Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our historical results of operations and our liquidity and capital resources should be read together with the consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, this Annual Report on Form 10-K contains “forward-looking statements.” You should review the “Special Note Regarding Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for factors and uncertainties that may cause our actual future results to be materially different from those in our forward-looking statements. Forward-looking statements in this Annual Report on Form 10-K are based on information available to us as of the date hereof, and we assume no obligation to update any such forward-looking statements.
Overview
We are a rapidly growing and innovative insurer focused on providing specialty insurance to residential and commercial customers. Our underwriting and analytical expertise allow us to concentrate on certain markets that we believe are underserved by other insurance companies, such as the markets for earthquake, hurricane and flood insurance. We use proprietary data analytics and a modern technology platform to offer our customers flexible products with customized and granular pricing for both the admitted and excess and surplus lines (“E&S”) markets.
We provide admitted insurance products through our Oregon domiciled insurance company, Palomar Specialty Insurance Company (“PSIC”), and non-admitted insurance products through our Arizona domiciled surplus lines insurance company, Palomar Excess and Surplus Insurance Company (“PESIC”). We distribute our products through multiple channels, including retail agents, program administrators, wholesale brokers, and partnerships with other insurance companies. Our business strategy is supported by a comprehensive risk transfer program with reinsurance coverage that we believe reduces earnings volatility and provides appropriate levels of protection from catastrophic events. Our management team combines decades of insurance industry experience across specialty underwriting, reinsurance, program administration, distribution, and analytics.
Founded in 2014, we have significantly grown our business and have generated attractive returns. We have organically increased gross written premiums from $16.6 million in our first year of operations to $354.4 million for the year ended December 31, 2020, which reflects a compound annual growth rate of approximately 66%. For the year ended December 31, 2020, we experienced average monthly premium retention rates above 93% for our Residential Earthquake and Hawaii Hurricane lines and approximately 87% overall across all lines of business, providing strong visibility into future revenue.
In February 2014, PSIC was awarded an “A−” rating from A.M. Best Company (“A.M. Best”), a leading rating agency for the insurance industry. An “A−” rating is categorized by A.M. Best as an excellent rating and indicates a stable outlook. In April 2020, A.M. Best affirmed the “A−” rating for PSIC and affirmed our “A−” group rating for Palomar Holdings, Inc. (“PHI”). In July 2020, PESIC was also awarded an “A−” rating by A.M. Best. These ratings reflect A.M. Best’s opinion of our financial strength, operating performance, and ability to meet obligations to policyholders and are not an evaluation directed towards the protection of investors.
We received regulatory approval for PESIC during the second quarter of 2020 and capitalized PESIC with approximately $100 million in initial surplus. PESIC is domiciled in the State of Arizona and licensed in Arizona to transact across all our existing lines of business. We believe that the underwriting acumen and market expertise we have established in the admitted insurance market is also applicable to the non-admitted market (also known as the “surplus lines” or “E&S” market), and that PESIC enables us to serve certain risks that our admitted products cannot currently satisfy. We began writing E&S business on a national basis during the third quarter of 2020.
We believe that our market opportunity, distinctive products, and differentiated business model position us to grow our business profitably.
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COVID-19 Update
The COVID-19 Pandemic ("the Pandemic") continues to impact businesses, households, communities, and financial markets.
In response to the Pandemic, we have been taking several actions to protect the health of the public and our employees while serving our policyholders and ensuring business continuity. Since March 2020, the majority of our employees have been working from home and we have put all business travel on hold indefinitely. We have implemented safeguards for employees in critical roles to ensure operational reliability and established safety protocols for employees who interact directly with the public. We also provide employees a reimbursement to help manage incremental costs associated with remote work. In addition, we are taking extra physical security and cybersecurity measures to safeguard our systems to serve the operational needs of our remote workforce and ensure uninterrupted service to our brokers and policyholders. We will continue to operate in this manner for the foreseeable future.
The mandated closures of certain business due to the Pandemic have caused a slowdown in certain sectors of the economy and a corresponding increase in unemployment. We have experienced an increase in the number of business interruption claims related to the Pandemic. Our All Risk and Commercial Earthquake (Difference in Conditions or “DIC”) policies offer business interruption coverage for insureds for a loss in business income caused by physical damage to the structure. Each of our All Risk policies has a virus and/or communicable disease exclusion. Our DIC policies require physical damage to the structure caused by the covered perils, whether it be an earthquake or flood. We are acknowledging, investigating, assessing and adjudicating each claim received and providing the policyholder requisite consideration.
Our results of operations depend, in part, on the performance of our investment portfolio. During 2020 we experienced volatility in the fair value of our investment portfolio due to unrealized losses and gains on our fixed income securities. The economic impacts of the Pandemic could reduce our net investment income and result in realized investment losses in future periods.
We have not seen a significant change in the growth rate of our gross written premiums since the beginning of the Pandemic. However, adverse events such as health-related concerns about working in our offices, the inability to travel, potential impact on our business partners and customers, and other matters affecting the general work and business environment could harm our business and impact the implementation of our business strategy. The macroeconomic effects of the Pandemic may persist for an indefinite period, even after the Pandemic has subsided and we cannot anticipate all the ways in which the Pandemic could adversely impact our business in the future.
Components of our results of operations
Gross Written Premiums
Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for policy acquisition costs, reinsurance costs or other deductions. The volume of our gross written premiums in any given period is generally influenced by:
● Volume of new business submissions in existing products or partnerships;
● Renewal rates of existing policies; and
● Average size and premium rate of bound policies.
Our gross written premiums are also impacted when we assume unearned in-force premiums due to new partnerships or other business reasons. In periods where we assume a large volume of unearned premiums, our gross
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written premiums may increase significantly compared to prior periods and the increase may not be indicative of future trends.
Ceded Written Premiums
Ceded written premiums are the amount of gross written premiums ceded to reinsurers. We enter into reinsurance contracts to limit our exposure to potential losses and to provide additional capacity for growth. We cede premiums primarily through excess of loss (“XOL”) agreements and quota share agreements. Ceded written premiums are earned pro-rata over the period of risk covered. The volume of our ceded written premiums is impacted by the amount of our gross written premiums and our decisions to increase or decrease limits or retention levels in our XOL agreements and co-participation levels in our quota share agreements.
Our ceded written premiums can be impacted significantly in certain periods due to changes in quota share agreements. In periods where we modify a quota share agreement, ceded written premiums may increase or decrease significantly compared to prior periods and these fluctuations may not be indicative of future trends. In addition, our XOL costs as a percentage of gross earned premiums vary over the life of XOL contracts due to changes of premium in force during the contract period.
Net Earned Premiums
Net earned premiums represent the earned portion of our gross written premiums, less the earned portion that is ceded to third-party reinsurers under our reinsurance agreements. Our insurance policies generally have a term of one year and premiums are earned pro rata over the term of the policy.
Commission and Other Income
Commission and other income consist of commissions earned on policies written on behalf of third-party insurance companies and where we have no exposure to the insured risk and certain fees earned in conjunction with underwriting policies. Commission and other income are earned on the effective date of the underlying policy.
Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses represent the costs incurred for losses, net of any losses ceded to reinsurers. These expenses are a function of the size and term of the insurance policies we write and the loss experience associated with the underlying coverage. Certain policies we write subject us to attritional losses such as building fires. In addition, most of the policies we write subject us to catastrophe losses. Catastrophe losses are certain losses resulting from events involving multiple claims and policyholders, including earthquakes, hurricanes, floods, convective storms, terrorist acts or other aggregating events. Our losses and loss adjustment expenses are generally affected by:
• The occurrence, frequency and severity of catastrophe events in the areas where we underwrite polices relating to these perils;
• The occurrence, frequency and severity of non-catastrophe attritional losses;
• The mix of business written by us;
• The reinsurance agreements we have in place at the time of a loss;
• The geographic location and characteristics of the policies we underwrite;
• Changes in the legal or regulatory environment related to the business we write;
• Trends in legal defense costs; and
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• Inflation in housing and construction costs.
Losses and loss adjustment expenses are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Losses and loss adjustment expenses may be paid out over multiple years.
Acquisition Expenses
Acquisition expenses are principally comprised of the commissions we pay retail agents, program administrators and wholesale brokers, net of ceding commissions we receive on business ceded under certain reinsurance contracts. In addition, acquisition expenses include premium-related taxes and other fees. Acquisition expenses related to each policy we write are deferred and expensed pro-rata over the term of the policy.
Other Underwriting Expenses
Other underwriting expenses represent the general and administrative expenses of our insurance operations including employee salaries and benefits, software and technology costs, office rent, stock-based compensation, licenses and fees, and professional services fees such as legal, accounting, and actuarial services.
Interest Expense
Interest expense consists primarily of interest expense on our surplus notes through September 2018 and our Floating Rate Notes after September 2018. In addition, we incurred interest expense related to prepayment penalties on the payoff of our surplus notes in September 2018 and related to the redemption premium paid on our Floating Rate Notes in May 2019.
Net Investment Income
We earn investment income on our portfolio of invested assets. Our invested assets are primarily comprised of fixed maturity securities, and may also include cash and cash equivalents, and equity securities. The principal factors that influence net investment income are the size of our investment portfolio, the yield on that portfolio and investment management expenses. As measured by amortized cost, which excludes changes in fair value caused by changes in interest rates, the size of our investment portfolio is mainly a function of our invested equity capital along with premium we receive from our insureds, less payments on policyholder claims and other operating expenses.
Net Realized and Unrealized Gains and Losses on Investments
Net realized and unrealized gains and losses on investments are a function of the difference between the amount received by us on the sale of a security and the security’s cost-basis, mark-to-market adjustments, and credit losses recognized in earnings.
Income Tax Expense
Currently our income tax expense consists mainly of federal income taxes imposed on our operations. Our effective tax rates are dependent upon the components of pretax earnings and the related tax effects.
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Key Financial and Operating Metrics
We discuss certain key financial and operating metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance.
Underwriting revenue is a non-GAAP financial measure defined as total revenue, excluding net investment income and net realized and unrealized gains and losses on investments. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of total revenue calculated in accordance with GAAP to underwriting revenue.
Underwriting income is a non-GAAP financial measure defined as income before income taxes excluding net investment income, net realized and unrealized gains and losses on investments and interest expense. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of income before income taxes calculated in accordance with GAAP to underwriting income.
Adjusted net income is a non-GAAP financial measure defined as net income excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook, net of tax impact. We calculate the tax impact only on adjustments which would be included in calculating our income tax expense using the estimated tax rate at which the company received a deduction for these adjustments. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of net income calculated in accordance with GAAP to adjusted net income.
Return on equity is net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period.
Adjusted return on equity is a non-GAAP financial measure defined as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of return on equity calculated using unadjusted GAAP numbers to adjusted return on equity.
Loss ratio, expressed as a percentage, is the ratio of losses and loss adjustment expenses, to net earned premiums.
Expense ratio, expressed as a percentage, is the ratio of acquisition and other underwriting expenses, net of commission and other income to net earned premiums.
Combined ratio is defined as the sum of the loss ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss.
Adjusted combined ratio is a non-GAAP financial measure defined as the sum of the loss ratio and the expense ratio calculated excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of combined ratio calculated using unadjusted GAAP numbers to adjusted combined ratio.
Diluted adjusted earnings per share is a non-GAAP financial measure defined as adjusted net income divided by the weighted-average common shares outstanding for the period, reflecting the dilution which could occur if equity-based awards are converted into common share equivalents as calculated using the treasury stock method. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of diluted earnings per share calculated in accordance with GAAP to diluted adjusted earnings per share.
Catastrophe loss ratio is a non-GAAP financial measure defined as the ratio of catastrophe losses to net earned premiums. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of loss ratio calculated using unadjusted GAAP numbers to catastrophe loss ratio.
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Adjusted combined ratio excluding catastrophe losses is a non-GAAP financial measure defined as adjusted combined ratio excluding the impact of catastrophe losses. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of combined ratio calculated using unadjusted GAAP numbers to adjusted combined ratio excluding catastrophe losses.
Tangible stockholders’ equity is a non-GAAP financial measure defined as stockholders’ equity less intangible assets. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of stockholders’ equity calculated in accordance with GAAP to tangible stockholders’ equity.
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Results of operations
Year ended December 31, 2020 compared to year ended December 31, 2019
The following table summarizes our results for the years ended December 31, 2020 and 2019:
Year Ended December 31, Percent
($ in thousands, except per share data)
Adjustments:
Stock-based compensation expense 2,167 24,103 (21,936) NM
Expenses associated with retirement of debt — 1,297 (1,297) NM
Expenses associated with catastrophe bond 399 — 399 NM
Key Financial and Operating Metrics
Annualized return on equity 2.1 % 6.7 %
Annualized adjusted return on equity (1) 3.0 % 24.1 %
Loss ratio 41.3 % 5.6 %
Expense ratio 61.2 % 85.7 %
Combined ratio 102.5 % 91.3 %
Adjusted combined ratio (1) 100.4 % 63.3 %
Diluted earnings per share $ 0.24 $ 0.49
Diluted adjusted earnings per share (1) $ 0.35 $ 1.73
Catastrophe losses $ 50,986 $ —
Catastrophe loss ratio (1) 32.9 % — %
NM-Not Meaningful
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Gross Written Premiums
Gross written premiums were $354.4 million for the year ended December 31, 2020 compared to $252.0 million for the year ended December 31, 2019, an increase of $102.4 million, or 40.6%. Premium growth was primarily due to an increased volume of policies written across our lines of business which was driven by new business generated with existing partners, strong premium retention rates for existing business, expansion of our products’ geographic and distribution footprint, and new partnerships. For commercial products, substantial rate increases also contributed to premium growth.
The following table summarizes our gross written premiums by line of business and shows each line’s percentage of total gross written premiums for each period:
Year Ended December 31,
($ in thousands)
% of % of
Amount GWP Amount GWP Change % Change
Product
During the twelve months ended December 31, 2019, we entered two new Residential Earthquake partnerships in which we assumed a total of $7.8 million of unearned premiums. Excluding the impact of these unearned premium assumptions, our Residential Earthquake gross written premiums increased by $18.3 million, or 14.9%.
During the fourth quarter of 2020, we ceased offering Commercial All Risk products on an admitted basis and will only offer them on an E&S basis going forward. This transition will impact the growth rate of our Commercial All Risk line in future periods. In addition, during the fourth quarter of 2020, we purchased the renewal rights of certain Hawaii Hurricane policies from another insurance company. We expect our Hawaii Hurricane written premiums to increase related to this purchase. However, there is no guarantee that policyholders will renew their policies with us and the ultimate impact to our future written premiums is uncertain.
Ceded Written Premiums
Ceded written premiums increased $46.8 million, or 43.2 %, to $155.1 million for the year ended December 31, 2020 from $108.3 million for the year ended December 31, 2019. The increase was primarily due to increased excess of loss reinsurance (“XOL”) expense commensurate with growth in exposure. In addition, catastrophe losses occurring in the third and fourth quarters of 2020 caused us to fully utilize portions of our XOL coverage. As a result, we incurred charges of $7.0 million during the fourth quarter of 2020 related to the acceleration of XOL expenses and the purchase and utilization of a backup XOL layer.
Premiums ceded under quota share arrangements also increased due to the growth in written premium lines subject to quota share arrangements. Ceded written premiums as a percentage of gross written premiums slightly increased to 43.8% for the year ended December 31, 2020 from 43.0% for the year ended December 31, 2019. This increase was primarily due to increased XOL expense offset by changes in our quota share agreements in our Specialty
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Homeowners and Commercial All Risk lines as we entered into new ceding arrangements on these lines which increased the percentage of premiums we retained.
Net Written Premiums
Net written premiums increased $55.6 million, or 38.7%, to $199.3 million for the year ended December 31, 2020 from $143.6 million for the year ended December 31, 2019. The increase was primarily due to higher gross written premiums, primarily in our Commercial Earthquake, Commercial All Risk, and Specialty Homeowners lines, offset by increased ceded written premiums.
Net Earned Premiums
Net earned premiums increased $54.9 million, or 54.7%, to $155.1 million for the year ended December 31, 2020 from $100.2 million for the year ended December 31, 2019 due primarily to the earned portion of the higher gross written premiums offset by the earned portion of the higher ceded written premiums. The table below shows the amount of premiums we earned on a gross and net basis for each period presented:
Year Ended
December 31,
($ in thousands)
Net earned premium ratio 51.4% 50.0%
Commission and Other Income
Commission and other income increased $0.6 million, or 23.4%, to $3.3 million for the year ended December 31, 2020 from $2.7 million for the year ended December 31, 2019 due primarily to an increase in policy related fees associated with an increased volume of premiums written.
Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses increased $58.5 million, or 1,046.3%, to $64.1 million for the year ended December 31, 2020 from $5.6 million for the year ended December 31, 2019. During the year ended December 31, 2020, losses were primarily attributable to catastrophe events occurring during the third and fourth quarters in our Specialty Homeowners and Commercial All Risk lines of business. During the year ended December 31, 2019, losses were primarily attributable to attritional losses in our Commercial All Risk and Specialty Homeowners lines of business and windstorm exposure in Japan through our assumed reinsurance portfolio.
Losses and loss adjustment expenses consisted of the following elements during the respective periods:
Year Ended
December 31,
($ in thousands)
Catastrophe losses $ 50,986 $ — $ 50,986 NM
Total losses and loss adjustment expenses $ 64,115 $ 5,593 $ 58,522 NM
NM- not meaningful
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Our catastrophe loss ratio was 32.9% during the year ended December 31, 2020. Catastrophe losses primarily included losses from Hurricanes Sally, Laura, Hanna and Zeta. We did not experience any catastrophe losses during the year ended December 31, 2019.
Our non-catastrophe loss ratio was 8.5% for the year ended December 31, 2020 compared to 5.6% during the year ended December 31, 2019. Non-catastrophe losses increased due mainly to a higher percentage of business in lines subject to attritional losses such as Commercial All Risk, Specialty Homeowners, and Inland Marine.
Acquisition Expenses
Acquisition expenses increased $26.8 million, or 71.9%, to $64.0 million for the year ended December 31, 2020 from $37.3 million for the year ended December 31, 2019. The primary reason for the increase was increased commissions and premium-related taxes due to higher earned premiums. Acquisition expenses as a percentage of gross earned premiums were 21.2% for the year ended December 31, 2020 compared to 18.6% for the year ended December 31, 2019. Acquisition expenses as a percentage of gross earned premiums increased due primarily to lower earned ceding commissions. Earned ceding commissions decreased due to changes in our Specialty Homeowners and All Risk ceding arrangements where we retained a higher percentage of premiums and received less ceding commission as a result. Acquisition expenses as a percentage of gross earned premiums fluctuates based on mix of business produced and quota share arrangements in place.
Other Underwriting Expenses
Other underwriting expenses decreased $17.2 million, or 33.6%, to $34.1 million for the year ended December 31, 2020 from $51.3 million for the year ended December 31, 2019. This decrease was primarily due to a decrease in expenses relating to unique items. During the prior year, the company incurred significant charges associated with an IPO, tax restructuring, secondary offerings, retirement of debt, and one-time incentive cash bonuses. The company also incurred a stock compensation charge of $23.0 million upon modification of its management incentive plan in the prior year.
Other underwriting expenses as a percentage of gross earned premiums were 11.3% for the year ended December 31, 2020 compared to 25.6% for the year ended December 31, 2019. Excluding the impact of expenses relating to our IPO, tax restructuring, secondary offerings, one-time incentive cash bonuses, stock-based compensation, retirement of debt, and catastrophe bonds, other underwriting expenses as a percentage of gross earned premiums were 10.2% for the year ended December 31, 2020 compared to 11.6% for the year ended December 31, 2019. This percentage decreased due to higher gross earned premiums without a proportional increase to expenses.
Interest Expense
Interest expense decreased to zero for the year ended December 31, 2020 from $1.1 million for the year ended December 31, 2019. We redeemed our Floating Rate Notes in May 2019 and did not have any long-term debt during the year ended December 31, 2020 whereas we had outstanding Floating Rate Notes during a portion of the year ended December 31, 2019.
Net Investment Income and Net Realized and Unrealized Gains (Losses) on Investments
Net investment income increased $2.6 million, or 44.1%, to $8.6 million for the year ended December 31, 2020 from $6.0 million for the year ended December 31, 2019. The increase was primarily due to a higher average balance of investments during the year ended December 31, 2020 due primarily to proceeds from our January and June 2020 stock offerings. The increase from a higher average investment balance was partially offset by lower yields on investments due to a lower interest rate environment in 2020 versus 2019.
Net realized and unrealized gains on investments decreased $3.0 million, to a $1.5 million gain for the year ended December 31, 2020 from a $4.4 million gain for the year ended December 31, 2019. We had a higher balance of
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equity securities during the prior year period and experienced appreciation on those equity securities during that period. We mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds with the remainder of investments in equity securities. Our equity securities are comprised of mutual funds that provide exposure to the U.S. investment-grade bond market. The following table summarizes the components of our investment income for each period presented:
Year Ended
December 31,
($ in thousands)
Investment management fees and expenses (431) (343) (88) 25.7 %
Income Tax Expense (Benefit)
The company had an immaterial income tax benefit for the year ended December 31, 2020 compared to a $7.5 million expense for the year ended December 31, 2019 primarily because of lower pre-tax income during the year ended December 31, 2020. During the year ended December 31, 2020, our income tax rate differed from the statutory rate of 21% due primarily to the tax impact of the permanent component of employee stock option exercises. For the year ended December 31, 2019, our income tax expense was significantly impacted by the reversal of our U.S. federal deferred tax valuation allowance in March 2019, offset by an addback related to a nondeductible stock compensation charge incurred upon the modification of our management incentive plan in March 2019.
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Year ended December 31, 2019 compared to year ended December 31, 2018
The following table summarizes our results for the years ended December 31, 2019 and 2018:
Year Ended December 31, Percent
($ in thousands except per share data)
Income tax expense (benefit) 7,456 (6) 7,462 NM %
Adjustments:
Stock-based compensation expense 24,103 — 24,103 NM
Expenses associated with retirement of debt 1,297 495 802 NM
Tax impact (1,149) — (1,149) NM
Key Financial and Operating Metrics
Annualized return on equity 6.7 % 20.9 %
Annualized adjusted return on equity (1) 24.1 % 22.7 %
Loss ratio 5.6 % 9.0 %
Expense ratio 85.7 % 62.6 %
Combined ratio 91.3 % 71.6 %
Adjusted combined ratio (1) 63.3 % 69.5 %
Diluted earnings per share $ 0.49 $ 1.07
Diluted adjusted earnings per share (1) $ 1.73 $ 1.17
Catastrophe losses $ — $ 5,000
Catastrophe loss ratio (1) — % 7.2 %
NM- Not Meaningful
Gross Written Premiums
Gross written premiums were $252.0 million for the year ended December 31, 2019 compared to $154.9 million for the year ended December 31, 2018, an increase of $97.1 million, or 62.7%. Premium growth was primarily
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due to an increased volume of policies written across our lines of business which was driven by new business generated with existing partners, strong premium retention rates for existing business, expansion of our products’ distribution footprint, and new partnerships. The following table summarizes our gross written premiums by line of business and shows each line’s percentage of total gross written premiums for each period:
Year Ended December 31,
($ in thousands)
% of % of
Amount GWP Amount GWP Change % Change
Product
Inland Marine 2,465 1.0 % — — % 2,465 NM %
NM- not meaningful
Approximately $19.4 million of the increase to Residential Earthquake premiums was due to a new partnership with a homeowners carrier in which we assumed $6.6 million of unearned premiums and wrote an additional $12.8 million in premiums.
Ceded Written Premiums
Ceded written premiums increased $25.4 million, or 30.6%, to $108.3 million for the year ended December 31, 2019 from $82.9 million for the year ended December 31, 2018. The increase was primarily due to increased cessions to new quota share reinsurance partners in our Commercial All Risk line. We also incurred increased excess of loss reinsurance expense commensurate with growth in exposure. Ceded written premiums as a percentage of gross written premiums decreased to 43.0% for the year ended December 31, 2019 from 53.6% for the year ended December 31, 2018. The cession percentage was higher in the prior year due to an $11.8 million transfer of unearned premiums in June 2018 related to our entering into a fronting arrangement in our Specialty Homeowners line in the state of Texas. This fronting arrangement terminated in June 2019 in conjunction with the inception of our Specialty Homeowners Facility (“SHF”).
Net Written Premiums
Net written premiums increased $71.7 million, or 99.6%, to $143.6 million for the year ended December 31, 2019 from $71.9 million for the year ended December 31, 2018. The increase was primarily due to higher gross written premiums, primarily in our Residential Earthquake, Commercial Earthquake and Commercial All Risk lines, offset by increased ceded written premiums.
Net Earned Premiums
Net earned premiums increased $30.3 million, or 43.4%, to $100.2 million for the year ended December 31, 2019 from $69.9 million for the year ended December 31, 2018 due primarily to the earned portion of the higher gross written premiums offset by the earned portion of the higher ceded written premiums under reinsurance agreements.
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The table below shows the amount of premiums we earned on a gross and net basis for each period presented:
Year Ended
December 31,
($ in thousands)
Net earned premium ratio 50.0% 50.7%
Commission and Other Income
Commission and other income increased $0.3 million, or 11.1%, to $2.7 million for the year ended December 31, 2019 from $2.4 million for the year ended December 31, 2018 due primarily to an increase in policy related fees associated with an increased volume of premiums written.
Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses decreased $0.7 million, or 10.9%, to $5.6 million for the year ended December 31, 2019 from $6.3 million for the year ended December 31, 2018.
Losses and loss adjustment expenses consisted of the following elements during the respective periods:
Year Ended
December 31,
($ in thousands)
Catastrophe losses $ — $ 5,000 $ (5,000) NM
Total losses and loss adjustment expenses $ 5,593 $ 6,274 $ (681) (10.9) %
NM- not meaningful
During the year ended December 31, 2019, losses were primarily attributable to attritional losses in our Commercial All Risk and Specialty Homeowners lines of business and windstorm exposure in Japan through our assumed reinsurance portfolio. During the year ended December 31, 2018, losses were primarily attributable a $5 million catastrophe loss from Hurricane Florence and attritional losses in our Commercial All Risk and Specialty Homeowners lines of business. Losses decreased during the year ended December 31, 2019 due to a reduction in the severity of weather-related losses.
Our non-catastrophe loss ratio was 5.6% for the year ended December 31, 2019 compared to 1.8% during the year ended December 31, 2018. Non-catastrophe losses increased due mainly to a higher percentage of business in lines subject to attritional losses such as Commercial All Risk, Specialty Homeowners, and Inland Marine and due to losses on our assumed reinsurance portfolio.
Acquisition Expenses
Acquisition expenses increased $9.1 million, or 32.0%, to $37.3 million for the year ended December 31, 2019 from $28.2 million for the year ended December 31, 2018. The primary reason for the increase was higher earned premiums which resulted in higher commissions and premium-related taxes. Acquisition expenses as a percentage of gross earned premiums were 18.6% for the year ended December 31, 2019 compared to 20.5% for the year ended December 31, 2018. Acquisition expenses as a percentage of gross earned premiums decreased due to higher earned ceding commissions related to our Specialty Homeowners and Commercial All Risk lines.
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Other Underwriting Expenses
Other underwriting expenses increased $33.3 million, or 185.7%, to $51.3 million for the year ended December 31, 2019 from $18.0 million for the year ended December 31, 2018. During the year ended December 31, 2019, we incurred increased payroll, professional fees, technology expenses, stock-based compensation and other expenses necessary to support our growth. During the year ended December 31, 2019, other underwriting expenses included a stock compensation charge of $23.0 million related to the modification of our former parent company’s management incentive plan, $0.4 million of expenses associated with our IPO and tax restructuring, a $0.9 million charge related to the write-off of debt amortization costs upon redemption of our Floating Rate Notes, and $2.6 million of expenses from one-time incentive cash bonuses triggered by the September 2019 Secondary Offering and expenses associated with both Secondary Offerings. During the year ended December 31, 2018, other underwriting expenses included $1.1 million of expenses associated with our IPO and tax restructuring and $0.5 million of expenses related to the repayment of our surplus notes in September 2018.
Other underwriting expenses as a percentage of gross earned premiums were 25.6% for the year ended December 31, 2019 compared to 13.0% for the year ended December 31, 2018. Excluding the impact of expenses relating to our IPO, tax restructuring, Secondary Offerings, one-time incentive cash bonuses, stock-based compensation and retirement of debt, other underwriting expenses as a percentage of gross earned premiums were 11.6% for the year ended December 31, 2019 compared to 12.0% for the year ended December 31, 2018. This percentage decreased due to higher gross earned premiums without a proportional increase to expenses.
Interest Expense
Interest expense decreased $1.2 million, or 53.6%, to $1.1 million for the year ended December 31, 2019 from $2.3 million for the year ended December 31, 2018. Interest expense decreased as we redeemed our Floating Rate Notes in May 2019 and did not have any long-term debt after May 2019 whereas we had outstanding surplus notes and Floating Rate Notes during the entire year ended December 31, 2018. In addition, interest expense for the year ended December 31, 2019 includes a $0.4 million charge incurred upon redemption of our Floating Rate Notes in May 2019. Interest expense for the year ended December 31, 2018 includes a $0.1 million charge incurred upon repayment of our surplus notes in September 2018.
Net Investment Income and Net Realized and Unrealized Gains (Losses) on Investments
Net investment income increased $2.8 million, or 84.5%, to $6.0 million for the year ended December 31, 2019 from $3.2 million for the year ended December 31, 2018. The primary reason for the increase was a higher average balance of investments during the year ended December 31, 2019 due primarily to proceeds from our IPO which were received in April 2019.
Net realized and unrealized gains on investments increased $7.0 million, or 272.9%, to a $4.4 million gain for the year ended December 31, 2019 from a loss of $2.6 million for the year ended December 31, 2018. The primary reason for the increase was an improvement in the performance of our equity securities during the year ended December 31, 2019 compared to the year ended December 31, 2018. We mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and
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corporate bonds with the remainder of investments in equity securities. The following table summarizes the components of our investment income for the years ended December 31, 2019 and 2018:
Year Ended
December 31,
($in thousands)
Less: investment management fees and expenses (343) (312) (31) 9.9 %
Income Tax Expense (Benefit)
Income tax expense increased to $7.5 million for the year ended December 31, 2019 from an immaterial amount for the year ended December 31, 2018 as a result of positive taxable income during the year ended December 31, 2019 occurring after our U.S. domestication in March 2019 partially offset by the benefit from the reduction of the valuation allowance on our federal deferred tax assets. For the year ended December 31, 2019, our income tax expense was significantly impacted by the reversal of our U.S. federal deferred tax valuation allowance in March 2019, offset by an addback related to a nondeductible stock compensation charge incurred upon the modification of our management incentive plan in March 2019.
We are subject to income taxes in certain jurisdictions in which we operate. Our U.S. subsidiaries are subject to federal and state income taxes. We earn income in Bermuda, a non-taxable jurisdiction, primarily as a result of quota share reinsurance agreements between our U.S. insurance subsidiary and PSRE, and the investment income earned in PSRE. Prior to July 1, 2019, our U.S. insurance subsidiary and PSRE were subject to a quota share reinsurance agreement under which the U.S. insurance subsidiary ceded 50% of the earthquake and Hawaii hurricane gross premiums earned as well as losses and loss adjustment expenses to PSRE in exchange for a 25% ceding commission.
As a result of our multinational operations our effective tax rate has historically been below that of a fully U.S. based operation. All of our operations became subject to U.S. income tax in 2019 as a result of our domestication to the United States.
Reconciliation of Non-GAAP Financial Measures
Underwriting Revenue
We define underwriting revenue as total revenue excluding net investment income and net realized and unrealized gains and losses on investments. Underwriting revenue represents revenue generated by our underwriting operations and allows us to evaluate our underwriting performance without regard to investment income. We use this metric as we believe it gives our management and other users of our financial information useful insight into our
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underlying business performance. Underwriting revenue should not be viewed as a substitute for total revenue calculated in accordance with GAAP, and other companies may define underwriting revenue differently.
Total revenue calculated in accordance with GAAP reconciles to underwriting revenue as follows:
Year Ended
December 31,
(in thousands)
Underwriting Income
We define underwriting income as income before income taxes excluding net investment income, net realized and unrealized gains and losses on investments, and interest expense. Underwriting income represents the pre-tax profitability of our underwriting operations and allows us to evaluate our underwriting performance without regard to investment income. We use this metric as we believe it gives our management and other users of our financial information useful insight into our underlying business performance. Underwriting income should not be viewed as a substitute for pre-tax income calculated in accordance with GAAP, and other companies may define underwriting income differently.
Income before income taxes calculated in accordance with GAAP reconciles to underwriting income as follows:
Year Ended
December 31,
(in thousands)
Interest expense — 1,068 2,303
Adjusted Net Income
We define adjusted net income as net income excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook, net of tax impact. We calculate the tax impact only on adjustments which would be included in calculating our income tax expense using the estimated tax rate at which the company received a deduction for these adjustments. We use adjusted net income as an internal performance measure in the management of our operations because we believe it gives our management and financial statement users useful insight into our results of operations and our underlying business performance. Adjusted net income does not reflect the overall profitably of our business and should not be viewed as a substitute for net income calculated in accordance with GAAP. Other companies may define adjusted net income differently.
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Net income calculated in accordance with GAAP reconciles to adjusted net income as follows:
Year Ended December 31,
(in thousands)
Adjustments:
Stock-based compensation expense 2,167 24,103 —
Expenses associated with retirement of debt — 1,297 495
Expenses associated with catastrophe bond 399 — —
Tax impact (664) (1,149) —
Adjusted Return on Equity
We define adjusted return on equity as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. We use adjusted return on equity as an internal performance measure in the management of our operations because we believe it gives our management and financial statement users useful insight into our results of operations and our underlying business performance. Adjusted return on equity should not be viewed as a substitute for return on equity calculated using unadjusted GAAP numbers, and other companies may define adjusted return on equity differently.
Adjusted return on equity is calculated as follows:
Year Ended December 31,
($ in thousands)
Adjusted return on equity 3.0 % 24.1 % 22.7 %
Adjusted Combined Ratio
We define adjusted combined ratio as the sum of the loss ratio and the expense ratio calculated excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook. We use adjusted combined ratio as an internal performance measure in the management of our operations because we believe it gives our management and financial statement users useful insight into our results of operations and our underlying business performance. Adjusted combined ratio should not be viewed as a substitute for combined ratio calculated using unadjusted GAAP numbers, and other companies may define adjusted combined ratio differently.
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Adjusted combined ratio is calculated as follows:
Year Ended December 31,
($ in thousands)
Adjustments to numerator:
Stock-based compensation expense (2,167) (24,103) —
Expenses associated with catastrophe bond (399) — —
Adjusted combined ratio 100.4 % 63.3 % 69.5 %
Diluted adjusted earnings per share
We define diluted adjusted earnings per share as adjusted net income divided by the weighted-average common shares outstanding for the period, reflecting the dilution which could occur if equity-based awards are converted into common share equivalents as calculated using the treasury stock method. We use diluted adjusted earnings per share as an internal performance measure in the management of our operations because we believe it gives our management and financial statement users useful insight into our results of operations and our underlying business performance. Diluted adjusted earnings per share should not be viewed as a substitute for diluted earnings per share calculated in accordance with GAAP, and other companies may define diluted adjusted earnings per share differently.
Diluted adjusted earnings per share is calculated as follows:
Year Ended December 31,
(in thousands except shares and per share data)
Diluted adjusted earnings per share $ 0.35 $ 1.73 $ 1.17
Catastrophe Loss Ratio
Catastrophe loss ratio is defined as the ratio of catastrophe losses to net earned premiums. Although we are inherently subject to catastrophe losses, the frequency and severity of catastrophe losses is unpredictable and their impact on our operating results may vary significantly between periods and obscure other trends in our business. Therefore, we are providing this metric because we believe it gives our management and other financial statement users useful insight into our results of operations and trends in our financial performance without the volatility caused by catastrophe losses. Catastrophe loss ratio should not be viewed as a substitute for loss ratio calculated using unadjusted GAAP numbers, and other companies may define catastrophe loss ratio differently.
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Catastrophe loss ratio is calculated as follows:
Year Ended December 31,
($ in thousands)
Numerator: Losses and loss adjustment expenses $ 64,115 $ 5,593 $ 6,274
Numerator: Catastrophe losses $ 50,986 $ — $ 5,000
Catastrophe loss ratio 32.9 % 0.0 % 7.2 %
Adjusted Combined Ratio Excluding Catastrophe Losses
Adjusted combined ratio excluding catastrophe losses is defined as adjusted combined ratio excluding the impact of catastrophe losses. Although we are inherently subject to catastrophe losses, the frequency and severity of catastrophe losses is unpredictable and their impact on our operating results may vary significantly between periods and obscure other trends in our business. Therefore, we are providing this metric because we believe it gives our management and other financial statement users useful insight into our results of operations and trends in our financial performance without the volatility caused by catastrophe losses. Adjusted combined ratio excluding catastrophe losses should not be viewed as a substitute for combined ratio calculated using unadjusted GAAP numbers, and other companies may define adjusted combined ratio excluding catastrophe losses differently.
Adjusted combined ratio excluding catastrophe losses is calculated as follows:
Year Ended December 31,
($ in thousands)
Adjustments to numerator:
Stock-based compensation expense (2,167) (24,103) —
Expenses associated with catastrophe bond (399) — —
Catastrophe losses (50,986) — (5,000)
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Tangible Stockholders’ Equity
We define tangible stockholders’ equity as stockholders’ equity less intangible assets. Our definition of tangible stockholders’ equity may not be comparable to that of other companies, and it should not be viewed as a substitute for stockholders’ equity calculated in accordance with GAAP. We use tangible stockholders’ equity internally to evaluate the strength of our balance sheet and to compare returns relative to this measure.
Stockholders’ equity calculated in accordance with GAAP reconciles to tangible stockholders’ equity as follows:
December 31,
(in thousands)
Liquidity and Capital Resources
Sources and Uses of Funds
We operate as a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders and pay taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries and affiliates, whose ability to pay us is highly regulated.
The Company’s U.S. insurance company subsidiaries, PSIC and PESIC are restricted by the statutes as to the amount of dividends that they may pay without prior approval by state insurance commissioners.
Under California and Oregon statute which govern PSIC, dividends paid in a consecutive twelve month period cannot exceed the greater of (i) 10% of an insurance company’s statutory policyholders’ surplus as of December 31 of the preceding year or (ii) 100% of its statutory net income for the preceding calendar year. Any dividends or distributions in excess of these amounts would require regulatory approval. In addition, under Oregon statute PSIC may only declare a dividend from earned surplus, which does not include contributed capital. Surplus arising from unrealized capital gains or revaluation of assets is not considered part of earned surplus. Based on the above restrictions, PSIC may pay a dividend or distribution of no greater than $11.3 million in 2021 without approval by the California and Oregon Insurance Commissioners.
Under Arizona statute with governs PESIC, dividends paid in a consecutive twelve month period cannot exceed the lesser of (i) 10% of an insurance company’s statutory policyholders’ surplus as of December 31 of the preceding year or (ii) 100% of its statutory net income for the preceding calendar year. As such, PESIC is unable to pay a dividend or distribution in 2021 without the approval of the Arizona Insurance Commissioner as it had a statutory net loss in 2020.
In addition to the above limitations, any dividend or distribution declared is also subject to state regulatory approval prior to payment. In the future, state insurance regulatory authorities may adopt statutory provisions and dividend limitations more restrictive than those currently in effect.
Insurance companies in the United States are also required by state law to maintain a minimum level of policyholder’s surplus. State insurance regulators have a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of the insurer’s assets and liabilities and its mix of net written premium. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2020 and December 31, 2019, the total adjusted capital of PSIC and PESIC were in excess of their respective prescribed risk-based capital requirements.
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Under the Insurance Act and related regulations, our Bermuda reinsurance subsidiary is required to maintain certain solvency and liquidity levels, which it maintained as of December 31, 2020 and December 31, 2019.
Our Bermuda reinsurance subsidiary maintains a Class 3A license and thus must maintain a minimum liquidity ratio in which the value of its relevant assets is not less than 75% of the amount of its relevant liabilities for general business. Relevant assets include cash and cash equivalents, fixed maturity securities, accrued interest income, premiums receivable, losses recoverable from reinsurers, and funds withheld. The relevant liabilities include total general business insurance reserves and total other liabilities, less sundry liabilities. As of December 31, 2020 and December 31, 2019, we met the minimum liquidity ratio requirement.
Bermuda regulations limit the amount of dividends and return of capital paid by a regulated entity. A Class 3A insurer is prohibited from declaring or paying a dividend if it is in breach of its minimum solvency margin, its enhanced capital requirement, or its minimum liquidity ratio, or if the declaration or payment of such dividend would cause such a breach. If a Class 3A insurer has failed to meet its minimum solvency margin on the last day of any financial year, it will also be prohibited, without the approval of the BMA, from declaring or paying any dividends during the next financial year. Furthermore, the Insurance Act limits the ability of our Bermuda reinsurance subsidiary to pay dividends or make capital distributions by stipulating certain margin and solvency requirements and by requiring approval from the BMA prior to a reduction of 15% or more of a Class 3A insurer’s total statutory capital as reported on its prior year statutory balance sheet. Moreover, an insurer must submit an affidavit to the BMA, sworn by at least two directors and the principal representative in Bermuda of the Class 3A insurer, at least seven days prior to payment of any dividend which would exceed 25% of that insurer’s total statutory capital and surplus as reported on its prior year statutory balance sheet. The affidavit must state that in the opinion of those swearing the declaration of such dividend has not caused the insurer to fail to meet its relevant margins.
Further, under the Companies Act, our Bermuda reinsurance subsidiary may only declare or pay a dividend, or make a distribution out of contributed surplus, if it has no reasonable grounds for believing that: (1) it is, or would after the payment be, unable to pay its liabilities as they become due or (2) the realizable value of its assets would be less than its liabilities.
Pursuant to Bermuda regulations, the maximum amount of dividends and return of capital available to be paid by a reinsurer is determined pursuant to a formula. Under this formula, the maximum amount of dividends and return of capital available from our Bermuda subsidiary during 2021 is calculated to be approximately $10.5million. However, this dividend amount is subject to annual enhanced solvency requirement calculations. There were no dividends approved or paid in 2020 or 2019.
One of our insurance company subsidiaries, PSIC, is a member of the Federal Home Loan Bank of San Francisco (FHLB). Membership allows PSIC access to collateralized advances, which may be used to support and enhance liquidity management. The amount of advances that may be taken is dependent on statutory admitted assets. As of December 31, 2020, there are no advances outstanding under the FHLB facility.
Cash Flows
Our primary sources of cash flow are written premiums, investment income, reinsurance recoveries, sales and redemptions of investments, and proceeds from offerings of debt and equity securities. We use our cash flows primarily to pay operating expenses, losses and loss adjustment expenses, and income taxes.
Our cash flows from operations may differ substantially from our net income due to non-cash charges or due to changes in balance sheet accounts.
The timing of our cash flows from operating activities can also vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant. Therefore, their timing can influence cash flows from operating activities in any given period. The potential for a large claim under an insurance or reinsurance contract means that our insurance
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subsidiaries may need to make substantial payments within relatively short periods of time, which would have a negative impact on our operating cash flows.
We generated positive cash flows from operations for each of the years ended December 31, 2020, 2019 and 2018. Management believes that cash receipts from premium, proceeds from investment sales and redemptions, and investment income and reinsurance recoveries, if necessary, are sufficient to cover cash outflows in the foreseeable future.
The following table summarizes our cash flows for the years ended December 31, 2020, 2019 and 2018:
Year Ended December 31,
($ in thousands)
Cash provided by (used in):
Our cash flow from operating activities has been positive in each of the last three years. Variations in operating cash flow between periods are primarily driven by variations in our gross and ceded written premiums and the volume and timing of premium receipts, claim payments, and reinsurance payments. In addition, fluctuations in losses and loss adjustment expenses and other insurance operating expenses impact operating cash flow.
Cash used in investing activities for each of the last three years related primarily to purchases of fixed income and equity securities in excess of sales and maturities.
Cash provided by financing activities for year ended December 31, 2020 was related to the receipt of $35.5 million in net proceeds from the January 2020 stock offering, the receipt of $90.1 million in net proceeds from the June 2020 stock offering, the receipt of $0.7 million in proceeds related to the issuance of common stock via our employee stock purchase plan, and the receipt of $2.0 million related to the issuance of common stock via stock option exercises. Cash provided by financing activities for the year ended December 31, 2019 was related to the receipt of $87.4 million in net proceeds from our IPO in April 2019, offset by $20.0 million of cash paid to redeem our Floating Rate Notes in May 2019 and a one-time cash distribution of $5.1 million to our then sole stockholder, GC Palomar Investor LP in March 2019. Cash provided by financing activities in 2018 was related to the issuance of Floating Rate Notes and the payoff of surplus notes in September 2018.
We do not have any current plans for material capital expenditures other than current operating requirements. We believe that we will generate sufficient cash flows from operations to satisfy our liquidity requirements for at least the next 12 months and beyond. The key factor that will affect our future operating cash flows is the frequency and severity of catastrophic loss events. To the extent our future operating cash flows are insufficient to cover our net losses from catastrophic events, we had $456.1 million in cash and investment securities available at December 31, 2020. We also have the ability to access additional capital through pursuing third-party borrowings, sales of our equity or debt securities or entrance into a reinsurance arrangement.
Notes Payable
Surplus Notes
Prior to September 2018, the Company had $17.5 million in outstanding surplus notes which had been issued by PSIC on February 3, 2015 for a term of seven years. The surplus notes bore interest at the rate of LIBOR plus 8.00% and had restrictions as to payments of interest and principal. Any such payments required the prior approval of the
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Oregon Insurance Commissioners before such payments could be made. Such payments could only be made from surplus.
Floating Rate Notes
In September 2018, the Company completed a private placement financing of $20.0 million floating rate senior secured notes (the “Floating Rate Notes”), bearing interest at the three-month treasury rate plus 6.50% per annum. As part of the financing agreement, the Company immediately used surplus funds to pay down the existing $17.5 million in surplus notes. As part of this pre-payment, the Company incurred a penalty of $0.1 million which, along with unamortized debt issuance costs of $0.4 million, was charged to income in 2018.
The Floating Rate Notes were redeemed pursuant to their terms on May 23, 2019, at a redemption price equal to 102% of the principal amount of the Floating Rate Notes, or $20.4 million (plus $0.3 million of accrued and unpaid interest thereon). The Company recognized a charge of $1.3 million upon redemption with $0.4 million due to the redemption premium and $0.9 million due to the write-off of unamortized debt issuance costs. The $0.4 million redemption premium was recognized as a component of interest expense and the $0.9 million issuance cost write-off was recognized as a component of other underwriting expenses in the Company’s consolidated statements of income and comprehensive income.
The Company incurred $1.1 million in interest expense related to the Floating Rate Notes for the year ended December 31, 2019 (inclusive of the $0.4 million redemption premium) and $0.6 million for the year ended December 31, 2018 and paid $1.2 million and $0.5 million for each period, respectively. The Company incurred and paid $1.2 million in interest expense related to the surplus notes for the year ended December 31, 2018.
Contractual Obligations and Commitments
The following table illustrates our contractual obligations and commercial commitments by due date as of December 31, 2020:
One Year Three Years
Less Than to Less Than to Less Than More Than
Total One Year Three Years Five Years Five Years
(in thousands)
The reserve for losses and loss adjustment expenses represent management’s estimate of the ultimate cost of settling losses. As more fully discussed in “—Critical Accounting Policies—Reserve for Losses and Loss Adjustment Expenses” below, the estimation of the reserve for losses and loss adjustment expenses is based on various complex and subjective judgments. Actual losses paid may differ, perhaps significantly, from the reserve estimates reflected in our consolidated financial statements. Similarly, the timing of payment of our estimated losses is not fixed and there may be significant changes in actual payment activity. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid can be significantly different from the amounts disclosed above.
The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2020 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts of obligations paid by us in the time periods shown will be greater than those indicated in the table.
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Financial Condition
Stockholders’ Equity
At December 31, 2020 total stockholders’ equity was $363.7 million and tangible stockholders’ equity was $352.2 million, compared to total stockholders’ equity of $218.6 million and tangible stockholders’ equity of $217.8 million as of December 31, 2019. Stockholder’s equity increased primarily due to net income, receipt of proceeds from our January 2020 and June 2020 common stock offerings, and unrealized gains on fixed maturity securities. It also increased due to issuance of common stock and stock-based compensation expense from our equity compensation plans. Stock-based compensation expense is treated as an additional paid-in-capital and increases stockholder’s equity.
Tangible stockholders’ equity is a non-GAAP financial measure. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of stockholders’ equity in accordance with GAAP to tangible stockholders’ equity.
Investment Portfolio
Our primary investment objectives are to maintain liquidity, preserve capital and generate a stable level of investment income. We purchase securities that we believe are attractive on a relative value basis and seek to generate returns in excess of predetermined benchmarks. Our Board of Directors approves our investment guidelines in compliance with applicable regulatory restrictions on asset type, quality and concentration. Our current investment guidelines allow us to invest in taxable and tax-exempt fixed maturities, as well as publicly traded mutual funds and common stock of individual companies. Our cash and invested assets consist of cash and cash equivalents, fixed maturity securities, and equity securities. As of December 31, 2020, the majority of our investment portfolio, or $398.0 million, was comprised of fixed maturity securities that are classified as available-for-sale and carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. Also included in our investment portfolio were $24.3 million of equity securities, primarily comprised of mutual funds that provide exposure to the U.S. investment-grade bond market. In addition, we maintained a non-restricted cash and cash equivalent balance of $33.5 million at December 31, 2020. Our fixed maturity securities, including cash equivalents, had a weighted average effective duration of 3.96 and 3.49 years and an average rating of “A2/A” and “A1/A+” at December 31, 2020 and December 31, 2019, respectively. Our fixed income investment portfolio had a book yield of 2.27% as of December 31, 2020, compared to 2.90% as of December 31, 2019.
At December 31, 2020 and December 31, 2019 the amortized cost and fair value on available-for-sale securities were as follows:
Amortized Fair % of Total
December 31, 2020 Cost or Cost Value Fair Value
($ in thousands)
Fixed maturities:
States, territories, and possessions 6,208 6,636 1.7 %
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Amortized Fair % of Total
December 31, 2019 Cost or Cost Value Fair Value
($ in thousands)
Fixed maturities:
States, territories, and possessions 2,298 2,445 1.1 %
The following tables provide the credit quality of investment securities as of December 31, 2020 and December 31, 2019:
Estimated % of
December 31, 2020 Fair Value Total
($ in thousands)
Rating
Estimated % of
December 31, 2019 Fair Value Total
($ in thousands)
Rating
The amortized cost and fair value of our available-for-sale investments in fixed maturity securities summarized by contractual maturity as of December 31, 2020 were as follows:
Amortized Fair % of Total
December 31, 2020 Cost Value Fair Value
($ in thousands)
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. See “Critical Accounting Policies and Estimates- Investment Valuation and Fair Value” for discussion of investment valuation considerations.
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Critical Accounting Policies and Estimates
We identified the accounting estimates below as critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and which require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. For a detailed discussion of our accounting policies, see the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K.
Reserve for Losses and Loss Adjustment Expenses
The reserve for losses and loss adjustment expenses represents our estimated ultimate cost of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. We do not discount this reserve. We seek to establish reserves that will ultimately prove to be adequate.
We categorize our reserves for unpaid losses and loss adjustment expenses into two types: case reserves and reserves for incurred but not yet reported losses (“IBNR”). Through our third-party administrators (“TPAs”), we generally are notified of losses by our insureds or their agents or brokers. Based on the information provided by the TPAs, we establish initial case reserves by estimating the ultimate losses from the claim, including administrative costs associated with the ultimate settlement of the claim. Our personnel use their knowledge of the specific claim along with internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses.
We establish IBNR reserves to provide for (i) the estimated amount of future loss payments on incurred claims not yet reported, and (ii) potential development on reported claims. IBNR reserves are estimated based on generally accepted actuarial reserving techniques that consider quantitative loss experience data and, where appropriate, qualitative factors. With the assistance of an independent actuarial firm, we use statistical analysis to estimate the cost of losses and loss adjustment expenses related to IBNR. Those estimates are based on our historical information, industry information and practices, and estimates of trends that may affect the ultimate frequency of incurred but not reported claims and changes in ultimate claims severity.
We regularly review our reserve estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in current operations. During the loss settlement period, if we have indications that claims frequency or severity exceeds our initial expectations, we generally increase our reserves for losses and loss adjustment expenses. Conversely, when claims frequency and severity trends are more favorable than initially anticipated, we generally reduce our reserves for losses and loss adjustment expenses once we have sufficient data to confirm the validity of the favorable trends. Even after such adjustments, the ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimate included in our consolidated financial statements.
The following tables summarize our gross and net reserves for unpaid losses and loss adjustment expenses at December 31, 2020 and 2019.
Gross % of Total Net % of Total
Loss and Loss Adjustment Reserves ($ in thousands)
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Gross % of Total Net % of Total
Loss and Loss Adjustment Reserves
The process of estimating the reserves for losses and loss adjustment expenses requires a high degree of judgment and is subject to several variables. On a quarterly basis, we perform an analysis of our loss development and select the expected ultimate loss ratio for each of our product lines by accident year. In our actuarial analysis, we use input from our TPAs and our underwriting departments, including premium pricing assumptions and historical experience. Multiple actuarial methods are used to estimate the reserve for losses and loss adjustment expenses. These methods utilize, to varying degrees, the initial expected loss ratio, detailed statistical analysis of past claims reporting and payment patterns, claims frequency and severity, paid loss experience, industry loss experience, and changes in market conditions, policy forms, exclusions, and exposures. The actuarial methods used to estimate loss and loss adjustment expenses reserves are:
The method(s) used vary based on the line of business and the nature of the loss event. Development patterns for catastrophic events are based on the time since event versus an accident quarter and year pattern used for non-catastrophic events. Considering each of the alternative ultimate estimates, we select an estimate of ultimate loss for each line of business. For Earthquake and “Difference in Conditions” policies, more emphasis is placed on reported methods. For the remainder, a weighted average is selected.
Loss Adjustment Expense reserves are estimated based on the ratio of paid loss adjustment expense to paid loss, which is estimated separately by line of business as well as split by hurricane and excluding hurricane. We then apply this ratio to our estimated unpaid loss, by multiplying the ratio times 50% of loss case reserves and 100% of loss IBNR reserves. This is applied by line of business and accident year to arrive at estimated unpaid loss adjustment expense on a gross basis. We then add the estimated unpaid loss adjustment expense on a gross basis to the paid loss adjustment expense to calculate estimated ultimate loss adjustment expense.
On a quarterly basis, the Chief Executive Officer, President, Chief Risk Officer, Chief Financial Officer, Chief Accounting Officer, and Vice President Legal—Compliance & Claims, meet to review the recommendations made by the independent actuarial consultant and use their best judgment to determine the best estimate to be recorded for the reserve for losses and loss adjustment expenses on our balance sheet.
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Our reserves are driven by several important factors, including litigation and regulatory trends, legislative activity, climate change, social and economic patterns and claims inflation assumptions. Our reserve estimates reflect current inflation in legal claims’ settlements and assume we will not be subject to losses from significant new legal liability theories. Our reserve estimates assume that there will not be significant changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business, but no assurance can be given that our attempt to quantify such inputs will be accurate or successful.
The table below quantifies the impact of potential reserve deviations from our carried reserve at December 31, 2020. We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. We believe that potential changes such as these would not have a material impact on our liquidity.
Net Ultimate Potential Impact
Accident Sensitivity Net Ultimate Net LLAE Pre‐tax Stockholders’
Sensitivity Year Factor Incurred LLAE Reserve income Equity*
($ in thousands)
* Effective tax rate estimated to be 21%
The amount by which estimated losses differ from those originally reported for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved, or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed.
The following tables present the development of our loss reserves by accident year on a gross basis and net of reinsurance recoveries during each of the below calendar years:
Gross Ultimate Loss and LAE
Development- (Favorable) Unfavorable
(in thousands)
$ (3,177) $ (951) $ (3,275)
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Net Ultimate Loss and LAE
Development- (Favorable) Unfavorable
(in thousands)
$ (1,891) $ (181) $ (64)
During the year ended December 31, 2020, our gross incurred losses for accident years 2018 and prior developed favorably by $3.3 million. The gross favorable development was due to reported losses emerging at a lower level than expected, primarily in our homeowners and special property lines of business, offset by higher frequency and severity of losses emerging in our assumed reinsurance line. The net favorable development of $0.1 million reflects the effect of ceding the gross favorability under our reinsurance program.
During the year ended December 31, 2019, our gross incurred losses for accident years 2018 and prior developed favorably by $1.0 million. This favorable development was due to reported losses emerging at a lower level than expected, primarily in our Specialty Homeowners business, offset by higher frequency and severity of claims in our special property lines of business. The net favorable development of $0.2 million reflects the effect of ceding the gross favorability under our reinsurance program.
During the year ended December 31, 2018, our gross incurred losses for accident years 2017 and prior developed favorably by $3.2 million. This favorable development was due to reported losses emerging at a lower level than expected, primarily in our Specialty Homeowners business. The net favorable development of $1.9 million reflects the effect of ceding the gross favorability under our reinsurance program.
Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting and payment patterns could differ from our expected reporting and payment patterns, which are based on our own data and industry data. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in the results of current operations.
Investment Valuation and Fair Value
We invest in a variety of investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds. All of our investments in fixed maturity securities and equity securities are carried at fair value, defined as the price that we would receive upon selling an investment in an orderly transaction to an independent buyer in the principal or most advantageous market of the investment. Market participants are assumed to be independent, knowledgeable, able and willing to transact an exchange and not acting under duress.
In our disclosure of the fair value of our investments, we utilize a hierarchy based on the quality of inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Adjustments to transaction prices or quoted market prices may be required in illiquid or disorderly markets in order to estimate fair value. The three levels of the fair value hierarchy are described below:
Level 1—Unadjusted quoted prices are available in active markets for identical investments as of the reporting date.
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Level 2—Pricing inputs are quoted prices for similar investments in active markets; quoted prices for identical or similar investments in inactive markets; or valuations based on models where the significant inputs are observable or can be corroborated by observable market data.
Level 3—Pricing inputs into models are unobservable for the investment. The unobservable inputs require significant management judgment or estimation.
We use independent pricing sources to obtain the estimated fair values of investments. The fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, the fair value is based on a variety of valuation techniques depending on the type of investment. The fair values obtained from independent pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation.
The fair value of our investments in fixed maturity securities is estimated using relevant inputs, including available market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. An Option Adjusted Spread model is also used to develop prepayment and interest rate scenarios. These fair value measurements are estimated based on observable, objectively verifiable market information rather than market quotes; therefore, these investments are classified and disclosed in Level 2 of the hierarchy.
The fair value of our investments in equity securities is based on quoted prices available in active markets and classified and disclosed in Level 1 of the hierarchy.
Investment securities are subject to fluctuations in fair value due to changes in issuer-specific circumstances, such as credit rating, and changes in industry-specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. In addition, fixed maturities are subject to fluctuations in fair value due to changes in interest rates. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Unrealized gains and losses on our fixed maturity securities are included in accumulated other comprehensive income as a separate component of total stockholders’ equity. Equity securities are carried at fair value with unrealized gains and losses included as a component of net income on the Company’s consolidated statement of income. Prior to 2018, unrealized gains and losses on equity securities were included in accumulated other comprehensive income as a separate component of stockholders’ equity.
The Company adopted new accounting guidance beginning with this Annual Report on 10-K, and is now required to consider recognizing an allowance for credit losses on its financial assets, including its available-for-sale securities. All financial assets measured at amortized cost are required to be presented at the net amount expected to be collected by means of an allowance for credit losses that is included in net income. Credit losses relating to available-for-sale debt securities are also required to be recorded through a reversible allowance for credit losses, but the allowance is limited to the amount by which fair value is less than amortized cost. The previous accounting guidance delayed the recognition of credit losses until it was probable a loss had been incurred.
The Company reviews all securities with unrealized losses on a regular basis to assess whether the decline in the securities fair value necessitates the recognition of an allowance for credit losses. Factors considered in the review include the extent to which the fair value has been less than amortized cost, and current market interest rates and whether the unrealized loss is credit-driven or a result of changes in market interest rates. The Company also considers factors specific to the issuer including the general financial condition of the issuer, the issuers industry and future business prospects, any past failure of issuer to make scheduled interest or principal payments, and the payment structure of the investment and the issuers ability to make contractual payments on the investment.
The Company also considers whether it intends to sell the security or if it is more likely than not that it will be required to sell the security before recovery of its amortized cost. When assessing whether it intends to sell a fixed-maturity security or if it is likely to be required to sell a fixed-maturity security before recovery of its amortized cost, the Company evaluates facts and circumstances including, but not limited to, decisions to reposition the investment
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portfolio, potential sales of investments to meet cash flow needs, and potential sales of investments to capitalize on favorable pricing.
For fixed-maturity securities where a decline in fair value is below the amortized cost basis and the Company intends to sell the security, or it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost, a credit-loss charge is recognized in net income based on the fair value of the security at the time of assessment. For fixed-maturity securities that the Company has the intent and ability to hold, the Company compares the estimated present value of the cash flows expected to be collected to the amortized cost of the security. The extent to which the estimated present value of the cash flows expected to be collected is less than the amortized cost of the security represents the credit-related portion of the impairment, which is recognized in net income through an allowance for credit losses. Any remaining decline in fair value represents the noncredit portion of the impairment, which is recognized in other comprehensive income.
The Company reports accrued interest receivable as a component of accrued investment income on its consolidated balance sheet which is presented separately from available-for-sale securities. The Company does not measure an allowance for credit losses on accrued interest receivable and instead would write off accrued interest receivable at the time an issuer defaults or is expected to default on payments.
The Company did not recognize any credit losses during the years ended December 31, 2020 and 2019 related to its available-for-sale securities.
Deferred Income Taxes
We account for taxes under the asset and liability method, under which we record deferred income taxes as assets or liabilities on our balance sheet to reflect the net tax effect of the temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and their respective tax bases. Deferred tax assets and liabilities are measured by applying enacted tax rates in effect for the years in which such differences are expected to reverse.
Our deferred tax assets result from temporary differences primarily attributable to unearned premiums and net operating losses (“NOLs”). Our deferred tax liabilities result primarily from deferred acquisition costs and unrealized gains in the investment portfolio. On a quarterly basis, we review our deferred tax assets and, if we determine that it is more likely than not that some portion or all of the deferred tax assets will not be realized, we reduce our deferred tax asset with a valuation allowance. The assessment requires significant judgement and review of all positive and negative evidence to reach a conclusion that it is more likely than not that all or some of portion of the deferred tax asset will not be realized. We consider multiple factors, including the nature and amount of the deferred tax asset, the expected timing of when an asset will be used, and the historical profitability of our entities.
Prior to March 2019, the Company was a Cayman Islands incorporated holding company with U.K. tax residency. In addition, the Company’s Bermuda based subsidiary, PSRE, was not required to pay any taxes on its income or capital gains but was subject to a 1% U.S. federal excise tax on reinsurance premiums assumed. As a result of our multinational operations our effective tax rate has historically been below that of a fully U.S. based operation. In 2019, the Company became a Delaware corporation and all income and became subject to U.S. federal income tax.
Prior to 2019, the Company maintained a valuation allowance on the U.S. tax attributes due to significant negative evidence, including cumulative U.S. losses in the most recent three-year period and our assessment that the realization of the net deferred tax assets did not meet the “more likely than not” criteria under ASC 740, Income Taxes. Management assessed available positive and negative evidence to estimate whether sufficient future taxable income would be generated to permit use of the existing deferred tax assets. The projected reversal of temporary differences, the Domestication, and projected future operating income in the U.S. represents significant positive evidence, which outweighed the historical negative evidence.
Based on this evidence, management determined it was more likely than not that the federal deferred tax assets are recoverable and therefore the associated valuation allowance was released as of March 31, 2019. We decreased the
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valuation allowance on the federal deferred tax assets by $1.7 million because of this analysis. State NOL carryforwards, due to the limited carryforward period, did not meet the “more likely than not” criteria and we continued to maintain a valuation allowance on the associated deferred tax assets. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period change or if objective negative evidence in the form of cumulative losses is no longer present.
Recent Accounting Pronouncements
See “Note 2—Recent Accounting Pronouncements” in the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K for a discussion of accounting pronouncements recently adopted and recently issued accounting pronouncements not yet adopted and their potential impact to our financial statements.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements (as defined by applicable regulations of the SEC) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Item 7A.Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in equity prices, interest rates, foreign currency exchange rates and commodity prices. Our consolidated balance sheets include assets and liabilities with estimated fair values that are subject to market risk. Our primary market risks have been equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. We do not have material exposure to foreign currency exchange rate risk or commodity risk.
Credit risk is the potential loss resulting from adverse changes in an issuer’s ability to repay its debt obligations. General concern exists about the number of municipalities experiencing financial difficulties in light of the adverse economic conditions experienced over the past several years. We manage the exposure to credit risk in our municipal bond portfolio by investing in high quality securities and by diversifying our holdings, which are typically either general obligation or revenue bonds related to essential products and services. We manage the exposure to credit risk in our corporate bond portfolio by investing in high quality securities and by diversifying our holdings.
We monitor our investment portfolio to ensure that credit risk does not exceed prudent levels. The majority of our investment portfolio is invested in high credit quality, investment grade fixed maturity securities. We also invest in higher yielding fixed maturities and equity securities. Our fixed maturity portfolio has an average rating by at least one nationally recognized rating organization of “AA−,” with approximately 74.2% rated “A−” or better. At December 31, 2020, 0.6%of our fixed maturity portfolio was unrated or rated below investment grade. Our fixed maturity portfolio includes some securities issued with financial guaranty insurance. We purchase fixed maturities based on our assessment of the credit quality of the underlying assets without regard to insurance.