 increased $61.0 million (32.7%) from $186.5 million in 2016 to $247.5 million in 2017, due
primarily to adverse prior accident year development and growth in net premiums earned. The 2017 loss ratio was 75.4%, compared to 67.6% for 2016. The higher loss ratio during 2017 was the result of adverse loss development in our commercial
automobile related liability coverages from prior accident years. The prior year reserve deficiency in 2017 increased the loss ratio for 2017 by 5.9 percentage points compared to a 5.0 percentage point increase experienced in 2016 due to the prior
year reserve deficiencies in 2016. We had an overall reserve deficiency on prior year claims during 2017 of $19.2 million and a $13.8 million deficiency on prior year claims during 2016.
Net investment income for 2017 increased 24.9% to $18.1 million compared to $14.5 million for 2016, primarily due to higher interest rates
leading to higher reinvestment yields for fixed income securities, increased dividends from equity securities and an increase in average funds invested resulting from positive cash flow. After-tax investment income of $12.7 million increased 23.0%
during 2017 compared to the prior year reflecting the above factors, as well as the mix between taxable and tax-exempt investment income.
Net realized and unrealized gains on investments totaled $19.7 million in 2017 compared to $23.2 million during 2016. Direct trading gains
during 2017 were $8.2 million lower compared to the prior year. Other-than-temporary impairment of $0.4 million, netted with gains of $1.6 million on previously impaired available-for-sale securities that were sold in 2017, are included in the net
gains stated above. Investments in limited partnerships produced gains of $12.5 million in 2017, compared to gains of $2.5 million during 2016. Limited partnership investments utilized by us are primarily engaged in long-short equities, private
equity, country-focused funds and real estate development as an alternative to direct equity investments. The aggregate of our share of gains and losses in these entities represented a 16.3% appreciation in value for 2017, compared to a 3.3%
increase in value for 2016.
Other operating expenses for 2017 increased $24.1 million (27.0%) to $113.6 million from $89.5 million in 2016. This increase was due
primarily to an increase in commission expense as a result of the increase in premiums written and higher salary and salary-related expenses, reflective of our increased workforce in response to the continued expansion of our products and
services. Reinsurance ceded credits, included as an offset to other operating expenses, were 30.8% lower in 2017, resulting primarily from ceding a lower percentage of workers' compensation premium to reinsurers in our most recent reinsurance
treaty.
Income tax benefit was $8.2 million for 2017 compared to income tax expense of $14.1 million in 2016. We recorded a benefit of $9.6 million
related to the remeasurement of deferred tax assets and liabilities in the fourth quarter of 2017 pursuant to the U.S. Tax Act. Our effective federal tax rate for 2017 was (81.0%) as compared to 32.8% in 2016. The effective tax rate for 2017 was
affected primarily by the impact of the U.S. Tax Act discussed above.
As a result of the factors discussed above, net income for 2017 decreased $10.6 million to $18.3 million compared to $28.9 million in 2016.
Critical Accounting Policies
The Company's significant accounting policies that are material and/or subject to significant degrees of judgment are highlighted below.
Investment Valuation
All marketable securities are included in the Company's balance sheets at current fair market value.
Approximately 59% of the Company's assets are composed of investments at December 31, 2018. Approximately 92% of these investments are
publicly-traded, owned directly and have readily-ascertainable market values. The remaining 8% of investments are composed primarily of minority interests in several limited partnerships. These limited partnerships are engaged in long-short
equities, private equity, country-focused funds and real estate development as an alternative to direct equity investments. These partnerships do not have readily-determinable market values themselves. Rather, the values recorded are those
provided to the Company by the respective partnerships based on the underlying assets of the limited partnerships. While a substantial portion of the underlying assets are publicly-traded securities, those which are not publicly-traded have been
valued by the respective limited partnerships using their experience and judgment.
Under Financial Accounting Standards Board ("FASB") guidance, if a fixed income security is in an unrealized loss position and the Company
has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded to net
realized gains (losses) on investments in the consolidated statements of operations. For impaired fixed income securities that the Company does not intend to sell or it is more likely than not that the Company will not have to sell such
securities, but the Company expects that it will not fully recover the amortized cost basis, the credit component of the other-than-temporary impairment is recognized in net realized gains (losses) on investments in the consolidated statements of
operations and the non-credit component of the other-than-temporary impairment is recognized directly in shareholders' equity within accumulated other comprehensive income (loss).
In conjunction with the adoption of ASU 2016-01, unrealized gains or losses on equity securities will be recognized in the consolidated
statements of operations and are no longer evaluated for other-than-temporary declines.
It is important to note that all available-for-sale securities included in the Company's consolidated financial statements are valued at
current fair market values. The evaluation process for determination of other-than-temporary decline in value of investments, as described above, does not change these valuations but, rather, determines when a decline in value will be recognized
in the consolidated statements of operations (other-than-temporary decline), as opposed to a charge to shareholders' equity (temporary decline). This evaluation process is subject to risks and uncertainties because it is not always clear what has
caused a decline in value of an individual security or because some declines may be associated with general market conditions or economic factors, which relate to an industry in general, but not necessarily to an individual issue. The Company has
attempted to minimize many of these uncertainties by adopting a largely objective evaluation process as described above. However, to the extent that certain declines in value are reported as unrealized at December 31, 2018, it is possible that
future earnings charges will result should the declines in value increase or persist or should the security actually be disposed of while market values are less than cost. At December 31, 2018, the total gross unrealized loss included in the
Company's fixed income portfolio was approximately $10.8 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2018, there would have been no impact
on total shareholders' equity or book value since the decline in value of these securities was previously recognized as a reduction to shareholders' equity.
Reinsurance Recoverable
Reinsurance ceded transactions were as follows for the years ended December 31 (dollars in thousands):
|
|
2018
|
|
|
2017
|
|
|
2016
|
|
Reinsurance recoverable
|
|
$
|
392,436
|
|
|
$
|
318,331
|
|
|
$
|
255,024
|
|
Premium ceded (reduction to premium earned)
|
|
|
131,080
|
|
|
|
145,201
|
|
|
|
130,012
|
|
Losses ceded (reduction to losses incurred)
|
|
|
148,285
|
|
|
|
128,086
|
|
|
|
108,656
|
|
Reinsurance ceded credits (reduction to operating expenses)
|
|
|
23,124
|
|
|
|
23,187
|
|
|
|
33,512
|
|
A discussion of the Company's reinsurance strategies is presented in Part I, Item 1, "
Business
", of this Annual Report on Form 10-K.
Amounts recoverable under the terms of reinsurance contracts comprised approximately 26% of total Company assets as of December 31, 2018. In
order to be able to provide the high limits required by the Company's insureds, the Company shares a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts.
Some reinsurance contracts provide that a loss will be shared among the Company and its reinsurers on a predetermined pro-rata basis ("quota-share"), while other contracts provide that the Company will keep a fixed amount of the loss, similar to a
deductible, with reinsurers taking all losses above this fixed amount ("excess of loss"). Some risks are covered by a combination of quota-share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms
of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded
as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by certain of the Company's insurance policies for
commercial automobile liability, workers' compensation and professional liability risks provide more variability in the estimation process than lines of business with lower coverage limits.
It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in
charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the gross underlying loss that is critical.
As with any receivable, credit risk exists in the recoverability of reinsurance. This may be even more pronounced than in normal receivable
situations since recoverable amounts are not generally due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms
of the contracts, the Company would be responsible to satisfy the reinsurer's portion of the loss. The financial condition of each of the Company's reinsurers is vetted upon the execution of a given treaty, and only reinsurers with superior credit
ratings are utilized. However, as noted above, reinsurers are often not called upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each
reinsurer are made frequently and, should impairment in the ability of a reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges are included
in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit loss rather than a deficiency associated with the loss reserving process.
Loss and Loss Expense Reserves
The Company's reserves for losses and loss expenses ("reserves") are determined based on complex estimation processes using historical
experience, current economic information and available industry statistics. The Company's claims range from routine "fender benders" to the highly complex and costly third-party bodily injury claims involving large tractor-trailer rigs. Reserving
for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in many of the Company's policies provide for greater volatility in the
reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments
subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established loss
and loss expense reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. See Note C to the consolidated financial statements for additional information relating to loss
and loss expense reserve development.
The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting periods.
A detailed analysis and discussion for each of the above basic reserve categories follows:
Reserves for known losses (Case reserves)
Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of a similar nature, and a "case" reserve
appropriate for the individual loss occurrence is established. For routine "short-tail" claims, such as physical damage, the Company records an initial reserve that is based upon historical loss settlements adjusted for current trends. As
information regarding the loss occurrence is gathered in the claim handling process, the initial reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims, which can tend toward being "long-tail" in
nature, an experienced claims adjuster will review the facts and circumstances surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an
evaluation of potential jury awards, in addition to the factual information, to determine the value of each claim. Each claim is frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the
settlement life cycle.
Reserves for incurred but not reported
losses
The Company uses both standard actuarial techniques common to most insurance companies as well as proprietary techniques developed by the
Company in connection with its specialty business products. For its short-tail lines of business, the Company uses predominantly the incurred or paid loss development factor methods. The Company has found that the use of accident quarter loss
development triangles, rather than those based upon accident year, are most responsive to claim settlement trends and fluctuations in premium exposure for its short-tail lines. A minimum of 12 running accident quarters is used to project the
reserve necessary for incurred but not reported ("IBNR") losses for its short-tail lines.
The Company also uses the loss development factor approach for its long-tail lines of business. A minimum of 15 accident years is included
in the loss development triangles used to calculate link ratios and the selected loss development factors used to determine the reserves for IBNR losses. A minimum of 20 accident years is used for long-tail workers' compensation reserve
projections. Significant emphasis is placed on the use of tail factors for the Company's long-tail lines of business.
For the Company's commercial automobile risks, which are covered by regularly changing reinsurance agreements and which contain wide-ranging
self-insured retentions ("SIR"), traditional actuarial methods are supplemented by other methods, as described below, in consideration of the Company's exposures to loss. In situations where the Company's reinsurance structure, the insured's SIR
selections, policy volume, and other factors are changing, current accident period loss exposures may not be homogenous enough with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company
supplements the above-described actuarial methods with loss ratio reserving techniques developed from the Company's proprietary databases to arrive at the reserve for IBNR losses for the calendar/accident period under review. As losses for a given
calendar/accident period develop with the passage of time, management evaluates such development on a monthly and quarterly basis and adjusts reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate
incurred losses. This process continues until all losses are settled for each period subject to this method.
Reserves for loss adjustment expenses
While certain of the Company's products involve case basis reserving for allocated loss adjustment expenses, the majority of such reserves
are determined on a bulk basis. The Company uses historical analysis of the ratios of allocated loss adjustment expenses paid to losses paid on closed claims to arrive at the expected ultimate incurred loss adjustment expense factors applicable to
each affected product. Once developed, the factors are applied to the expected ultimate incurred losses, including IBNR, on all open claims. The resulting ultimate incurred allocated loss adjustment expense is then reduced by amounts paid to date
on all open claims to arrive at the reserve for allocated loss adjustment expenses to be incurred in the future for the handling of specific claims.
For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated loss
adjustment expenses), the Company uses a variation of the standard industry loss adjustment expenses paid to losses paid (net of reinsurance) ratio analysis that equally weighs paid and incurred losses to establish the necessary reserves. The
selected factors are applied to 100% of IBNR reserves and to case reserves, with consideration given for that portion of loss adjustment expense already paid at the reserve measurement date. Such factors are monitored and revised, as necessary, on
a quarterly basis.
Sensitivity Analysis - Potential impact
on reserve volatility from changes in key assumptions
Management is aware of the potential for variation from the reserves established at any particular point in time. Savings or deficiencies
could develop in future valuations of the currently established loss and loss expense reserve estimates under a variety of reasonably possible scenarios. The Company's reserve selections are developed to be a "best estimate" of unpaid losses at a
point in time and, due to the unique nature of its exposures, particularly in the large commercial automobile excess product, ranges of reserve estimates are not established during the reserving process. However, basic assumptions that could
potentially impact future volatility of the Company's valuations of current loss and loss expense reserve estimates include, but are not limited to, the following:
|
●
|
Consistency in the individual case reserving processes;
|
|
●
|
The selection of loss development factors in the establishment of bulk reserves for incurred but not reported losses and loss expenses;
|
|
●
|
Projected future loss trend; and
|
|
●
|
Expected loss ratios for the current book of business, particularly the Company's commercial automobile products, where the number of accounts insured,
selected SIRs, policy limits and reinsurance structures may vary widely from period to period.
|
Under reasonably possible scenarios, it is conceivable that the Company's selected loss estimates could be 10% or more redundant or
deficient. The majority of the Company's reserves for losses and loss expenses, on a net of reinsurance basis, relate to its commercial automobile products. Perhaps the most significant example of sensitivity to variation in the key assumptions
is the loss ratio selection for the Company's commercial automobile products for policies subject to certain major reinsurance treaties. The following table presents the approximate impacts on gross and net loss reserves of both a hypothetical 10
percentage point and a hypothetical 20 percentage point increase or decrease in the loss factors actually utilized in the Company's reserve determination at December 31, 2018 for the prior six treaty periods, which covers exposures earned on
policies written between July 3, 2012 and December 31, 2018. The Company's selection of the range of values presented should not be construed as the Company's prediction of future events, but rather simply an illustration of the impact of such
events, should they occur.
The variation in impact from loss ratio increases and decreases is attributable to minimum and maximum premium rate factors included in the
various reinsurance contracts. In between the minimum and maximum ceded premium provisions within the treaty terms, net premiums earned can be increased or decreased based on a change in loss expectation. The total impact to profitability in the
same scenarios is shown below ($ in millions):
|
|
10% Loss Ratio Increase
|
|
|
10% Loss Ratio Decrease
|
|
|
20% Loss Ratio Increase
|
|
|
20% Loss Ratio Decrease
|
|
Gross Reserves
|
|
$
|
72.0
|
|
|
$
|
(72.0
|
)
|
|
$
|
144.1
|
|
|
$
|
(144.1
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Reserves
|
|
$
|
18.0
|
|
|
$
|
(19.5
|
)
|
|
$
|
36.0
|
|
|
$
|
(49.5
|
)
|
Net premiums earned
|
|
$
|
(0.4
|
)
|
|
$
|
16.5
|
|
|
$
|
(0.4
|
)
|
|
$
|
41.1
|
|
Cumulative Net Underwriting Income (Loss)
|
|
$
|
(18.4
|
)
|
|
$
|
36.0
|
|
|
$
|
(36.4
|
)
|
|
$
|
90.6
|
|
Federal Income Tax Considerations
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined
based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal
income tax is based on items of income and expense that are reported in different years in the consolidated financial statements and tax returns and are measured at the tax rate in effect in the year the difference originated.
On December 22, 2017, the U.S. Tax Act was signed into law. The U.S. Tax Act lowered the U.S. corporate income tax rate from 35% to 21%
effective January 1, 2018. GAAP requires the impact of tax legislation to be recognized in the period in which the law was enacted. As a result of the U.S. Tax Act, the Company recorded a tax benefit of $9.6 million related to the remeasurement
of its deferred tax assets and liabilities during the fourth quarter of 2017. As of December 31, 2017, the IRS had not yet published all of the detailed regulations resulting from the enactment of the U.S. Tax Act; therefore, while the Company had
not completed its accounting for the tax effects, it made a reasonable estimate of the tax effects on its existing deferred tax balances at December 31, 2017. The Company
finalized its accounting for the tax effects of the U.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded in 2018.
Net deferred tax liabilities reported at December 31 are as follows (dollars in thousands):
|
|
2018
|
|
|
2017
|
|
Total deferred tax liabilities
|
|
$
|
(12,906
|
)
|
|
$
|
(23,836
|
)
|
Total deferred tax assets
|
|
|
19,168
|
|
|
|
9,478
|
|
Net deferred tax assets (liabilities)
|
|
$
|
6,262
|
|
|
$
|
(14,358
|
)
|
Deferred tax assets at December 31, 2018 included approximately $10.0 million related to the timing of deductibility of loss and loss expense
reserves, the majority of which relate to policy liability discounts required by the Internal Revenue Code of 1986, as amended, which are perpetual in nature and, in the absence of the termination of the Company's business, will not, in the
aggregate, reverse to a material degree in the foreseeable future. $3.5 million of deferred tax assets are related to the results of the Company's limited partnership investments. Unearned premiums discount and deferred ceding commissions represent
$2.3 million and $1.2 million of deferred tax assets, respectively. An additional $0.6 million relates to impairment adjustments made to investments, as required by accounting regulations. The unrealized gains in the Company's investment
portfolios would allow for the recovery of this deferred tax at any time. The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material. As a result of its analysis, management has
determined that no valuation allowance is necessary at December 31, 2018.
FASB provides guidance for recognizing and measuring uncertain tax positions and prescribes a threshold condition that a tax position must
meet for any of the benefit of the uncertain tax position to be recognized in the consolidated financial statements. Based on this guidance, management regularly analyzes tax positions taken or expected to be taken in a tax return based on the
threshold condition prescribed. Tax positions that do not meet or exceed this threshold condition are considered uncertain tax positions. Interest related to uncertain tax positions, if any, would be recognized in income tax expense. Penalties,
if any, related to uncertain tax positions would be recorded in income tax expense (benefit).
Impact of Inflation
To the extent possible, the Company attempts to recover the impact of inflation on loss costs and operating expenses by increasing the
premiums it charges. Within the commercial automobile business, a majority of the Company's accounts are charged as a percentage of an insured's gross revenue, mileage or payroll. As these charging bases increase with inflation, premium revenues
are immediately increased. The remaining premium rates charged are adjustable only at periodic intervals and often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases.
To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment
portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are impacted.
Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of investment. For additional information, see Part II, Item 7A, "
Quantitative and Qualitative Disclosures about Market Risk"
, in this Annual Report on Form 10-K.
Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves, as portions of
these reserves are expected to be paid over extended periods of time. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses.
Contractual Obligations
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2018.
|
|
Payments Due by Period
|
|
|
|
Total
|
|
|
Less than 1 year
|
|
|
1 - 3 Years
|
|
|
3 - 5 Years
|
|
|
More Than 5 Years
|
|
|
|
(dollars in millions)
|
|
Loss and loss expense reserves
|
|
$
|
865.3
|
|
|
$
|
302.9
|
|
|
$
|
285.6
|
|
|
$
|
103.8
|
|
|
$
|
173.0
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment commitment
|
|
|
1.3
|
|
|
|
1.3
|
|
|
|
–
|
|
|
|
–
|
|
|
|
–
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating leases
|
|
|
0.5
|
|
|
|
0.4
|
|
|
|
0.1
|
|
|
|
–
|
|
|
|
–
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Borrowings
|
|
|
20.0
|
|
|
|
20.0
|
|
|
|
–
|
|
|
|
–
|
|
|
|
–
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
887.1
|
|
|
$
|
324.6
|
|
|
$
|
285.7
|
|
|
$
|
103.8
|
|
|
$
|
173.0
|
|
The Company's loss and loss expense reserves do not have contractual maturity dates, and the exact timing of the payment of claims cannot be
predicted with certainty. However, based upon historical payment patterns, the above table presents an estimate of when the Company might expect its direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid.
Timing of the collection of the related reinsurance recoverable, estimated to be $392.4 million at December 31, 2018, or 45% of the amounts presented in the above table, would approximate that of the above projected direct reserve payout but could
lag behind such payments by several months in some instances.
The investment commitment in the above table relates to a maximum unfunded capital obligation for a limited partnership investment at
December 31, 2018. The actual call dates for such funding could vary from that presented.
Borrowings made under the Company's line of credit can be called by the lender, under certain circumstances, with short notice. The Company
entered into a new line of credit on August 9, 2018 with an expiration date of August 9, 2022.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.