You should read the following discussion in conjunction with our consolidated financial statements and related notes and information included under this Item 2 and elsewhere in this quarterly report on Form 10-Q and in our Form 10-K filed with the
Securities and Exchange Commission("SEC") on March 12, 2014. Unless the context requires otherwise, as used in this Form 10-Q, the terms "HCI," "we," "us," "our," "the Company," "our company," and similar references refer to HCI Group, Inc., a Floridacorporation incorporated in 2006, and its subsidiaries. All dollar amounts, except per share amounts stated in this Management's Discussion and Analysis of Financial Condition and Results of Operations are in thousands unless specified otherwise.
In addition to historical information, this quarterly report contains forward-looking statements as defined under federal securities laws. Such statements involve risks and uncertainties, such as statements about our plans, objectives, expectations, assumptions or future events. These statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from any future results, performances or achievements expressed or implied by the forward-looking statements. Typically, forward-looking statements can be identified by terminology such as "anticipate," "estimate," "plan," "project," "continuing," "ongoing," "expect," "believe," "intend," "may," "will," "should," "could," and similar expressions. The important factors that could cause actual results to differ materially from those indicated by such forward-looking statements include but are not limited to the effect of governmental regulation; changes in insurance regulations; the frequency and extent of claims; uncertainties inherent in reserve estimates; catastrophic events; a change in the demand for, pricing of, availability of or collectability of reinsurance; restrictions on our ability to change premium rates; increased rate pressure on premiums; and other risks and uncertainties detailed herein and from time to time in our
SECreports. OVERVIEW - General HCI Group, Inc.owns subsidiaries engaged in property and casualty insurance, information technology, real estate and reinsurance. Based on our organizational structure, revenue sources, and evaluation of financial and operating performances by management, we manage our operations under one business segment, which includes the following operations: a) Insurance Operations • Property and casualty insurance • Reinsurance b) Other Operations • Real estate • Information technology 21
Table of Contents
For the three months ended
March 31, 2014and 2013, revenues from property and casualty insurance operations represented 96.2% and 94.6%, respectively, of total revenues of all operating segments. As a result, our property and casualty insurance operations are our only reportable operating segment.
Homeowners Choice Property & Casualty Insurance Company, Inc.("HCPCI"), is a leading provider of property and casualty insurance in the state of Florida. HCPCI along with certain of our other subsidiaries currently provides property and casualty insurance to homeowners, condominium owners, and tenants in the state of Floridaunder our Homeowners Choice brand. HCPCI offers insurance products at competitive rates, while pursuing profitability using selective underwriting criteria. HCPCI began operations in 2007 by participating in a "take-out program," which is a legislatively mandated program designed to encourage private insurance companies to assume policies from Citizens Property Insurance Corporation("Citizens"), a Floridastate-supported insurer. Our growth since inception has resulted primarily from a series of policy assumptions from Citizens and one from HomeWise Insurance Company("HomeWise"). This growth track has been beneficial to us in terms of reduced policy acquisition costs and periods of lower reinsurance costs. Even though expanding our policyholder base through opportunistic assumptions continues to be important to our growth plan, we plan to seek other opportunities to expand and to provide new or additional product offerings. In January 2014, HCPCI began offering flood coverage on a limited basis as a policy endorsement to eligible new and pre-existing Floridacustomers. As part of geographical expansion into other states, Homeowners Choice Assurance Company, Inc.("HCA") was organized to enter the Alabamaproperty and casualty insurance market. HCA was approved and licensed by the Alabama Department of Insurancein August 2013. HCA expects to begin writing policies during 2014.
We have a
Bermuda-based wholly-owned reinsurance subsidiary, Claddaugh Casualty Insurance Company Ltd., which participates in HCPCI's reinsurance program under our Claddaugh brand. Other Operations Information Technology Our information technology operations include a team of experienced software developers with extensive knowledge in developing web-based products and applications for mobile devices. The operations, which are primarily in India, are focused on developing cloud-based, innovative products or services that can be marketed to the public in addition to providing affiliates with back-office technology support services that can facilitate and improve ongoing operations. 22
Table of Contents
Some of the technologies originally developed in-house for our own insurance operations have been launched for use by third parties under our Exzeo brand. Exzeo is a free to join, web-based application available at Exzeo.com that enables seamless integration between organizations, co-workers and business partners. Exzeoallows users to manage projects through communication and collaboration with other participants in a real-time work environment.
Operating under our Greenleaf Capital brand, real estate operations consist of several properties we own including our headquarters building in
Tampa, Floridaand a secondary insurance operations site in Ocala, Florida. In addition, the Ocalalocation serves as our alternative site in the event we experience any significant disruption at our headquarters building. We also own investment real estate in Treasure Island, Florida and Tierra Verde, Florida with a combined 20 acres of waterfront property. With the exception of the Ocalalocation, we lease office or retail space at each location to non-affiliates on various terms. In addition, we own and operate one full-service restaurant and two marinas that we acquired in connection with our purchase of the waterfront properties. The combined marina facilities offer to the general public: a) one dry-stack boat storage facility with capacity for approximately 180 boats; b) approximately 70 wet slips; c) two fuel facilities; and d) open areas for parking and storage. Dry-stack boat storage space is generally rented on a monthly or annual basis while the wet slips are rented on a daily or monthly basis.
Table of Contents
RESULTS OF OPERATIONS
The following table summarizes our results of operations for the three months ended
March 31, 2014and 2013 (amounts in thousands, except per share amounts): Three Months Ended March 31, 2014 2013 Operating Revenue Gross premiums earned $ 93,888 $ 82,547Premiums ceded (27,508 ) (21,996 ) Net premiums earned 66,380 60,551 Net investment income 1,059 139 Policy fee income 257 772
Net realized investment gains 4
20 Other income 417 329 Total operating revenue 68,117 61,811 Operating Expenses Losses and loss adjustment expenses 18,565
Policy acquisition and other underwriting expenses 9,129 5,968 Interest expense 2,574 686 Other operating expenses 9,539 6,115 Total operating expenses 39,807 28,641 Income before income taxes 28,310 33,170 Income tax expense 10,690 12,783 Net income
$ 17,620 $ 20,387
Preferred stock dividends 3
Income available to common stockholders
Ratios to Net Premiums Earned:
Loss Ratio 27.97 % 26.21 % Expense Ratio 32.00 % 21.09 % Combined Ratio 59.97 % 47.30 %
Ratios to Gross Premiums Earned:
Loss Ratio 19.77 % 19.23 % Expense Ratio 22.62 % 15.47 % Combined Ratio 42.39 % 34.70 % Per Share Data:
Basic earnings per common share
Diluted earnings per common share
Table of Contents
Comparison of the Three Months ended
Our results of operations for the three months ended
Gross Premiums Earned for the three months ended
March 31, 2014and 2013 were $93,888and $82,547, respectively, and primarily reflect the revenue from policies acquired from HomeWise and policies originally assumed from Citizens and subsequent renewals. The $11,341increase over the corresponding period in 2013 was primarily attributable to revenue from the Citizens assumption completed in November 2013. Premiums Ceded for the three months ended March 31, 2014and 2013 were approximately $27,508and $21,996, respectively. Our premiums ceded represent amounts paid to reinsurers to cover losses from catastrophes that exceed thresholds defined by our catastrophe excess of loss reinsurance treaties. During the three months ended March 31, 2014, premiums ceded reflect a reduction of $5,484that relates to provisions under certain reinsurance contracts. See "Economic Impact of Reinsurance Contracts with Retrospective Provisions" under "Critical Accounting Policies and Estimates." Our reinsurance rates are based primarily on policy exposures reflected in gross premiums earned. Premiums ceded were 29.3% and 26.6% of gross premiums earned during the three months ended March 31, 2014and 2013, respectively.
Net Premiums Written during the three months ended
Net Premiums Earned for the three months ended
The following is a reconciliation of our total Net Premiums Written to Net Premiums Earned for the three months ended
Three Months Ended March 31, 2014 2013 Net Premiums Written
$ 51,43147,253 Decrease in Unearned Premiums 14,949 13,298 Net Premiums Earned $ 66,38060,551 Net Investment Income for the three months ended March 31, 2014and 2013 was $1,059and $139, respectively. The increase in 2014 is primarily due to increased investments and lower operating losses related to certain of our real estate investments. 25
Table of Contents
Our Losses and Loss Adjustment Expenses amounted to
Policy Acquisition and Other Underwriting Expenses for the three months ended
March 31, 2014and 2013 of $9,129and $5,968, respectively, primarily reflect the amortization of deferred acquisition costs, commissions payable to agents for production and renewal of policies, premium taxes and brokerage fees. The $3,161increase from the corresponding period in 2013 is primarily attributable to the policies assumed from Citizens in 2012 and 2013 that are renewing in 2014 and included in direct written premiums, which are subject to commissions and premium taxes. Interest Expense for the three months ended March 31, 2014and 2013 was $2,574and $686, respectively. The $1,888increase was due to the 3.875% convertible debt offering completed in December 2013. Other Operating Expenses for the three months ended March 31, 2014and 2013 were $9,539and $6,115, respectively. The $3,424increase is primarily attributable to a $3,311increase in compensation and related expenses of which $2,613relates to stock-based compensation and accrued bonus expense. As of March 31, 2014, we had 174 employees located at our headquarters in Floridacompared to 163 employees as of March 31, 2013. We also have 79 employees located in Noida, Indiaat March 31, 2014versus 59 at March 31, 2013. Income Tax Expense for the three months ended March 31, 2014and 2013 were $10,690and $12,783, respectively, for state, federal, and foreign income taxes resulting in an effective tax rate of 37.8% for 2014 and 38.5% for 2013. The slight decrease in the 2014 effective tax rate was primarily attributable to investment income on tax-exempt securities.
The loss ratio applicable to the three months ended
The expense ratio applicable to the three months ended
March 31, 2014(defined as underwriting expenses, interest and other operating expenses related to net premiums earned) was 32.0% compared with 21.1% for the three months ended March 31, 2013. The increase in our expense ratio is primarily attributable to the increase in 2014 specific to compensation and related costs as well as interest expense. The combined ratio (total of all expenses in relation to net premiums earned) is the measure of overall underwriting profitability before other income. Our combined ratio for the three months ended March 31, 2014was 60.0% compared with 47.3% for the three months ended March 31, 2013. Due to the impact our reinsurance costs have on net premiums earned from period to period, our management believes the combined ratio measured to gross premiums earned is more relevant in assessing overall performance. The combined loss and expense ratio to gross premiums earned for the three months ended March 31, 2014was 42.4% compared with 34.7% for the three months ended March 31, 2013. 26
Table of Contents
Seasonality of Our Business
Our insurance business is seasonal as hurricanes and tropical storms typically occur during the period from
June 1 through November 30each year. Moreover, with our reinsurance treaty year effective June 1each year, any variation in the cost of our reinsurance, whether due to changes in reinsurance rates or changes in the total insured value of our policy base, will occur and be reflected in our financial results beginning June 1each year.
LIQUIDITY AND CAPITAL RESOURCES
Over the years, our liquidity requirements have been met through issuance of our common and preferred stock, debt offerings and funds from operations. We expect our future liquidity requirements will be met by funds from operations, primarily the cash received by insurance subsidiaries from premiums written and investment income. We may consider raising additional capital through debt and equity offerings to support our growth and future investment opportunities. Our insurance subsidiary,
Homeowners Choice Property & Casualty Insurance Company, Inc.("HCPCI") requires liquidity and adequate capital to meet ongoing obligations to policyholders and claimants and to fund operating expenses. In addition, we attempt to maintain adequate levels of liquidity and surplus to manage any differences between the duration of our liabilities and invested assets. In the insurance industry, cash collected for premiums from policies written is invested, interest and dividends are earned thereon, and loss and loss adjustment expenses are paid out over a period of years. This period of time varies by the circumstances surrounding each claim. A substantial portion of our losses and loss adjustment expenses are fully settled and paid within 90 days of the claim receipt date. Additional cash outflow occurs through payments of underwriting costs such as commissions, taxes, payroll, and general overhead expenses.
We believe that we maintain sufficient liquidity to pay HCPCI's claims and expenses, as well as to satisfy commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies. We maintain a comprehensive reinsurance program at levels management considers adequate to diversify risk and safeguard our financial position.
In the future, we anticipate our primary use of funds will be to pay claims, reinsurance premiums, interest, and dividends and also to fund operating expenses.
Our long-term debt at
March 31, 2014consisted of 8% Senior Notes due 2020 (the "Notes") and 3.875% Senior Convertible Notes due 2019 (the "Convertible Notes"), both of which were issued for gross proceeds of $40,250and $103,000, respectively, during 2013. We pay $805interest on the Notes quarterly on January 30, April 30, July 30and October 30and approximately $1,996interest on the Convertible Notes semiannually in arrears on March 15and September 15of each year. See Note 6 - "Long-Term Debt" to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q for additional information. 27
Table of Contents
Share Repurchase Plan
March 18, 2014, our Board of Directors approved a one-year plan to repurchase up to $40,000of common shares under which we may purchase shares of common stock in open market purchases, block transactions and privately negotiated transactions in accordance with applicable federal securities laws. See Note 11 - "Stockholders' Equity" to our unaudited consolidated financial statements under Item 1 of this Quarterly Report on Form 10-Q and "Part II - Item 2 - Unregistered Sales of Equity Securitiesand Use of Proceeds" for additional information.
Cash Flows for the Three months ended
Net cash provided by operating activities for the three months ended
March 31, 2014was approximately $35,068, which consisted primarily of cash received from net written premiums less cash disbursed for operating expenses, losses and loss adjustment expenses and interest payments. Net cash used in investing activities of $22,338was primarily due to the purchases of available-for-sale securities of $27,015offset by redemptions and repayments of fixed-maturity securities of $633, and the proceeds from sales of available-for-sale securities of $4,455. Net cash used in financing activities totaled $9,569, which was primarily due to $6,987used in a share repurchase plan and $3,035of net cash dividend payments.
Cash Flows for the Three months ended
Net cash provided by operating activities for the three months ended
March 31, 2013was approximately $15,277, which consisted primarily of cash received from net written premiums less cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash used in investing activities of $2,434was primarily due to the purchases of available-for-sale securities of $2,653, and the purchase of $2,364in property and equipment offset by redemptions and repayments of fixed-maturity securities of $1,237, and the proceeds from sales of available-for-sale securities of $1,398. Net cash provided by financing activities totaled $36,277, which was primarily due to approximately $40,250from the sale of the Notes offset by $1,502in related underwriting and issuance costs paid during the quarter and $2,493of cash dividend payments.
The main objective of our investment policy is to maximize our after-tax investment income with a minimum of risk given the current financial market. Our excess cash is invested primarily in money market accounts and available-for-sale investments.
March 31, 2014, we had $155,985of available-for-sale investments, which are carried at fair value. Changes in the general interest rate environment affect the returns available on new fixed-maturity investments. While a rising interest rate environment enhances the returns available on new investments, it reduces the market value of existing fixed-maturity investments and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new fixed-maturity investments but increases the market value of existing fixed-maturity investments, creating the opportunity for realized investment gains on disposition. 28
Table of Contents
With the exception of large national banks, it is our current policy not to maintain cash deposits of more than an aggregate of
$5,500in any one bank at any time. From time to time, we may have in excess of $5,500of cash designated for investment and on deposit at a single national brokerage firm. In the future, we may alter our investment policy to include or increase investments in federal, state and municipal obligations, preferred and common equity securities and real estate mortgages, as permitted by applicable law, including insurance regulations.
OFF-BALANCE SHEET ARRANGEMENTS
The following table summarizes our contractual obligations as of
March 31, 2014: Payment Due by Period (in thousands) Less than More than Total 1 Year 1-3 Years 3-5 Years 5 Years Operating lease (1) $ 1,098120 257 284 437 Service agreement (1) 198 22 46 51 79 Reinsurance contracts (2) 48,700 28,700 20,000 - - Long-term debt obligations (3) 182,526 7,211 14,423 117,422 43,470 Total $ 232,52236,053 34,726 117,757 43,986
(1) Represents the lease and maintenance service agreement for office space in
(2) Represents the minimum payment of reinsurance premiums under multi-year
retrospective reinsurance contracts.
(3) Amounts represent principal and interest payments over the life of the Notes
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We have prepared our consolidated financial statements and related disclosures in accordance with accounting principles generally accepted in
the United States of America("U.S. GAAP"). The preparation of these consolidated financial statements and related disclosures requires us to make judgments, assumptions and estimates to develop amounts reflected and disclosed in our financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances. Actual results may differ from these estimates and such differences may be material. We believe our critical accounting policies and estimates are those related to losses and loss adjustment expenses, reinsurance with retrospective provisions, deferred income taxes, and stock-based compensation expense. These policies are critical to the portrayal of our financial condition and operating results. They require management to make judgments and estimates about inherently uncertain matters. Material estimates that are particularly susceptible to significant change in the near term are related to our losses and loss adjustment expense reserves, which include amounts estimated for claims incurred but not yet reported, income taxes and reinsurance contracts with retrospective provisions. 29
Table of Contents
Reserves for Losses and Loss Adjustment Expenses
Our liability for losses and loss adjustment expense ("Reserves") are specific to property insurance, which is HCPCI's only line of business. The Reserves include both case reserves on reported claims and our reserves for incurred but not reported ("IBNR") losses. At each period end date, the balance of our Reserves is based on our best estimate of the ultimate cost of each claim for those known cases and the IBNR loss reserves are estimated based primarily on our historical experience. Changes in the estimated liability are charged or credited to operations as the losses and loss adjustment expenses are adjusted. The IBNR reserve represents our estimate of the ultimate cost of all claims that have occurred but have not been reported to us, and in some cases may not yet be known to the insured, and future development of reported claims. Estimating the IBNR component of our Reserves involves considerable judgment on the part of management. At
March 31, 2014, $22,263of the total $43,597we have reserved for losses and loss adjustment expenses is specific to our estimate of IBNR. The remaining $21,334relates to known cases which have been reported but not yet fully settled in which case we have booked a reserve based on our best estimate of the ultimate cost of each claim. At March 31, 2014, $13,990of the $21,334in reserves for known cases relates to claims incurred during prior years. Our Reserves decreased slightly from $43,686at December 31, 2013to $43,597at March 31, 2014. The $89decrease in our Reserves is comprised of $12,307in new reserves specific to the 2014 loss year offset by reductions in our Reserves of $9,520for 2013 and $2,876for 2012 and prior loss years. The $12,307in Reserves established for 2014 claims is primarily due to the increase in our policy count and exposures. The decrease of $12,396specific to our 2013 and prior loss-year reserves is due both to settlement of claims and favorable development related to those loss years. Factors that are attributable to favorable development may include a lower severity of claims than the severity of claims considered in establishing our Reserves, a lower number of new claims reported than anticipated, and actual case development may be more favorable than originally anticipated. Based on all information known to us, we believe our Reserves at March 31, 2014are adequate to cover our claims for losses that had occurred as of that date including losses yet to be reported to us. However, these estimates are subject to trends in claim severity and frequency and must continually be reviewed by management. As part of the process, we review historical data and consider various factors, including known and anticipated regulatory and legal developments, changes in social attitudes, inflation and economic conditions. As experience develops and other data becomes available, these estimates are revised, as required, resulting in increases or decreases to the existing unpaid losses and loss adjustment expenses. Adjustments are reflected in the results of operations in the period in which they are made and the liabilities may deviate substantially from prior estimates. 30
Table of Contents
Economic Impact of Reinsurance Contracts with Retrospective Provisions
Certain of the reinsurance agreements include retrospective provisions that adjust premiums, increase the amount of future coverage, or result in profit commissions in the event losses are minimal or zero. In accordance with generally accepted accounting principles, we will recognize an asset in the period in which the absence of loss experience gives rise to an increase in future coverage or obligates the reinsurer to pay cash or other consideration under the contract. In the event that a loss arises, we will derecognize such asset in the period in which a loss arises. Such adjustments to the asset, which accrue throughout the contract term, will negatively impact our operating results when a catastrophic loss event occurs. There were no benefits accrued for the three months ended
March 31, 2013. For the three months ended March 31, 2014, we have accrued a benefit of $3,988and deferred recognition of $1,496in ceded premiums for a total reduction in 2014 ceded premiums of $5,484in connection with these agreements. As of March 31, 2014, we have accrued a benefit of $12,803and deferred recognition of $5,202in ceded premiums, amounts that would be charged to earnings in the event we experience a catastrophic loss that exceeds the coverage limits provided under such agreements. In addition to Reserves and reinsurance contracts, we believe our accounting policies specific to deferred income taxes and stock-based compensation expense involve our most significant judgments and estimates material to our consolidated financial statements. These accounting estimates and related risks that we consider to be our critical accounting estimates are more fully described in our Annual Report on Form 10-K, which we filed with the SECon March 12, 2014. For the three months ended March 31, 2014, there have been no material changes with respect to any of our critical accounting policies.
We account for income taxes in accordance with U.S. GAAP, resulting in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. We determine deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur. Valuation allowances are provided against assets that are not likely to be realized, if any. We have elected to classify interest and penalties, if any, as income tax expense as permitted by current accounting standards.
We account for our stock option and incentive plan under the fair value recognition provisions of U.S. GAAP, which requires the measurement, and recognition of compensation for all stock-based awards made to employees and directors including stock options and restricted stock issuances based on estimated fair values. We recognize stock-based compensation in the consolidated statements of income on a straight-line basis over the vesting period. We use the Black-Scholes option-pricing model, which requires the following variables for input to calculate the fair value of each stock award on the option grant date: 1) expected volatility of our stock price, 2) the risk-free interest rate, 3) expected term of each award, 4) expected dividends, and 5) an expected forfeiture rate. For restricted stock awards with market-based conditions, we estimate their fair values by using a Monte Carlo simulation model, which requires for input the following variables: 1) expected dividends per share, 2) expected volatility, 3) risk-free interest rate, 4) estimated cost of capital, and 5) expected term of each award. 31
Table of Contents
RECENT ACCOUNTING PRONOUNCEMENTS
For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 2 to our Notes to Consolidated Financial Statements. 32
Table of Contents