UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2012
or
For the transition period from to
Commission File Number 001-33251
UNIVERSAL INSURANCE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1110 W. Commercial Blvd., Fort Lauderdale, Florida 33309
(Address of principal executive offices)
(954) 958-1200
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definitions of “large accelerated filer” and “accelerated filer” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 40,871,028 shares of common stock, par value $0.01 per share, outstanding on November 2, 2012.
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item 2.
Item 3.
Item 4.
Item 1.
Item 1A.
Item 6.
Signatures
2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To The Board of Directors and Stockholders of
Universal Insurance Holdings, Inc. and Subsidiaries
Fort Lauderdale, Florida
We have reviewed the accompanying condensed consolidated balance sheet of Universal Insurance Holdings, Inc. (the “Company”) and its Subsidiaries as of September 30, 2012 and the related condensed consolidated statements of comprehensive income for the three and nine-month periods ended September 30, 2012 and cash flows for the nine-month period ended September 30, 2012. These interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying interim financial statements as of September 30, 2012 and for the three and nine-month periods then ended for them to be in conformity with accounting principles generally accepted in the United States of America.
The condensed consolidated statements of comprehensive income for the three and nine-month periods ended September 30, 2011 and statement of cash flows for the nine-month period ended September 30, 2011 of Universal Insurance Holdings, Inc. (the “Company”) and its Subsidiaries were reviewed by other accountants whose report dated November 8, 2011, stated that based on their procedures, they were not aware of any material modifications that should be made to those financial statements in order for them to be in conformity with accounting principles generally accepted in the United States of America.
/s/ Plante & Moran, PLLC
Chicago, Illinois
November 9, 2012
3
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
UNIVERSAL INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in thousands, except per share data)
ASSETS:
Cash and cash equivalents
Restricted cash and cash equivalents
Fixed maturities, at fair value
Equity securities, at fair value
Prepaid reinsurance premiums
Reinsurance recoverables
Reinsurance receivable, net
Premiums receivable, net
Receivable from securities sold
Other receivables
Property and equipment, net
Deferred policy acquisition costs, net
Income taxes recoverable
Deferred income tax asset, net
Other assets
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY LIABILITIES:
Unpaid losses and loss adjustment expenses
Unearned premiums
Advance premium
Accounts payable
Bank overdraft
Payable for securities purchased
Reinsurance payable
Income taxes payable
Dividends payable to shareholders
Other liabilities and accrued expenses
Long-term debt
Total liabilities
Commitments and Contingencies (Note 11)
STOCKHOLDERS’ EQUITY:
Cumulative convertible preferred stock, $.01 par value
Authorized shares - 1,000
Issued shares - 108
Outstanding shares - 108
Minimum liquidation preference, $2.66 per share
Common stock, $.01 par value
Authorized shares - 55,000
Issued shares - 41,889 and 41,100
Outstanding shares - 40,871 and 40,082
Treasury shares, at cost - 1,018
Additional paid-in capital
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
The accompanying notes to condensed consolidated financial statements are an integral part of these statements.
4
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)
PREMIUMS EARNED AND OTHER REVENUES
Direct premiums written
Ceded premiums written
Net premiums written
Change in net unearned premium
Premiums earned, net
Net investment income (expense)
Net realized gains (losses) on investments
Net unrealized gains (losses) on investments
Net foreign currency gains (losses) on investments
Commission revenue
Policy fees
Other revenue
Total premiums earned and other revenues
OPERATING COSTS AND EXPENSES
Losses and loss adjustment expenses
General and administrative expenses
Total operating costs and expenses
INCOME BEFORE INCOME TAXES
Income taxes, current
Income taxes, deferred
Income taxes, net
NET INCOME AND COMPREHENSIVE INCOME
Basic earnings per common share
Weighted average of common shares outstanding - Basic
Fully diluted earnings per common share
Weighted average of common shares outstanding - Diluted
Cash dividends declared per common share
5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)
Cash flows from operating activities:
Net Income
Adjustments to reconcile net income to net cash provided by operating activities:
Bad debt expense (recovery)
Depreciation
Amortization of stock-based compensation
Net realized (gains) losses on investments
Net unrealized (gains) losses on investments
Net foreign currency (gains) losses on investments
Amortization of premium / accretion of discount, net
Deferred income taxes
Excess tax (benefits) shortfall from stock-based compensation
Other
Net change in assets and liabilities relating to operating activities:
Accrued investment income
Proceeds from sale of trading securities
Purchases of trading securities
Reinsurance payable, net
Net cash provided by (used in) operating activities
Cash flows from investing activities:
Proceeds from sale of property and equipment
Purchases of property and equipment
Net cash provided by (used in) investing activities
Cash flows from financing activities:
Preferred stock dividend
Common stock dividend
Issuance of common stock
Payments related to tax withholding for share-based compensation
Excess tax benefits (shortfall) from stock-based compensation
Repayment of debt
Net cash provided by (used in) financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental cash flow disclosures
Interest
Income taxes
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Nature of Operations
Universal Insurance Holdings, Inc. (“UIH”) is a Delaware corporation originally incorporated as Universal Heights, Inc. in November 1990. UIH, with its wholly-owned subsidiaries (the “Company”), is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. Through its wholly-owned subsidiaries, including Universal Property & Casualty Insurance Company (“UPCIC”) and American Platinum Property and Casualty Insurance Company (“APPCIC”), collectively referred to as the “Insurance Entities”, the Company is principally engaged in the property and casualty insurance business offered primarily through a network of independent agents. Risk from catastrophic losses is managed through the use of reinsurance agreements. The Company’s primary product is homeowners’ insurance offered in seven states as of September 30, 2012, including Florida, which comprises the vast majority of the Company’s in-force policies. See Note 5, Insurance Operations, for more information regarding the Company’s insurance operations.
The Company generates revenues primarily from the collection of premiums and the investment of available funds in excess of those retained for claims-paying obligations and insurance operations. Other significant sources of revenue include commissions collected from reinsurers and policy fees.
Basis of Presentation
The Company has prepared the accompanying unaudited Condensed Consolidated Financial Statements (“Financial Statements”) in accordance with the rules and regulations of the United States Securities and Exchange Commission (“SEC”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by United States Generally Accepted Accounting Principles (“GAAP”) for complete financial statements. Therefore, the Financial Statements should be read in conjunction with the audited Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the SEC on March 26, 2012. The condensed consolidated balance sheet at December 31, 2011, was derived from audited financial statements, but does not include all disclosures required by GAAP. In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation have been included in the Financial Statements. The results for interim periods do not necessarily indicate the results that may be expected for any other interim period or for the full year.
The Financial Statements include the accounts of UIH and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation.
Management must make estimates and assumptions that affect amounts reported in the Company’s Financial Statements and in disclosures of contingent assets and liabilities. Actual results could differ from those estimates.
To conform to the current period presentation, certain amounts in the prior periods’ consolidated financial statements and notes have been reclassified. An adjustment has been made to the Company’s Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2011 to reflect the effect of a reclassification made to the Company’s Condensed Consolidated Balance Sheet as of September 30, 2011 related to restricted cash and cash equivalents. The Company reclassified amounts out of cash and cash equivalents that were restricted in terms of their use and withdrawal and has presented those amounts of restricted cash and cash equivalents as a separate line item on the face of the Condensed Consolidated Balance Sheets.
7
The following line items were adjusted (in thousands):
Condensed Consolidated Statements of Cash Flows:
Net cash flows provided by (used in) operating activities
Net increase in cash and cash equivalents
The Company reported Significant Accounting Policies in its Annual Report on Form 10-K for the year ended December 31, 2011. The following are new or revised disclosures or disclosures required on a quarterly basis.
Concentrations of Credit Risk. The Company is exposed to concentrations of credit risk, consisting principally of cash and cash equivalents, restricted cash and cash equivalents, debt securities, premiums receivable, prepaid reinsurance premiums, reinsurance receivable and reinsurance recoverables.
Concentrations of credit risk with respect to cash and cash equivalents and restricted cash and cash equivalents are limited by guarantees currently provided by the financial institutions that maintain the Company’s depository or custodial accounts.
The Company maintains depository relationships with SunTrust Bank and Wells Fargo Bank N.A., and other banking institutions and invests excess cash with custodial institutions that invest primarily in money market accounts consisting of short-term U.S. Treasury securities. These accounts are held primarily by the Institutional Trust & Custody division of U.S. Bank and SunTrust Bank Escrow Services.
Restricted cash and cash equivalents are maintained in money market accounts consisting of U.S. Treasury and government agency securities.
The following table presents the amount of cash and cash equivalents as of the periods presented (in thousands):
Institution
U. S. Bank IT&C
SunTrust Bank
SunTrust Bank Escrow Services
Wells Fargo Bank N.A.
All Other Banking Institutions
Total
8
The following table presents the amount of restricted cash and cash equivalents as of the periods presented (in thousands):
Bank of New York Mellon Trust Co. (1)
Florida Department of Financial Services
Concentrations of credit risk with respect to premiums receivable are limited due to the large number of individuals comprising the Company’s customer base. However, the majority of the Company’s revenues are currently derived from products and services offered to customers in Florida, which could be adversely affected by economic downturns, an increase in competition or weather-related events.
In order to reduce credit risk for amounts due from reinsurers, the Insurance Entities seek to do business with financially sound reinsurance companies and regularly evaluate the financial strength of all reinsurers used. Everest Reinsurance Company, the reinsurer to which the Insurance Entities ceded the most risk through May 31, 2012, has the following ratings from each of the rating agencies: A+ from A.M. Best Company; A+ from Standard and Poor’s Rating Services and; Aa3 from Moody’s Investors Service, Inc. Odyssey Reinsurance Company, the reinsurer to which the Insurance Entities cede the most risk effective June 1, 2012, has the following ratings from each of the rating agencies: A from A.M. Best Company; A- from Standard and Poor’s Rating Services and; A3 from Moody’s Investors Service, Inc.
The following table presents the unsecured net amounts due from the Company’s reinsurers whose aggregate balance exceeds 3% of the Company’s stockholders’ equity (in thousands):
Reinsurer
Everest Reinsurance Company
Florida Hurricane Catastrophe Fund
Odyssey Reinsurance Company
Total (1)
Recently Issued Accounting Pronouncements
In December 2011, the Financial Accounting Standards Board (“FASB”) updated its guidance to the Balance Sheet Topic 210 of the FASB Accounting Standards Codification (“ASC”). This updated guidance requires entities that have financial instruments and derivative instruments that are offset, to disclose information about offsetting and related arrangements to enable users of financial statements to understand the effect of those arrangements on an entity’s financial position. This guidance is to be applied for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Disclosure is required retrospectively for all comparative periods presented. The additional disclosures required by the updated guidance will not have an impact on the Company’s operating results, cash flows or financial position.
9
In June 2011, the FASB updated its guidance related to the Comprehensive Income Topic 220 of the FASB ASC. This updated guidance increases the prominence of items reported in other comprehensive income by eliminating the option of presenting components of other comprehensive income as part of the statement of changes in stockholders’ equity. The guidance requires that total comprehensive income (including both the net income components and other comprehensive income components) be reported in either a single continuous statement of comprehensive income (the approach currently used in the Company’s financial statements), or two separate but consecutive statements. This guidance is to be applied retrospectively to fiscal years (and interim periods within those years) beginning after December 15, 2011. The Company adopted this guidance effective January 1, 2012. This guidance did not have an impact on the presentation of the Company’s financial statements and notes herein, as the Company did not have any amounts of other comprehensive income during the periods presented.
In May 2011, the FASB updated its guidance related to the Fair Value Measurement, Topic 820 of the ASC, to achieve common fair value measurement and disclosure requirements with International Financial Reporting Standards. The amendments change the wording used to describe many of the requirements under GAAP, to clarify the intent of application of existing fair value measurement and disclosure requirements, and to change particular principles or requirements for measuring and disclosing fair value measurements. The amendments are to be applied prospectively to interim and annual reporting periods beginning after December 15, 2011. The Company adopted this guidance effective January 1, 2012. The adoption of this guidance resulted in additional disclosure but did not impact the Company’s results of operations, cash flows or financial position.
In September 2010, the FASB issued guidance related to accounting for costs associated with acquiring or renewing insurance contracts. This guidance defines allowable deferred policy acquisition costs as costs incurred by insurance entities for the successful acquisition of new and renewal contracts. Such costs result directly from and are essential to the contract transaction(s) and would not have been incurred by the insurance entity had the contract(s) not occurred. This guidance is effective for periods beginning after December 15, 2011, with early adoption permitted. The Company adopted this guidance prospectively effective January 1, 2012. Under the new guidance, the Company’s net deferred policy acquisition costs were reduced from $13.0 million to $11.4 million, a difference of 13% at December 31, 2011. The resulting $1.6 million difference was charged directly to earnings during the three months ended March 31, 2012. This charge represents a charge-off of capitalized costs existing at December 31, 2011, which would have been amortized to earnings within a twelve-month period under the old guidance.
10
The following table presents the Company’s investment holdings by type of instrument as of the periods presented (in thousands):
Cash and cash equivalents (1)
Restricted cash and cash equivalents (1)
Trading portfolio:
Debt securities:
U.S. government obligations and agencies
Equity securities:
Common stock:
Metals and mining
Energy
Exchange-traded and mutual funds:
Agriculture
Indices
Non-hedging derivative asset (2)
Other investments (3)
Total trading portfolio investments
Total investments
The Company has made an assessment of its invested assets for fair value measurement as further described in Note 12 – Fair Value Measurements.
11
The following table presents net investment income (expense) comprised primarily of interest and dividends (in thousands):
Debt securities
Equity securities
Total investment income
Less investment expenses
Net investment (expense) income
Trading Portfolio
The following table presents the effect of trading activities on the Company’s results of operations by type of instrument and by line item in the condensed consolidated statements of income (in thousands):
Realized gains (losses) on investments:
Derivatives (non-hedging instruments) (1)
Total realized gains (losses) on trading portfolio
Unrealized gains (losses) on investments:
Total unrealized gains (losses) on trading portfolio
Net gains (losses) recognized on trading securities
The Company seeks to reduce its risk of loss by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers, generally, as of the beginning of the hurricane season on June 1 of each year. The Company’s reinsurance program consists of excess of loss, quota share and catastrophe reinsurance, subject to the terms and conditions of the applicable agreements. The Company is responsible for insured losses related to catastrophes and other events in excess of coverage provided by its reinsurance program. The Company also remains responsible for the settlement of insured losses in the event of the failure of any of its reinsurers to make payments otherwise due to the Company. The estimated insured value of the Company’s in-force policyholder coverage for windstorm exposures as of September 30, 2012 was approximately $127.6 billion.
The Company has reduced the percentage of premiums ceded by UPCIC to its quota share reinsurer to 45% under the reinsurance program which became effective June 1, 2012, from 50% under the prior year quota share contract effective June 1, 2011 through May 31, 2012. The Company’s intent is to increase its profitability over the contract term by ceding 5% less premium to its quota share reinsurer. This reduction of cession rate also decreases the amount of losses and loss adjustment expenses that may be ceded by
12
UPCIC and effectively increases the amount of risk retained by UPCIC and the Company. The reduction of cession rate also reduces the amount of ceding commissions earned from the Company’s quota share reinsurer during the contract term and decreases the amount of deferred ceding commission, as of September 30, 2012, that is a component of net deferred policy acquisition costs.
Amounts recoverable from reinsurers are estimated in a manner consistent with the reinsurance contracts. Reinsurance premiums, losses and loss adjustment expenses (“LAE”) are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Deferred ceding commissions are netted against policy acquisition costs and amortized over the effective period of the related insurance policies.
The Company’s reinsurance arrangements had the following effect on certain items in the Condensed Consolidated Statements of Income (in thousands):
Direct
Ceded
Net
The following prepaid reinsurance premiums and reinsurance recoverables and receivables are reflected in the Condensed Consolidated Balance Sheets (in thousands):
Reinsurance recoverable on unpaid losses and LAE
Reinsurance recoverable on paid losses
Reinsurance receivables, net
Reinsurance recoverables and receivables
The Company’s primary product is homeowners insurance currently offered by APPCIC in one state (Florida) and by UPCIC in seven states, including Florida.
13
The following table provides the percentage of concentrations with respect to the Insurance Entities’ nationwide policies-in-force as of the periods presented:
Percentage of Policies-In-Force:
In Florida
With wind coverage
With wind coverage in SouthFlorida (1)
Deferred Policy Acquisition Costs
The Company defers certain costs in connection with written policies, called Deferred Policy Acquisition Costs (“DPAC”), net of corresponding amounts of ceded reinsurance commissions, called Deferred Reinsurance Ceding Commissions (“DRCC”). Net DPAC is amortized over the effective period of the related insurance policies.
The following table presents the beginning and ending balances and the changes in DPAC, net of DRCC, for the periods presented (in thousands):
DPAC, beginning of period (1)
Capitalized costs
Amortization of DPAC
DPAC, end of period
DRCC, beginning of period (1)
Ceding commissions written
Earned ceding commissions
DRCC, end of period
DPAC (DRCC), net, beginning of period (1)
Capitalized costs, net
Amortization of DPAC (DRCC), net
DPAC (DRCC), net, end of period
As discussed in Note 2 – Significant Accounting Policies, the Company prospectively adopted new accounting guidance effective January 1, 2012 related to accounting for costs associated with acquiring or renewing insurance contracts. This guidance resulted in a 13% reduction of our net deferred policy acquisition costs as of December 31, 2011, and a corresponding pre-tax charge of $1.6 million against earnings during the first quarter of 2012. This charge represents a charge-off of capitalized costs existing at December 31, 2011, which would have been amortized to earnings within a twelve-month period under the old guidance. In the period of adoption (three months ended March 31, 2012), approximately $9 million of net costs would have been deferred under the old guidance compared to the $5.6 million under the new guidance. Future expenses will be higher with the adoption of this guidance, as the amounts being deferred have decreased, partially offset by less amortization. The effect of this change in periods subsequent to March 31, 2012, on income and per share amounts is not determinable as the historical methodology will have been discontinued after adoption.
14
Liability for Unpaid Losses and Loss Adjustment Expenses
Set forth in the following table is the change in liability for unpaid losses and LAE for the periods presented (in thousands):
Balance at beginning of period
Less reinsurance recoverable
Net balance at beginning of period
Incurred related to:
Current year
Prior years
Total incurred
Paid related to:
Total paid
Net balance at end of period
Plus reinsurance recoverables
Balance at end of period
Regulatory Requirements
The Insurance Entities are subject to regulations and standards of the Florida Office of Insurance Regulation (“OIR”). UPCIC is also subject to the laws of other states in which it operates. The OIR standards require the Insurance Entities to maintain specified levels of statutory capital and restrict the timing and amount of dividends and other distributions that may be paid to the parent company. Except in the case of extraordinary dividends, these standards generally permit the Insurance Entities to pay dividends from statutory unassigned surplus to the parent company. The dividends are limited based on the Insurance Entities’ level of statutory net income and statutory capital and surplus. These dividends are referred to as “ordinary dividends” and generally can be paid without prior regulatory approval. If the dividend, together with other dividends paid within the preceding twelve months, exceeds a specified statutory limit or is paid from sources other than earned surplus, the entire dividend is generally considered an “extraordinary dividend” and must receive prior regulatory approval.
Based on the 2011 statutory net income and statutory capital and surplus levels, UPCIC and APPCIC do not have the capacity to pay ordinary dividends during 2012. For the nine months ended September 30, 2012, no dividends were paid from UPCIC or APPCIC to the parent company. Dividends paid to the shareholders of UIH are paid from the surplus of UIH and not that of the Insurance Entities.
15
The Florida Insurance Code requires companies to maintain capitalization equivalent to the greater of ten percent of the insurer’s total liabilities or $5.0 million. The following table presents the amount of statutory capital and surplus, and an amount representing ten percent of total liabilities for both UPCIC and APPCIC as of the periods presented (in thousands):
Ten percent of total liabilities
UPCIC
APPCIC
Statutory capital and surplus
At such dates, both UPCIC and APPCIC met the Florida capitalization requirement. UPCIC and APPCIC are also required to adhere to prescribed premium-to-capital surplus ratios and have met those requirements as well.
The Company is required by various state laws and regulations to maintain certain assets in depository accounts. The following table represents assets held by insurance regulators as of the periods presented (in thousands):
Investments
16
The following table presents certain information related to stock options and non-vested shares (“restricted stock”) (in thousands, except per share data):
Outstanding as of June 30, 2012
Granted
Forfeited
Exercised (1)
Vested
Expired
Outstanding as of September 30, 2012 (2)
Exercisable as of September 30, 2012
Outstanding as of December 31, 2011
n/a - Not applicable
17
The following table presents certain information regarding the Company’s stock-based compensation for the periods presented (in thousands):
Compensation expense:
Stock options
Restricted stock
Deferred tax benefits:
Realized tax benefits:
Excess tax benefits(shortfall):
Weighted average fair value per share:
Stock option grants
Restricted stock grants
Intrinsic value of options exercised
Fair value of restricted stock vested
Cash received for strike price and tax withholdings
Shares acquired through cashless exercise (1)
Value of shares acquired
The following table presents the amount of unrecognized compensation expense as of the most recent balance sheet date and the weighted average period over which those expenses will be recorded for both stock options and restricted stock (dollars in thousands):
Unrecognized expense
Weighted average remaining years
Dividends
On February 23, 2012, the Company declared a dividend of $0.10 per share on our outstanding common stock paid on April 6, 2012, to the shareholders of record at the close of business on March 28, 2012.
On April 23, 2012, the Company declared a dividend of $0.08 per share on our outstanding common stock paid on July 9, 2012, to the shareholders of record at the close of business on June 26, 2012.
On September 10, 2012, the Company declared a dividend of $0.08 per share on our outstanding common stock paid on October 9, 2012, to the shareholders of record at the close of business on September 26, 2012.
18
Downes and Associates, a multi-line insurance adjustment corporation based in Deerfield Beach, Florida, performs certain claims adjusting work for UPCIC. Downes and Associates is owned by Dennis Downes, who is the father of Sean P. Downes, Senior Vice President and Chief Operating Officer of the Company.
The following table presents payments made by the Company to Downes and Associates for the periods presented (in thousands):
Claims adjusting fees
There were no amounts due to Downes and Associates as of September 30, 2012 and December 31, 2011.
Deferred income taxes represent the temporary differences between the GAAP and tax basis of the Company’s assets and liabilities. The tax effects of temporary differences are as follows for the periods presented (in thousands):
Deferred income tax assets:
Advanced premiums
Unpaid losses and LAE
Stock-based compensation
Accrued wages
Allowance for uncollectible receivables
Additional tax basis of securities
Unrealized losses on investments
Total deferred income tax assets
Deferred income tax liabilities:
Total deferred income tax liabilities
Net deferred income tax asset
A valuation allowance is deemed unnecessary as of September 30, 2012 and December 31, 2011, because management believes it is probable that the Company will generate taxable income sufficient to realize the tax benefits associated with the net deferred income tax asset shown above in the near future.
Tax years that remain open for purposes of examination of the Company’s income tax liability by taxing authorities include the years ended December 31, 2011, 2010 and 2009. The Company’s 2009 consolidated federal income tax return is currently under examination by the Internal Revenue Service.
19
The following table reconciles the statutory federal income tax rate to the Company’s effective tax rate for the periods presented:
Statutory federal income tax rate
Increases (decreases) resulting from:
Disallowed meals & entertainment
Disallowed compensation
True-up to prior year tax returns
State income tax, net of federal tax benefit (1)
Other, net
Effective tax rate
Basic earnings per share (“EPS”) is based on the weighted average number of common shares outstanding for the period, excluding any dilutive common share equivalents. Diluted EPS reflects the potential dilution resulting from exercises of stock options, vesting of restricted stock and conversion of preferred stock.
The following table reconciles the numerator (i.e., income) and denominator (i.e., shares) of the basic and diluted earnings per share computations for the periods presented (in thousands, except per share data):
Numerator for EPS:
Net income
Less: Preferred stock dividends
Income available to common stockholders
Denominator for EPS:
Weighted average common shares outstanding
Plus: Assumed conversion of stock-based compensation (1)
Assumed conversion of preferred stock
Weighted average diluted common shares outstanding
Diluted earnings per common share
20
Employment Agreements
The Company has employment agreements with certain employees which are in effect as of September 30, 2012. The agreements provide for minimum salaries, which may be subject to annual percentage increases, and non-equity incentive compensation for certain executives based on pre-tax income or net income levels attained by the Company. The agreements also provide for payments contingent upon the occurrence of certain events.
The following table presents the amount of commitments and estimated contingent payments the Company is obligated to pay in the form of salaries and non-equity incentive compensation under the agreements with named executive officers (in thousands):
Commitments
Contingent payments upon certain events:
Termination
Change in control
Death
Disability
Litigation
Certain lawsuits have been filed against the Company. These lawsuits involve matters that are routine litigation incidental to the claims aspect of the Company’s business for which estimated losses are included in Unpaid Losses and Loss Adjustment Expenses in the Company’s Condensed Consolidated Financial Statements. In the opinion of management, these lawsuits are not material individually or in the aggregate to the Company’s financial position or results of operations. Accruals made or assessments of materiality of disclosure related to probable or possible losses do not consider any anticipated insurance proceeds.
Loss Contingencies
In late August 2012, the Company decided to forego efforts to collect $5.4 million the Company believed was owed by a reinsurer. This decision was based upon management’s belief that the tangible and intangible costs associated with the effort to collect would exceed the $5.4 million that the Company believed was recoverable from the predecessor quota-share reinsurer. Management considered several factors in making this decision, including the legal and internal costs associated with the collection effort, the potential disruption of business and diversion of internal resources during hurricane season, management’s desire to maintain good business relationships with the predecessor quota-share reinsurer and the successor quota-share reinsurer, as the Company currently conducts business with both parties. The write-off of the associated reinsurance receivable of $5.4 million is reflected as an increase in ceded written and ceded earned premiums in the Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2012. The after-tax effect of the write-off of the reinsurance receivable was $0.08 per diluted share for both the three and nine months ended September 30, 2012.
21
GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. GAAP describes three approaches to measuring the fair value of assets and liabilities: the market approach, the income approach and the cost approach. Each approach includes multiple valuation techniques. GAAP does not prescribe which valuation technique should be used when measuring fair value, but does establish a fair value hierarchy that prioritizes the inputs used in applying the various techniques. Inputs broadly refer to the assumptions that market participants use to make pricing decisions, including assumptions about risk. Level 1 inputs are given the highest priority in the hierarchy while Level 3 inputs are given the lowest priority. Assets and liabilities carried at fair value are classified in one of the following three categories based on the nature of the inputs to the valuation technique used:
Level 1 — Observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in active markets as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2 — Observable market-based inputs or unobservable inputs that are corroborated by market data.
Level 3 — Unobservable inputs that are not corroborated by market data. These inputs reflect management’s best estimate of fair value using its own assumptions about the assumptions a market participant would use in pricing the asset or liability.
Summary of significant valuation techniques for assets measured at fair value on a recurring basis
Level 1
Cash and cash equivalents and restricted cash and cash equivalents: Cash equivalents and restricted cash equivalents comprise actively traded money market funds that have daily quoted net asset values for identical assets that the Company can access. The carrying value of cash and cash equivalents and restricted cash and cash equivalents approximates fair value due to its liquid nature.
Common stock:Comprise actively traded, exchange-listed U.S. and international equity securities. Valuation is based on unadjusted quoted prices for identical assets in active markets that the Company can access.
Exchange-traded and mutual funds: Comprise actively traded funds. Valuation is based on daily quoted net asset values for identical assets in active markets that the Company can access.
Other investments: Currently comprise physical metal positions held by the Company.Valuation is based on unadjusted quoted prices for identical assets in active markets that the Company can access.
Level 2
Common Stock: Comprise exchange-listed U.S. and international equity securities that are either not actively traded or have been delisted. The Company uses prices and inputs closest to the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for these instruments.
U.S. government obligations and agencies: Comprise U.S. Treasury Bills or Notes or U.S. Treasury Inflation Protected Securities (TIPS). The primary inputs to the valuation include quoted prices for identical assets in inactive markets or similar assets in active or inactive markets, contractual cash flows, benchmark yields and credit spreads.
22
Derivatives: The primary inputs to the valuation include quoted prices or quoted net asset values for identical or similar assets in markets that are not active or highly active.
As required by GAAP, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect their placement within the fair value hierarchy levels.
23
The following tables set forth by level within the fair value hierarchy the Company’s assets that were accounted for at fair value on a recurring basis as of the periods presented (in thousands):
Non-hedging derivative asset
Other investments
The Company utilizes third-party independent pricing services that provide a price quote for each debt security, equity security and derivative. Management reviews the methodology used by the pricing services. If management believes that the price used by the pricing service does not reflect an orderly transaction between participants, management will use an alternative valuation methodology. There were no adjustments made by the Company to the prices obtained from the independent pricing source for any debt securities, equity securities or derivatives included in the tables above.
24
The Company’s policy is to record transfers of assets and liabilities between Level 1 and Level 2 at their fair values as of the end of each reporting period, consistent with the date of the determination of fair value. Assets and liabilities are transferred out of Level 1 when exchange-listed U.S. and international equity securities are either not actively traded or have been delisted.
The Company transferred equity securities from Level 1 to Level 2 with a fair value of $38 thousand as of September 30, 2012. Transfers from Level 1 to Level 2 were made because of the absence of quoted prices in active markets as of the end of the reporting period.
The following table summarizes the carrying value and estimated fair values of the Company’s financial instruments that are not carried at fair value (in thousands):
Liabilities:
25
Level 3
Long-term debt: The fair value of long-term debt was determined by management from the expected cash flows discounted using the interest rate quoted by the issuer of the note, the State Board of Administration of Florida (“SBA”) which is below prevailing rates quoted by private lending institutions. However, as the Company’s use of funds from the surplus note is limited by the terms of the agreement, the Company has determined the interest rate quoted by the SBA to be appropriate for purposes of establishing the fair value of the note.
The Company performed an evaluation of subsequent events through the date the Financial Statements were issued and determined that, other than what is described below, there were no recognized or unrecognized subsequent events that would require an adjustment or additional disclosure in the Financial Statements as of September 30, 2012.
Late October 2012, Tropical Storm/Hurricane Sandy affected the vast majority of the eastern coastal states of the United States, including several states in which the Insurance Entities write policies. At October 28, 2012, the Insurance Entities had policies-in-force with wind coverage as follows: 541,224 in Florida, 15,391 in North Carolina, 3,395 in South Carolina, 1,060 in Georgia, 96 in Massachusetts, and 8 in Maryland. The Company has not yet determined the extent of insured losses under its Insurance Entities’ policies due to the storm. Florida, the state in which the insurance Entities have most of the wind policies, was not severely affected.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Unless the context otherwise requires, all references to “we,” “us,” “our,” and “Company” refer to Universal Insurance Holdings, Inc. and its subsidiaries. You should read the following discussion together with our unaudited condensed consolidated financial statements and the related notes thereto included in Part I, Item 1 “Financial Statements.” Operating results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for the year.
Forward-Looking Statements
In addition to historical information, the following discussion may contain “forward-looking statements” within the meaning of the Private Securities Reform Litigation Act of 1995. The words “expect,” “estimate,” “anticipate,” “believe,” “intend,” “project,” “plan” and similar expressions and variations thereof, speak only as of the date the statement was made and are intended to identify forward-looking statements. Forward-looking statements are based on various factors and assumptions that include known and unknown risks and uncertainties. Such statements may include, but not be limited to, projections of revenues, income or loss, expenses, plans, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future results could differ materially from those in the following discussion and those described in forward-looking statements as a result of the risks set forth below.
Risk Factors Summary
We operate in a rapidly changing environment that involves a number of uncertainties, some of which are beyond our control. Certain statements made in this report that reflect management’s expectations regarding future events are forward-looking in nature and, accordingly are subject to risks and uncertainties. These forward-looking statements are only current expectations about future events. Actual results could differ materially from those set forth in or implied by any forward-looking statement. Factors that could cause or contribute to such differences include, but are not limited to, risk factors set forth in filings with the Securities and Exchange Commission, including our annual and quarterly reports. The following is a summary of uncertainties which were disclosed in greater detail in “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011:
Risks Relating to the Property-Casualty Business
As a property and casualty insurer, we may face significant losses from catastrophes and severe weather events
Unanticipated increases in the severity or frequency of claims may adversely affect our profitability and financial condition
Actual claims incurred may exceed current reserves established for claims and may adversely affect our operating results and financial condition
Predicting claim expense relating to environmental liabilities is inherently uncertain and may have a material adverse effect on our operating results and financial condition
The failure of the risk mitigation strategies we utilize could have a material adverse effect on our financial condition or results of operations
26
Reinsurance may be unavailable at current levels and prices, which may limit our ability to write new business
Regulation limiting rate increases
The potential benefits of implementing our profitability model may not be fully realized
Our financial condition and operating results and the financial condition and operating results of the Insurance Entities may be adversely affected by the cyclical nature of the property and casualty business
Continued weakness in the Florida real estate market could adversely affect our loss results
Risks Relating to Investments
We have periodically experienced, and may experience further reductions in returns or losses on our investments especially during periods of heightened volatility, which could have a material adverse effect on our results of operations or financial condition
We are subject to market risk which may adversely impact investment income
Concentration of our investment portfolios in any particular segment of the economy may have adverse effects on our operating results and financial condition
Our overall financial performance is significantly dependent on the returns on our investment portfolio, which may have a material adverse effect on our results of operations or cause such results to be volatile
Risks Relating to the Insurance Industry and Other Factors
Our future results are dependent in part on our ability to successfully operate in an insurance industry that is highly competitive
Difficult conditions in the economy generally could adversely affect our business and operating results
There can be no assurance that actions of the U.S. federal government, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets and stimulating the economy will achieve the intended effect
We are subject to extensive regulation and potential further restrictive regulation may increase our operating costs and limit our growth
Reinsurance subjects us to the credit risk of our reinsurers and may not be adequate to protect us against losses arising from ceded risks, which could have a material adverse effect on our operating results and financial condition
The continued threat of terrorism and ongoing military actions may adversely affect the level of claim losses we incur and the value of our investment portfolio
A downgrade in our Financial Stability Rating® may have an adverse effect on our competitive position, the marketability of our product offerings, and our liquidity, operating results and financial condition
Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs or our ability to obtain credit on acceptable terms
Changing climate conditions may adversely affect our financial condition, profitability or cash flows
Loss of key executives could affect our operations
Overview
Universal Insurance Holdings, Inc. (“UIH”), with its wholly-owned subsidiaries, is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. Through our wholly-owned subsidiaries, including Universal Property & Casualty Insurance Company (“UPCIC”) and American Platinum Property and Casualty Insurance Company (“APPCIC”), collectively referred to as the “Insurance Entities”, we are principally engaged in the property and casualty insurance business offered primarily through a network of independent agents. Our primary product is homeowners insurance currently offered in seven states. Total policies-in-force as of September 30, 2012 and December 31, 2011 were 574 and 593 thousand, respectively. Of the total policy count as of September 30, 2012, the Insurance Entities had approximately 553 thousand polices totaling approximately $756.6 million of in-force premiums in Florida and 21 thousand policies totaling approximately $20.4 million of in-force premiums in North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland, combined.
27
Risk from catastrophic losses is managed through the use of reinsurance agreements.
We generate revenues primarily from the collection of premiums and the investment of funds in excess of those retained for claims-paying obligations and insurance operations. Other significant sources of revenue include commissions collected from reinsurers and policy fees.
2012 Developments
On January 11, 2012, we announced that UPCIC received OIR approval for premium rate increases for its homeowners and dwelling fire programs within Florida. The premium rate increases are expected to average approximately 14.9% statewide for its homeowners program and 8.8% statewide for its dwelling fire program. The effective dates for both of the premium rate increases are January 9, 2012 for new business and February 28, 2012 for renewal business.
UPCIC made a forms filing immediately after the rate filing to segregate sinkhole coverage and to include updated policy language as a result of the property insurance bill which became law in May 2011 (Senate Bill 408). The OIR approved the forms filing with effective dates of April 1, 2012 for new business and May 21, 2012 for renewals. With the approval of this forms filing, sinkhole coverage will be excluded from certain base homeowners policies but the coverage will be offered via endorsement for an additional surcharge, and a mandatory 10% deductible, to those policyholders that meet the proposed eligibility standards. Revised inspection and eligibility requirements will not be imposed upon existing policyholders who elect to continue sinkhole coverage at their policy renewal. Form changes for sinkhole coverage on dwelling fire policies, which are similar in nature to those filed for homeowners policies, were approved by the OIR with effective dates of May 1, 2012 for new business and June 8, 2012 for renewal business. Coverage for catastrophic ground cover collapse will remain a covered peril under all standard policy forms.
On February 23, 2012, we declared a dividend of $0.10 per share on our outstanding common stock paid on April 6, 2012, to shareholders of record at the close of business on March 28, 2012.
On April 23, 2012, we declared a dividend of $0.08 per share on our outstanding common stock paid on July 9, 2012, to shareholders of record at the close of business on June 26, 2012.
On June 26, 2012, Demotech, Inc. affirmed UPCIC’s Financial Stability Rating® of A. A Financial Stability Rating® of A is the third highest of six possible rating levels. According to Demotech, Inc., A ratings are assigned to insurers that have “…exceptional ability to maintain liquidity of invested assets, quality reinsurance, acceptable financial leverage and realistic pricing while simultaneously establishing loss and loss adjustment expense reserves at reasonable levels.” The rating of UPCIC is subject to at least annual review by, and may be revised upward or downward or revoked at the sole discretion of Demotech, Inc.
On July 11, 2012, we announced that UPCIC received approval from the Massachusetts Division of Insurance for homeowners policies rates and forms.
On August 1, 2012, we announced that UPCIC bound its first homeowners insurance policy in Massachusetts. The expansion marks the sixth state where UPCIC writes homeowners insurance.
28
On September 10, 2012, we declared a dividend of $0.08 per share on our outstanding common stock paid on October 9, 2012, to the shareholders of record at the close of business on September 26, 2012. We expect to declare an additional quarterly dividend in the same amount to shareholders of record in the fourth quarter of 2012. Declaration and payment of future dividends is subject to the discretion of UIH’s Board of Directors and will be dependent on future earnings, cash flows, financial requirements and other factors.
On September 18, 2012, we announced that UPCIC received approval from the Maryland Insurance Administration for homeowners policies rates and forms.
On October 11, 2012, Demotech, Inc. affirmed UPCIC’s Financial Stability Rating® of A. A Financial Stability Rating® of A is the third highest of six possible rating levels. According to Demotech, Inc., the affirmation represents a company’s continued positive surplus related to policyholders, liquidity of invested assets, an acceptable level of financial leverage, reasonable loss and loss adjustment expense reserves, and realistic pricing. The rating of UPCIC is subject to at least annual review by, and may be revised upward or downward or revoked at the sole discretion of Demotech, Inc.
On October 16, 2012, we announced that UPCIC had written its first homeowners insurance policy in Maryland. The expansion marks the seventh state where UPCIC writes homeowners insurance.
Impact of new accounting pronouncement
We prospectively adopted new accounting guidance related to accounting for costs associated with acquiring or renewing insurance contracts effective January 1, 2012. The overall impact under the new guidance, which was adopted on January 1, 2012, was a reduction in earnings of $2.7 million ($1.7 million after tax or $0.04 per diluted share). The $2.7 million pre-tax reduction in earnings during the three months ended March 31, 2012, includes an acceleration of capitalized costs existing as of December 31, 2011, which would have been amortized to earnings within a twelve-month period, and the immediate recognition of costs which otherwise would have been deferred, partially offset by a lesser amount of amortization expense due to the reduction in capitalized costs. The new guidance does not result in incremental charges to earnings, but rather affects the timing of the recognition of those charges in the income statement.
2012-2013 Reinsurance Program
Effective June 1, 2012, we entered into multiple reinsurance agreements comprising our 2012-2013 reinsurance program.
REINSURANCE GENERALLY
In the normal course of business, we limit the maximum net loss that can arise from large risks, risks in concentrated areas of exposure and catastrophes, such as hurricanes or other similar loss occurrences, by reinsuring certain levels of risk in various areas of exposure with other insurers or reinsurers through our reinsurance agreements. Our intention is to limit our exposure and the exposure of the Insurance Entities, thereby protecting stockholders’ equity and the Insurance Entities’ capital and surplus, even in the event of catastrophic occurrences, through reinsurance agreements. Without these reinsurance agreements, the Insurance Entities would be more substantially exposed to catastrophic losses with a greater likelihood that those losses could exceed their statutory capital and surplus. Any such catastrophic event, or multiple catastrophes, could have a material adverse effect on the Insurance Entities’ solvency and our results of operations, financial condition and liquidity.
Below is a description of our 2012-2013 reinsurance program. Although the terms of the individual contracts vary, we believe the overall terms of the 2012-2013 reinsurance program are more favorable than the 2011-2012 reinsurance program as reinsurance pricing remained largely the same as the prior year contracts while direct earned premium is expected to increase as a result of the previously approved and expected future rate increases. We also reduced the percentage of premiums ceded by UPCIC to its quota share reinsurer to 45% under the reinsurance program which became effective June 1, 2012, from 50% under the prior year quota share contract effective June 1, 2011 through May 31, 2012. Our intent is to increase profitability over the contract term by ceding 5% less premium to our quota share reinsurer. This reduction of cession rate also decreases the amount of losses and loss adjustment expenses that may be ceded by UPCIC and effectively increases the amount of risk we retain. The reduction of cession rate also reduces the amount of ceding commissions earned from our quota share reinsurer during the contract term. We also eliminated the loss corridor and the cap on losses and loss adjustment expenses in the quota share contract effective June 1, 2012.
29
The Insurance Entities are responsible for insured losses related to catastrophic events in excess of coverage provided by their reinsurance programs. The Insurance Entities also remain responsible for insured losses in the event of the failure of any reinsurer to make payments otherwise due to the Insurance Entities. The Insurance Entities’ inability to satisfy valid insurance claims resulting from catastrophic events could have a material adverse effect on our results of operations, financial condition and liquidity.
UPCIC REINSURANCE PROGRAM
Effective June 1, 2012, UPCIC entered into a quota share reinsurance contract with Odyssey Reinsurance Company. Under the quota share contract, through May 31, 2013, UPCIC cedes 45% of its gross written premiums, losses and loss adjustment expenses for policies with coverage for wind risk with a ceding commission equal to 25% of ceded gross written premiums. In addition, the quota share contract has a limitation for any one occurrence not to exceed $75 million (of which UPCIC’s net liability on the first $75 million of losses in a first event scenario is $24.75 million, in a second event scenario is $27.5 million and in a third event scenario is $16.5 million) and a limitation from losses arising out of events that are assigned a catastrophe serial number by the Property Claims Services (“PCS”) office not to exceed $180 million. The contract limits the amount of premium which can be deducted for inuring reinsurance to the lesser of actual costs or 32% of gross earned premium, excluding reinstatement premiums, or the lesser of actual costs or 32% of gross earned premium plus a maximum additional of $135.978 million including reinstatement premiums, if any.
Effective June 1, 2012 through May 31, 2013, UPCIC entered into a multiple line excess per risk contract with various reinsurers. Under the multiple line excess per risk contract, UPCIC obtained coverage of $1.4 million in excess of $600 thousand ultimate net loss for each risk and each property loss, and $1 million in excess of $300 thousand for each casualty loss. The contract has a limitation for any one occurrence not to exceed $1.4 million and a $7 million aggregate limit that applies to the term of the contract. Effective June 1, 2012 through May 31, 2013, UPCIC entered into a property per risk excess contract covering ex-wind only policies. Under the property per risk excess contract, UPCIC obtained coverage of $350 thousand in excess of $250 thousand for each property loss. The contract has a limitation for any one occurrence not to exceed $1.05 million and a $1.75 million aggregate limit that applies to the term of the contract.
Effective June 1, 2012 through May 31, 2013, under an underlying excess catastrophe contract, UPCIC obtained catastrophe coverage of 45% of $75 million in excess of $75 million and 55% of $105 million in excess of $45 million covering certain loss occurrences including hurricanes. UPCIC entered into this contract with a segregated account, Segregated Account T25 – Universal Insurance Holdings of White Rock Insurance (SAC) Ltd. (“T25”), which is owned by UIH and was established by a third-party reinsurer under Bermuda law. Under this T25 agreement, T25 retains a maximum, pre-tax liability of $91.5 million for the first catastrophic event up to $1.683 billion of losses. UPCIC is required to make premium installment payments aggregating $72.981 million to T25, subject to the terms of the agreement. Through capital contributions made to T25 by UIH, T25 contributes an amount equal to its liability for losses, net of UPCIC’s required premium payments and expenses thereon, to a trust account as collateral. The trust account is funded with the required collateral and invested in a cash reserve fund. The amounts held in the cash reserve fund are included in restricted cash and cash equivalents in our Condensed Consolidated Balance Sheets. The collateral is available to be used to pay any claims that may arise from the occurrence of covered events. The collateral is required to be held in trust for the benefit of UPCIC until the occurrence of a covered event or expiration or termination of the agreement between T25 and UPCIC. UIH has no requirement to fund T25 in the event losses exceed the amount of collateral held in trust.
UIH has secured the obligations of the segregated account by contributing the amount of the segregated account’s liability for losses net of UPCIC’s required premium payments, to a trust account for the current June 1, 2012 to May 31, 2013 contract period. In the event of a loss under the terms of this contract, the capital contributed by UIH would be used to pay claims and would have an adverse effect on stockholders’ equity and cash resources.
The agreements between T25 and the Insurance Entities are a cost-effective alternative to reinsurance that the Insurance Entities would otherwise purchase from third-party reinsurers. While we retain the risk that otherwise would be transferred to third party reinsurers, these agreements provide benefits to the Insurance Entities in “no-loss” years that cannot be replicated in the open reinsurance market. These benefits include the return to the Insurance Entities of a substantial portion of the earned reinsurance premiums under the contract. All the related intercompany transactions with respect to these agreements are eliminated in consolidation.
30
Effective June 1, 2012 through May 31, 2013, under excess catastrophe contracts, UPCIC obtained catastrophe coverage of $541.2 million in excess of $150 million covering certain loss occurrences including hurricanes. The coverage of $541.2 million in excess of $150 million has a second full limit available to UPCIC; additional premium is calculated pro rata as to amount and 100% as to time, as applicable. Effective June 1, 2012 through May 31, 2013, UPCIC purchased reinstatement premium protection which reimburses UPCIC for its cost to reinstate the catastrophe coverage of the first $371.2 million (part of $541.2 million) in excess of $150 million.
Effective June 1, 2012 through May 31, 2013, UPCIC also obtained subsequent catastrophe event excess of loss reinsurance to cover certain levels of UPCIC’s net retention through three catastrophe events including hurricanes. Specifically, UPCIC obtained catastrophe coverage for a second event of 45% of $75 million excess of $75 million in excess of $75 million otherwise recoverable and 55% of $100 million excess of $50 million in excess of $100 million otherwise recoverable. UPCIC also obtained catastrophe coverage for a third event of $120 million excess of $30 million in excess of $240 million otherwise recoverable.
Effective June 1, 2012 through May 31, 2013, under an excess catastrophe contract specifically covering risks located in Georgia, North Carolina and South Carolina, UPCIC obtained catastrophe coverage of 55% of $20 million in excess of $30 million and 55% of $25 million in excess of $50 million covering certain loss occurrences including hurricanes. Both layers of coverage have a second full limit available to UPCIC; additional premium is calculated pro rata as to amount and 100% as to time, as applicable. The cost of UPCIC’s excess catastrophe contracts specifically covering risks in Georgia, North Carolina and South Carolina is $2.565 million.
UPCIC also obtained coverage from the Florida Hurricane Catastrophe Fund (“FHCF”). The approximate coverage is estimated to be for 90% of $1.112 billion in excess of $434.6 million.
The total cost of UPCIC’s multiple line excess and property per risk reinsurance program, effective June 1, 2012 through May 31, 2013, is $4.35 million, of which UPCIC’s cost is $2.618 million, and the quota share reinsurer’s cost is the remaining $1.733 million. The total cost of UPCIC’s underlying excess catastrophe contract is $72.981 million. The total cost of UPCIC’s private catastrophe reinsurance program, effective June 1, 2012 through May 31, 2013, is $135.978 million, of which UPCIC’s cost is 55%, or $74.788 million, and the quota share reinsurer’s cost is the remaining 45%. In addition, UPCIC purchases reinstatement premium protection as described above, the cost of which is $24.042 million. The total cost of the subsequent catastrophe event excess of loss reinsurance is $26.306 million, of which UPCIC’s cost is $16.418 million, and the quota share reinsurer’s cost is the remaining $9.889 million. The estimated premium that UPCIC plans to cede to the FHCF for the 2012 hurricane season is $77.369 million of which UPCIC’s cost is 55%, or $42.553 million, and the quota share reinsurer’s cost is the remaining 45%.
The largest private participants in UPCIC’s reinsurance program include leading reinsurance companies such as Odyssey Re, Everest Re, Renaissance Re and Lloyd’s of London syndicates.
With the implementation of our 2012-2013 reinsurance program at June 1, 2012, we retain a maximum pre-tax net liability of $127.47 million for the first catastrophic event up to $1.683 billion of losses relating to the UPCIC Florida program, and a maximum pre-tax net liability of $18.796 million for the first catastrophic event up to $75 million of losses relating to the UPCIC other states’ program.
Separately from the Insurance Entities’ reinsurance programs, UIH protected its own interests against diminution in value due to catastrophe events by purchasing $80 million in coverage via a catastrophe risk-linked transaction contract, effective June 1, 2012 through December 31, 2012. The contract provides for recovery by UIH in the event of the exhaustion of UPCIC’s catastrophe coverage. The total cost to UIH of the risk-linked transaction contract is $10.960 million.
APPCIC REINSURANCE PROGRAM
Effective June 1, 2012 through May 31, 2013, under an excess catastrophe contract, APPCIC obtained catastrophe coverage of $5 million in excess of $1 million covering certain loss occurrences including hurricanes. The coverage of $5 million in excess of $1 million has a second full limit available to APPCIC; additional premium is calculated pro rata as to amount and 100% as to time, as applicable. The total cost of APPCIC’s private catastrophe reinsurance program effective June 1, 2012 through May 31, 2013 is $1.503 million.
31
APPCIC also obtained coverage from the FHCF. The approximate coverage is estimated to be for 90% of $12.8 million in excess of $5.0 million. The estimated premium that APPCIC plans to cede to the FHCF for the 2012 hurricane season is $888 thousand.
Effective October 1, 2011 through May 31, 2012, APPCIC had entered into a multiple line excess per risk contract with various reinsurers. Effective June 1, 2012, APPCIC elected to extend the multiple line excess per risk contract through June 30, 2012. Under this multiple line excess per risk contract, APPCIC had coverage of $8.4 million in excess of $600 thousand ultimate net loss for each risk and each property loss, and $1 million in excess of $300 thousand for each casualty loss. A $21 million aggregate limit applied to the term of the contract.
Effective July 1, 2012 through May 31, 2013, APPCIC entered into a multiple line excess per risk contract with various reinsurers. Under the multiple line excess per risk contract, UPCIC obtained three layers of coverage. The first layer provides coverage of $700 thousand in excess of $300 thousand ultimate net loss for each risk and each property loss, and $1 million in excess of $300 thousand for each casualty loss. The first layer has a limitation for any one property loss occurrence not to exceed $1.4 million and a $3.5 million aggregate limit that applies to the term of the contract. The first layer also has a limitation for any one liability loss occurrence not to exceed $1 million and a $2 million aggregate limit that applies to the term of the contract. The second layer provides coverage of $2 million in excess of $1 million ultimate net loss for each risk and each property loss. The second layer has a limitation for any one property loss occurrence not to exceed $2 million and a $6 million aggregate limit that applies to the term of the contract. The third layer provides coverage of $6 million in excess of $3 million ultimate net loss for each risk and each property loss. The third layer has a limitation for any one property loss occurrence not to exceed $6 million and a $12 million aggregate limit that applies to the term of the contract.
The total cost of the APPCIC multiple line excess reinsurance program effective July 1, 2012 through May 31, 2013 is $1.760 million.
The largest private participants in APPCIC’s reinsurance program include leading reinsurance companies such as Odyssey Re, Hannover Ruck, Amlin Bermuda and Lloyd’s of London syndicates.
With the implementation of our 2012-2013 reinsurance program at July 1, 2012, we retain a maximum pre-tax net liability of $2.063 million for the first catastrophic event up to $16.9 million of losses relating to the APPCIC program.
Wind Mitigation Discounts
The insurance premiums charged by the Insurance Entities are subject to various statutory and regulatory requirements. Among these, the Insurance Entities must offer wind mitigation discounts in accordance with a program mandated by the Florida Legislature and implemented by the OIR. The level of wind mitigation discounts mandated by the Florida Legislature to be effective June 1, 2007 for new business and August 1, 2007 for renewal business have had a significant negative effect on our premium.
The Insurance Entities fully experience the effect of rate or discount changes more than 12 months after implementation because insurance policies renew throughout the year. Although the Insurance Entities may seek to offset the impact of wind mitigation credits through subsequent rate increase filings with the OIR, there is no assurance that the OIR and the Insurance Entities will agree on the amount of rate change that is needed. In addition, any adjustments to the Insurance Entities’ rates similarly take more than 12 months to be fully integrated into its business.
The following table reflects the effect of wind mitigation credits received by UPCIC’s policy holders (in thousands):
Date
6/1/2007
12/31/2007
3/31/2008
6/30/2008
9/30/2008
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
6/30/2010
9/30/2010
12/31/2010
3/31/2011
6/30/2011
9/30/2011
12/31/2011
3/31/2012
6/30/2012
9/30/2012
32
The following table reflects the effect of wind mitigation credits received by APPCIC’s policy holders (in thousands):
The following table reflects the combined effect of wind mitigation credits received by our Insurance Entities’ policy holders (in thousands):
33
Results of Operations - Three Months Ended September 30, 2012, Compared to Three Months Ended September 30, 2011
The following table summarizes changes in each component of our Statement of Income for the three months ended September 30, 2012, compared to the same period in 2011 (in thousands):
Net foreign currency losses on investments
NET INCOME
NM - Not meaningful.
Net income increased by $7.3 million reflecting an increase in net earned premiums and improved performance in the investment trading portfolio. These increases in revenue were partially offset by increases in net losses and loss adjustment expenses and general and administrative expenses.
The increase in net earned premiums of $9.9 million, or 19.9%, reflects an increase in direct earned premiums of $15.4 million partially offset by an increase in ceded earned premiums of $5.5 million. The increase in direct earned premiums is due primarily to rate increases over the past 24 months, the most recent of which were in January and February of 2012. These rate increases, along with strategic initiatives we have undertaken to manage our exposure such as the decision not to renew certain policies we believe have inadequate premiums relative to projected risks and expenses, have resulted in a moderate reduction in the number of policies in force even as direct written premiums have increased. The benefit from the rate increases continued to be partially offset by wind mitigation credits within the state of Florida. The increase in ceded earned premiums of $5.5 million is attributable to an increase in quota-share ceded premiums in proportion to the growth in direct written premiums and an increase in ceded earned premiums of $5.4 million related to the settlement of a dispute with our predecessor quota-share reinsurer as further described in Note 11 – Commitments and Contingencies to our Condensed Consolidated Financial Statements. The after-tax effect of the settlement with our predecessor quota share reinsurer was $0.08 per diluted share. These increases were partially offset by a reduction in the quota-share cession rate from 50% for the 2011-2012 reinsurance program to 45% for the 2012-2013 reinsurance program.
34
Net realized losses on investments of $3.1 million recorded during the three months ended September 30, 2012 reflect loss in value of investments sold during the period. The majority of net realized losses recorded during the three months ended September 30, 2012 were in the metals and mining sector.
We hold debt and equity securities, derivatives and other investments in our trading portfolio. All unrealized gains and losses on investments in our trading portfolio are reflected in earnings. Unrealized gains and losses reflect the change in value during the period for investments held in our trading portfolio, including the reversal of unrealized gains and losses recorded when investments are sold. We recorded $8.1 million net unrealized gains during the three months ended September 30, 2012. The majority of the unrealized losses in the trading portfolio as of September 30, 2012 are in the metals and mining sector. Equity securities in the metals and mining sector represent approximately 30% of the fair value of investments held in the trading portfolio as of September 30, 2012.
The increase in net losses and loss adjustment expenses of $7.0 million was due primarily to losses incurred on prior loss years as well as $2.2 million of pre-tax losses related to Tropical Storm/Hurricane Isaac.
The net loss and LAE ratios, or net losses and loss adjustment expenses as a percentage of net earned premiums, were 61.0% and 59.1% during the three-month periods ended September 30, 2012 and 2011, respectively, and were comprised of the following components (in thousands):
Loss and loss adjustment expenses
Premiums earned
Loss & LAE ratios
The increase in net loss and LAE ratio reflects the $5.4 million increase in ceded earned premiums related to the settlement of the dispute with our predecessor quota-share reinsurer as described above, and losses incurred on prior loss years as well as losses related to Tropical Storm/Hurricane Isaac.
The increase in general and administrative expenses of $5.4 million was due primarily to factors related to net deferred policy acquisition costs. The reduction in the amount of ceding commissions received from the quota share reinsurer under the 2012-2013 reinsurance program effectively increased the amount of net deferred policy acquisition costs and related amortization. In addition, the Company is charging certain costs directly to earnings that were previously capitalized under the superseded FASB guidance which governed how we accounted for deferred policy acquisition costs until January 1, 2012. There were also increases in salaries, bonuses, and insurance, offset partially by a decrease in insurance department fees.
Income taxes increased by $5.5 million, or 2034.0% primarily as a result of an increase in pre-tax income. The effective tax rate increased to 40.9% for the three months ended September 30, 2012 from 21.6 % for the same period in the prior year primarily as a result of the relative impact of discrete items on the level of taxable income during the three months ended September 30, 2011.
35
Results of Operations - Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011
The following table summarizes changes in each component of our Statement of Income for the nine months ended September 30, 2012 compared to the same period in 2011 (in thousands):
Net income increased by $3.5 million, or 15.5%, primarily as a result of an increase in net earned premiums and improved performance in the investment trading portfolio, partially offset by increases in losses and loss adjustment expenses and general and administrative expenses. There was also an increase in commission revenue.
The increase in net earned premiums of $16.7 million, or 11.3%, reflects an increase in direct earned premiums of $46.1 million partially offset by an increase in ceded earned premiums of $29.4 million. The increase in direct earned premium is due primarily to rate increases over the past 24 months, the most recent of which were in January and February of 2012. These rate increases, along with strategic initiatives we have undertaken to manage our exposure such as the decision not to renew certain policies we believe have inadequate premiums relative to projected risks and expenses, have resulted in a moderate reduction in the number of policies in force even as direct written premiums have increased. The benefit from the rate increases continued to be partially offset by wind mitigation credits within the state of Florida. The increase in ceded earned premiums of $29.4 million is attributable to an increase in quota-share ceded premiums in proportion to the growth in direct written premiums, a $5.4 million increase related to the settlement of a dispute with our predecessor quota-share reinsurer as described above, and $4.4 million in the 2012 period relating to an underlying property catastrophe excess of loss reinsurance contract with an unaffiliated third-party reinsurer that did not exist during the 2011 period. The after-tax effect of the settlement with our predecessor quota share reinsurer was $0.08 per diluted share. These increases were partially offset by a reduction in the quota-share cession rate from 50% for the 2011-2012 reinsurance program to 45% for the 2012-2013 reinsurance program.
36
The reduction in net investment income for the nine months ended September 30, 2012, compared to the same period in the prior year, reflects a reduction in the amount of interest earning securities held in the investment portfolio and non-recurring charges for investment accounting services as we converted to a new investment accounting service provider.
Net realized losses on investments of $12.3 million recorded during the nine months ended September 30, 2012 reflect loss in value of investments sold during the period. The majority of realized losses recorded during the nine months ended September 30, 2012 were in the metals and mining sector.
We hold debt and equity securities, derivatives and other investments in our trading portfolio. All unrealized gains and losses on investments in our trading portfolio are reflected in earnings. Unrealized gains and losses reflect the change in value during the period for investments held in our trading portfolio, including the reversal of unrealized gains and losses recorded when investments are sold. We recorded net unrealized gains of $11.5 million during the nine months ended September 30, 2012. The majority of the unrealized gains in the trading portfolio as of September 30, 2012 are in the metals and mining sector. Equity securities in the metals and mining sector represent approximately 30% of the fair value of investments held in the trading portfolio as of September 30, 2012.
Commission revenue is comprised principally of brokerage commission we earn from reinsurers. The increase in commission revenue of $1.2 million is due to an increase in ceded earned premium for the reinsurance contract periods that were in effect during the nine months ended September 30, 2012 as compared to the same period in 2011.
Policy fees are comprised primarily of the managing general agent’s policy fee income from insurance policies. The decrease of $676 thousand reflects a reduction in the number of policies written and renewed primarily due to the rate increases that have taken effect, which has caused some attrition.
The increase in net losses and loss adjustment expenses of $10.5 million was due primarily to losses incurred on prior loss years as well as $2.2 million of pre-tax losses related to Tropical Storm/Hurricane Isaac.
The net loss and LAE ratios, or net losses and loss adjustment expenses as a percentage of net earned premiums, were 56.1% and 55.3% during the nine-month periods ended September 30, 2012 and 2011, respectively, and were comprised of the following components (in thousands):
The net loss and LAE ratio increased primarily due to the increase in ceded earned premiums of $5.4 million related to the settlement of the dispute with our predecessor quota-share reinsurer as described above, and losses incurred on prior loss years as well as losses related to Tropical Storm/Hurricane Isaac.
37
The increase in general and administrative expenses of $11.0 million was due primarily to factors related to net deferred policy acquisition costs. The reduction in the amount of ceding commissions received from the quota share reinsurer under the 2012-2013 reinsurance program effectively increased the amount of net deferred policy acquisition costs and related amortization. In addition, the Company is charging certain costs directly to earnings that were previously capitalized under the superseded FASB guidance which governed how we accounted for deferred policy acquisition costs until January 1, 2012. There were also increases in salaries, bonuses, and insurance, offset partially by a decrease in insurance department fees.
Income taxes increased by $2.3 million, or 15.1% primarily as a result of an increase in pre-tax income. The effective tax rate decreased to 40.0% for the nine months ended September 30, 2012 from 40.1% for the same period in the prior year.
Analysis of Financial Condition - As of September 30, 2012 Compared to December 31, 2011
We believe that premiums will be sufficient to meet our working capital requirements for at least the next twelve months.
Our policy is to invest amounts considered to be in excess of current working capital requirements. We have a receivable of $1.8 million at September 30, 2012 for securities sold that had not yet settled compared to $9.7 million at December 31, 2011, and a payable for securities purchased that had not yet settled of $4.7 million as of September 30, 2012 compared to $1.1 million at December 31, 2011.
The following table summarizes, by type, the carrying values of investments (in thousands):
Type of Investment
Total Investments
Reinsurance receivable, net, represents inuring premiums receivable, net of ceded premiums payable with our quota share reinsurer. The decrease of $24.7 million to $30.5 million during the nine months ended September 30, 2012 was due primarily to the timing of settlement with our quota-share reinsurer.
Premiums receivable represent amounts due from policyholders. The increase of $10.2 million to $56.0 million during the nine months ended September 30, 2012 was due to growth in, and timing of, direct written premiums.
The increase in Property and Equipment of $1.7 million to $8.8 million reflects the cost of constructing a new office building which was placed into service at the end of March 2012.
See Note 5, Insurance Operations, in our Notes to Condensed Consolidated Financial Statements for a roll-forward in the balance of our deferred policy acquisition costs.
See Note 9, Income Taxes, in our Notes to Condensed Consolidated Financial Statements for a schedule of deferred income taxes as of September 30, 2012 and December 31, 2012 which shows the components of deferred tax assets and liabilities as of both balance dates.
See Note 5, Insurance Operations, in our Notes to Condensed Consolidated Financial Statements, for a roll-forward in the balance of our unpaid losses and LAE.
38
Unearned premiums represent the portion of written premiums that will be earned pro rata in the future. The increase of $48.9 million to $408.7 million during the nine months ended September 30, 2012 was due to growth in, and timing of, direct written premiums.
Reinsurance payable, net, represents our liability to reinsurers for ceded written premiums, net of ceding commissions receivable. The increase of $36.4 million to $123.9 million during the nine months ended September 30, 2012 was primarily due to the timing of settlement with our reinsurers.
Liquidity and Capital Resources
Liquidity
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet its short and long-term obligations. Funds generated from operations have generally been sufficient to meet our liquidity requirements and we expect that in the future funds from operations will continue to meet such requirements.
The balance of cash and cash equivalents as of September 30, 2012 was $365.7 million compared to $229.7 million at December 31, 2011. See our Condensed Consolidated Statements of Cash Flows for a reconciliation of the balance of cash and cash equivalents between September 30, 2012 and December 31, 2011. Most of this amount is available to pay claims in the event of a catastrophic event pending reimbursement amounts recoverable under reinsurance agreements. The source of liquidity for possible claim payments consists of the collection of net premiums, after deductions for expenses, reinsurance recoverables and short-term loans.
The balance of restricted cash and cash equivalents as of September 30, 2012 was $95.1 million. Restricted cash as of September 30, 2012 is mostly comprised of cash equivalents on deposit with regulatory agencies in the various states in which our Insurance Entities do business.
The Company’s liquidity requirements primarily include potential payments of catastrophe losses, the payment of dividends to shareholders, and interest and principal payments on debt obligations. The declaration and payment of future dividends to shareholders will be at the discretion of our Board of Directors and will depend upon many factors, including our operating results, financial condition, capital requirements and any regulatory constraints.
Our insurance operations provide liquidity in that premiums are generally received months or even years before losses are paid under the policies sold. Historically, cash receipts from operations, consisting of insurance premiums, commissions, policy fees and investment income, have provided more than sufficient funds to pay loss claims and operating expenses. We maintain substantial investments in highly liquid, marketable securities. Liquidity can also be generated by funds received upon the sale of marketable securities in our investment portfolio.
The Insurance Entities are responsible for losses related to catastrophic events with incurred losses in excess of coverage provided by the Insurance Entities’ reinsurance programs and for losses that otherwise are not covered by the reinsurance programs, which could have a material adverse effect on either the Insurance Entities’ or our business, financial condition, results of operations and liquidity (see 2012-2013 Reinsurance Program above for a discussion of the 2012-2013 reinsurance program).
Capital Resources
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks and facilitate continued business growth. At September 30, 2012, we had total capital of $186.6 million, comprised of stockholders’ equity of $166.0 million and total debt of $20.6 million. Our debt-to-total-capital ratio and debt-to-equity ratio were 11.0% and 12.41%, respectively, at September 30, 2012. At December 31, 2011, we had total capital of $171.7 million, comprised of stockholders’ equity of $150 million and total debt of $21.7 million. Our debt-to-total-capital ratio and debt-to-equity ratio were 12.6% and 14.5%, respectively, at December 31, 2011.
At September 30, 2012, UPCIC was in compliance with all of the covenants under its surplus note and its total adjusted capital was in excess of regulatory requirements.
39
Cash Dividends
On February 23, 2012, we declared a dividend of $0.10 per share on our outstanding common stock paid on April 6, 2012, to the shareholders of record at the close of business on March 28, 2012.
On April 23, 2012, we declared a dividend of $0.08 per share on our outstanding common stock paid on July 9, 2012, to the shareholders of record at the close of business on June 26, 2012.
Contractual Obligations
There have been no material changes during the period covered by this Quarterly Report on Form 10-Q, outside of the ordinary course of business, to the contractual obligations specified in the table of contractual obligations included in Part 1, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2011.
Critical Accounting Policies and Estimates
There have been no material changes during the period covered by this Quarterly Report on Form 10-Q to Critical Accounting Policies and Estimates previously disclosed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2011.
Accounting Pronouncements Issued and Not Yet Adopted
In December 2011, the Financial Accounting Standards Board updated its guidance to the Balance Sheet Topic 210 of the FASB Accounting Standards Codification. The objective of this updated guidance requires entities that have financial and derivative instruments that are offset to disclose information about offsetting and related arrangements to enable users of financial statements to understand the effect of those arrangements on an entity’s financial position. This guidance is to be applied for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Disclosure is required retrospectively for all comparative periods presented. The additional disclosures required by the updated guidance will not have an impact on our operating results, cash flows or financial position.
Related Parties
See Note 8, Related Party Transactions, in our Notes to Condensed Consolidated Financial Statements for information about related parties.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the potential for economic losses due to adverse changes in fair value of financial instruments. Our primary market risk exposures are related to our investment portfolio and include interest rates, equity prices and commodity prices. We also have exposure to foreign currency exchange rates for investments denominated in foreign currencies, and to a lesser extent, our debt obligation in the form of a surplus note. The surplus note, as previously described in “Liquidity and Capital Resources,” accrues interest at an adjustable rate based on the 10-year Constant Maturity Treasury rate. Investments held in trading are carried on the balance sheet at fair value. Our investment trading portfolio is comprised primarily of debt and equity securities and also includes non-hedging derivatives and physical positions in precious metals. See Note 5, Investments, for a schedule of investment holdings as of September 30, 2012 and December 31, 2011.
40
Our investments have been, and may in the future be, subject to significant volatility. Our investment objective is to maximize total rate of return after federal income taxes while maintaining liquidity and minimizing risk. Our investment strategy includes maintaining investments to support unpaid losses and loss adjustment expenses for the Insurance Entities in accordance with guidelines established by insurance regulators. In addition to investment securities, we invest in derivative financial instruments to try to increase investment returns and for income-generation purposes. The most commonly used instruments are call and put equity options and written call options on common stock (i.e., covered calls). These derivatives are held in our trading portfolio and do not meet the criteria for hedge accounting.
Interest Rate Risk
Interest rate risk is the sensitivity of a fixed-rate instrument to changes in interest rates. When interest rates rise, the fair value of our fixed-rate investment securities declines.
The following table provides information about our fixed income investments, which are sensitive to changes in interest rates. The table presents cash flows of principal amounts and related weighted average interest rates by expected maturity dates for investments held in trading as of the periods presented (in thousands):
Average interest rate
United States government and agency securities are rated Aaa by Moody’s Investors Service, Inc., and AA+ by Standard and Poor’s Company.
Equity and Commodity Price Risk
Equity and commodity price risk is the potential for loss in fair value of investments in common stock, exchange-traded funds (ETF), and mutual funds from adverse changes in the prices of those instruments.
41
The following table provides information about the composition of equity securities, non-hedging derivatives and other investments held in the Company’s investment portfolio (in thousands):
A hypothetical decrease of 20% in the market prices of each of the equity securities, non-hedging derivatives, and other investments held at September 30, 2012, and December 31, 2011, would have resulted in decreases of $9.9 million and $19.2 million, respectively, in the fair value of the equity securities, non-hedging derivatives and other investment portfolio.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of the period covered by this report. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that disclosure controls and procedures were effective as of September 30, 2012, to ensure that information required to be disclosed by the Company in its reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control Over Financial Reporting
There was no change in the Company’s internal controls over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II — OTHER INFORMATION
Item 1. Legal Proceedings
We are subject to litigation in the normal course of our business. As of September 30, 2012, we were not a party to any non-routine litigation which is expected by management to have a material effect on our results of operations, financial condition or liquidity.
42
Item 1A. Risk Factors
In the opinion of management, other than the modification provided below to a risk factor that appeared in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, there have been no other material changes during the period covered by this Quarterly Report on Form 10-Q to the risk factors previously disclosed in Part I, Item 1A, “Risk Factors”, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
On April 17, 2012, Demotech, Inc. provided an update to guidance originally published in March 2010. Included in the update was a statement that Demotech will no longer provide full credit for the Mandatory Layer of the FHCF reinsurance coverage. As a result of this statement, the Company has modified the following risk factor that appeared in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The modification appears in bold.
Financial Stability Ratings® are important factors in establishing the competitive position of insurance companies and generally have an effect on an insurance company’s business. On an ongoing basis, rating agencies review the financial performance and condition of insurers and could downgrade or change the outlook on an insurer’s ratings due to, for example, a change in an insurer’s statutory capital; a change in a rating agency’s determination of the amount of risk-adjusted capital required to maintain a particular rating; a change in the perceived adequacy of an insurer’s reinsurance program; an increase in the perceived risk of an insurer’s investment portfolio; a reduced confidence in management or a host of other considerations that may or may not be under an insurer’s control. The current insurance Financial Stability Rating ® of UPCIC is from Demotech, Inc. The assigned rating is A. Because this rating is subject to continuous review, the retention of this rating cannot be assured. A downgrade in or withdrawal of this rating, or a decision by Demotech to require UPCIC’s parent company to make a capital infusion into UPCIC to maintain its rating, may adversely affect our liquidity, operating results and financial condition.
Item 6. Exhibits
Exhibit No.
Exhibit
43
In accordance with Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to the Quarterly Report on Form 10-Q shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or Exchange Act, except as shall be expressly set forth by specific reference in such filing.
44
SIGNATURES
In accordance with the requirements 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.
/s/ Bradley I. Meier
/s/ George R. De Heer
George R. De Heer, Chief Financial Officer (Principal
Accounting Officer)
45