Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in part II, item 1A of this Quarterly Report. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of many factors.
The results of operations for the three and nine months ended September 30, 2020 are not necessarily indicative of the results that may be expected for the full year ended December 31, 2020, or for any other future period. The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in Part I, Item 1 of this Quarterly Report, and in conjunction with our audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K as filed with the SEC on February 28, 2020.
References to the "Company," "Palomar," "we," "us," and "our" are to Palomar Holdings, Inc. and its subsidiaries, unless the context otherwise requires.
Overview
We are a rapidly growing and profitable company focused on the provision of specialty property insurance. We focus on certain markets that we believe are underserved by other insurance companies, such as the markets for earthquake, wind and flood insurance. We provide specialty property insurance products in our target markets to both individuals and businesses. We use proprietary data analytics and a modern technology platform to offer our customers flexible products with customized and granular pricing. We provide most of our products on an admitted basis, while having the flexibility to provide certain products on a non-admitted basis. We distribute our products through multiple channels, including retail agents, program administrators, wholesale brokers, and in partnership 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 in the event of a major catastrophe. 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 for the year ended December 31, 2014, our first year of operations, to $252.0 million for the year ended December 31, 2019, a compound annual growth rate (“CAGR”) of approximately 72%. For the nine months ended September 30, 2020, we experienced average monthly premium retention rates above 90% for our Residential Earthquake, Flood, and Hawaii Hurricane lines and approximately 90% overall across all lines of business, providing strong visibility into future revenue.
In February 2014, Palomar Specialty Insurance Company 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 Palomar Specialty Insurance Company and affirmed our “A−” group rating for Palomar Holdings, Inc. In July 2020, Palomar Excess and Surplus Lines Insurance Company was also awarded an “A−” rating by A.M. Best. These ratings reflect A.M. Best’s opinion of our subsidiaries’ financial strength, operating performance, and ability to meet obligations to policyholders and are not an evaluation directed towards the protection of investors.
In April 2019, we closed our Initial Public Offering (“IPO”) and received net proceeds of approximately $87.4 million, after deducting underwriting discounts and commissions and offering costs.
On January 9, 2020, we, along with certain selling stockholders, sold 5,750,000 shares of common stock at a price of $49.00 per share in an underwritten public offering. The offering was comprised of 5,000,000 shares sold by
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certain selling stockholders and 750,000 shares sold by us. We received net proceeds of approximately $35.5 million, after deducting underwriting discounts and commissions and offering costs.
On June 26, 2020, we sold 1,150,000 shares of common stock to the public at a price of $82.00 per share in an underwritten public offering. We received net proceeds of approximately $90.1 million, after deducting underwriting discounts and commissions and offering costs.
During the second quarter of 2020, we capitalized and received regulatory approval for a newly formed surplus lines insurance company subsidiary named Palomar Excess and Surplus Insurance Company (‘‘PESIC’’). We 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, or surplus lines market, and that PESIC enables us to serve certain risks that our admitted products cannot currently satisfy. We began writing surplus lines business, notably commercial earthquake, on a national basis during the third quarter of 2020 and have entered into several new partnerships which will enable us to write additional surplus lines business in the future.
We believe that our market opportunity, distinctive products, and differentiated business model position us to grow our business profitably.
COVID-19 Pandemic and Impact on Palomar
The COVID-19 Pandemic ("The Pandemic") continues to impact financial markets, businesses, households, and communities.
The Pandemic has impacted our operations and we are taking several actions to protect the health of the public and our employees and comply with directives and advice of governmental and health authorities. 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 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 further safeguard our systems to serve the operational needs of our remote workforce and ensure uninterrupted service to brokers and policyholders.
The initial economic impacts of the Pandemic, as well as the various stay at home orders and mandated closures of certain business, have caused a significant temporary 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. All of these policies are written on an admitted basis and all of our all risk policies have an Insurance Services Office (“ISO”) virus 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 of these claims and providing the policyholder requisite consideration.
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Our results of operations depend, in part, on the performance of our investment portfolio. During 2020 we have 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 and related economic downturn. 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. We cannot anticipate all the ways in which the Pandemic and financial market conditions 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;
● Binding of new business submissions in existing products or partnerships into policies;
● Entrance into new partnerships or the offering of new types of insurance products;
● 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 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.
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Commission and Other Income
Commission and other income consist of commissions earned on policies written on behalf of third party insurance companies 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. 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
● 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 quota share 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 consisted of interest expense on our Floating Rate Notes during the three and nine months ended September 30, 2019. These notes were redeemed in May 2019 and we did not have any debt or incur any interest expense thereafter.
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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 expenses due to external investment managers. 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 as well as any “other-than-temporary” impairments 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 components of pretax earnings and the related tax effects.
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 (loss) 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 (loss).
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 (loss) 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.
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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 (loss) 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.
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.
Adjusted net income excluding catastrophe losses is a non-GAAP financial measure defined as adjusted net income (loss) excluding catastrophe losses, 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 income before income taxes calculated in accordance with GAAP to adjusted net income 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
Three months ended September 30, 2020 compared to three months ended September 30, 2019
The following table summarizes our results for the three months ended September 30, 2020 and 2019:
Three months ended
September 30,
2020
2019
Change
% Change
($ in thousands, except per share data)
Revenue:
Gross written premiums
$
102,967
66,242
$
36,725
55.4
%
Ceded written premiums
(41,570)
(28,060)
(13,510)
48.1
%
Net written premiums
61,397
38,182
23,215
60.8
%
Net earned premiums
42,020
27,662
14,358
51.9
%
Commission and other income
816
709
107
15.1
%
Total underwriting revenue (1)
42,836
28,371
14,465
51.0
%
Losses and loss adjustment expenses
41,060
2,439
38,621
1,583.5
%
Acquisition expenses
17,976
10,243
7,733
75.5
%
Other underwriting expenses
7,805
8,330
(525)
(6.3)
%
Underwriting income (loss) (1)
(24,005)
7,359
(31,364)
(426.2)
%
Net investment income
2,138
1,729
409
23.7
%
Net realized and unrealized gains on investments
24
361
(337)
(93.4)
%
Income before income taxes
(21,843)
9,449
(31,292)
(331.2)
%
Income tax expense (benefit)
(6,158)
1,995
(8,153)
(408.7)
%
Net income (loss)
$
(15,685)
$
7,454
$
(23,139)
(310.4)
%
Adjustments:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
—
2,289
(2,289)
NM
Stock-based compensation expense
551
410
141
NM
Tax impact
(101)
(570)
469
NM
Adjusted net income (loss) (1)
$
(15,235)
$
9,583
$
(24,818)
(259.0)
%
Key Financial and Operating Metrics
Annualized return on equity
(17.0)
%
14.6
%
Annualized adjusted return on equity (1)
(16.5)
%
18.8
%
Loss ratio
97.7
%
8.8
%
Expense ratio
59.4
%
64.6
%
Combined ratio
157.1
%
73.4
%
Adjusted combined ratio (1)
155.8
%
63.6
%
Diluted earnings per share
$
(0.62)
$
0.31
Diluted adjusted earnings per share (1)
$
(0.60)
$
0.40
Catastrophe losses (2)
$
36,512
$
—
Catastrophe loss ratio (1)
86.9
%
—
%
Adjusted combined ratio excluding catastrophe losses (1)
68.9
%
63.6
%
Adjusted net income excluding catastrophe losses (1) (2)
$
13,672
$
9,583
NM- not meaningful
(1) Indicates non-GAAP financial measure; see “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of the non-GAAP financial measures to their most directly comparable financial measures prepared in accordance with GAAP.
(2) Catastrophe losses above are shown before their tax impact. Adjusted net income excluding catastrophe losses excludes catastrophe losses net of the estimated tax effect on them.
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Gross Written Premiums
Gross written premiums increased $36.8 million, or 55.4% to $103.0 million for the three months ended September 30, 2020 compared to $66.2 million for the three months ended September 30, 2019. Premium growth was primarily due to an increased volume of policies written across our lines of business which was driven by new business generated with existing partners, strong premium retention rates for existing business, expansion of our products’ distribution footprint, and new partnerships. The following table summarizes our gross written premiums by line of business and shows each line’s percentage of total gross written premiums for each period:
Three Months Ended September 30,
2020
2019
($ in thousands)
% of
% of
%
Amount
GWP
Amount
GWP
Change
Change
Product
Residential Earthquake
$
40,507
39.3
%
$
35,711
53.9
%
$
4,796
13.4
%
Commercial Earthquake
18,061
17.5
%
8,402
12.7
%
9,659
115.0
%
Specialty Homeowners
17,048
16.6
%
8,572
12.9
%
8,476
98.9
%
Commercial All Risk
12,467
12.1
%
7,077
10.7
%
5,390
76.2
%
Inland Marine
4,406
4.3
%
1,060
1.6
%
3,346
315.7
%
Hawaii Hurricane
4,360
4.2
%
3,299
5.0
%
1,061
32.2
%
Residential Flood
2,170
2.1
%
1,450
2.2
%
720
49.7
%
Other
3,948
3.9
%
671
1.0
%
3,277
488.4
%
Total Gross Written Premiums
$
102,967
100.0
%
$
66,242
100.0
%
$
36,725
55.4
%
We experienced the largest percentage increase in our Inland Marine and Commercial Earthquake lines. Other gross written premiums are comprised of various items including our Assumed Reinsurance program. Changes to other gross written premiums may not be indicative of future trends.
Ceded Written Premiums
Ceded written premiums increased $13.5 million, or 48.1%, to $41.6 million for the three months ended September 30, 2020 from $28.1 million for the three months ended September 30, 2019. The increase was primarily due to an increase in excess of loss (“XOL”) reinsurance expense commensurate with growth in exposure. In addition, we had increased quota share cession primarily in our specialty homeowners lines due to higher written premiums in those lines. Ceded written premiums as a percentage of gross written premiums decreased to 40.4% for the three months ended September 30, 2020 from 42.4% for the three months ended September 30, 2019. This decrease was primarily due to changes in our quota share agreements in our specialty 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 $23.2 million, or 60.8%, to $61.4 million for the three months ended September 30, 2020 from $38.2 million for the three months ended September 30, 2019. The increase was primarily due to an increase in gross written premiums, primarily in our commercial earthquake and specialty homeowners lines offset by increased ceded written premiums.
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Net Earned Premiums
Net earned premiums increased $14.3 million, or 51.9%, to $42.0 million for the three months ended September 30, 2020 from $27.7 million for the three months ended September 30, 2019 due primarily to the earning of increased gross written premiums offset by the earning of ceded written premiums under reinsurance agreements. The table below shows the amount of premiums we earned on a gross and net basis and net earned premiums as a percentage of gross earned premiums in each period presented:
Three Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Gross earned premiums
$
79,428
$
53,453
$
25,975
48.6
%
Ceded earned premiums
(37,408)
(25,791)
(11,617)
45.0
%
Net earned premiums
$
42,020
$
27,662
$
14,358
51.9
%
Net earned premium ratio
52.9%
51.8%
Commission and Other Income
Commission and other income increased $0.1 million or 15.1% to $0.8 million for the three months ended September 30, 2020 from $0.7 million for the three months ended September 30, 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 $38.7 million to $41.1 million for the three months ended September 30, 2020 from $2.4 million for the three months ended September 30, 2019. Losses and loss adjustment expenses consisted of the following elements during the respective periods:
Three Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Catastrophe losses
$
36,512
$
—
$
36,512
NM
Non-catastrophe losses
4,548
2,439
2,109
86.5
%
Total losses and loss adjustment expenses
$
41,060
$
2,439
$
38,621
1,583.5
%
NM- not meaningful
Our catastrophe loss ratio was 86.9% during the three months ended September 30, 2020. Catastrophe losses primarily included losses from Hurricanes Hanna, Isaias, Laura, Sally and Beta. We did not experience any catastrophe losses during the three months ended September 30, 2019.
Our non-catastrophe loss ratio was 10.8% for the three months ended September 30, 2020 compared to 8.8% during the three months ended September 30, 2019. Non-catastrophe losses increased due mainly to higher attritional loss activity on lines of business subject to attritional losses such as commercial all-risk, specialty homeowners, and inland marine.
Acquisition Expenses
Acquisition expenses increased $7.8 million, or 75.5%, to $18.0 million for the three months ended September 30, 2020 from $10.2 million for the three months ended September 30, 2019. The increase was primarily due to higher earned premiums which resulted in higher commissions and premium-related taxes. Acquisition expenses as a percentage of gross earned premiums were 22.6% for the three months ended September 30, 2020 compared to 19.2%
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for the three months ended September 30, 2019. Acquisition expenses as a percentage of gross earned premiums increased due primary to lower earned ceding commissions. Earned ceding commissions decreased due to changes in our specialty homeowners and all risk ceding arrangements which increased the percentage of premiums we retained and decreased our ceding commissions. 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 $0.5 million, or 6.3%, to $7.8 million for the three months ended September 30, 2020 from $8.3 million for the three months ended September 30, 2019. The decrease was primarily due to the company incurring significant expenses in the prior year quarter related to a stock offering and one-time incentive cash bonuses.
Other underwriting expenses as a percentage of gross earned premiums were 9.8% for the three months ended September 30, 2020 compared to 15.6% for the three months ended September 30, 2019. Excluding the impact of expenses relating to stock offerings and one-time incentive cash bonuses and stock-based compensation, other underwriting expenses as a percentage of gross earned premiums were 9.1% for the three months ended September 30, 2020 compared to 10.5% for the three months ended September 30, 2019. This percentage decreased due to higher gross earned premiums without a proportional increase to expenses.
Net Investment Income and Net Realized and Unrealized Gains on Investments
Net investment income increased $0.4 million, or 23.7%, to $2.1 million for the three months ended September 30, 2020 from $1.7 million for the three months ended September 30, 2019. The increase was primarily due to a higher average balance of investments during the three months ended September 30, 2020 due primarily to proceeds from our January and June 2020 stock offerings and the investing of our cash generated from operations, partially offset by lower yields on investments due to a lower interest rate environment.
Net realized and unrealized gains on investments decreased $0.4 million, or 93.4%, to an immaterial amount for the three months ended September 30, 2020 from $0.4 million for the three months ended September 30, 2019 due to lower appreciation on our fixed income based equity securities during the period ended September 30, 2020. Currently, we mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds. The following table summarizes the components of our investment income for each period presented:
Three Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Interest income
$
2,149
$
1,678
$
471
28.1
%
Dividend income
109
132
(23)
(17.4)
%
Investment management fees and expenses
(120)
(81)
(39)
48.1
%
Net investment income
2,138
1,729
409
23.7
%
Net realized and unrealized gains on investments
24
361
(337)
(93.4)
%
Total
$
2,162
$
2,090
$
72
3.4
%
Income Tax Expense (Benefit)
Income taxes decreased $8.2 million or 408.7% to $6.2 million of benefit for the three months ended September 30, 2020 from $2.0 million of expense for the three months ended September 30, 2019 as we had a pre-tax loss during the three months ended September 30, 2020. During the three months ended September 30, 2020, our income tax rate differed from the statutory rate of 21% due primarily to the tax impact of the permanent component of employee stock option exercises. During the three months ended September 30, 2019, our income tax rate was approximately equal to the statutory tax rate of 21%.
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Nine months ended September 30, 2020 compared to nine months ended September 30, 2019
The following table summarizes our results for the nine months ended September 30, 2020 and 2019:
Nine months ended
September 30,
2020
2019
Change
% Change
($ in thousands, except per share data)
Revenue:
Gross written premiums
$
258,268
$
178,619
$
79,649
44.6
%
Ceded written premiums
(101,264)
(78,797)
(22,467)
28.5
%
Net written premiums
157,004
99,822
57,182
57.3
%
Net earned premiums
116,145
69,220
46,925
67.8
%
Commission and other income
2,492
2,017
475
23.5
%
Total underwriting revenue (1)
118,637
71,237
47,400
66.5
%
Losses and loss adjustment expenses
46,901
3,398
43,503
1,280.3
%
Acquisition expenses
45,909
26,189
19,720
75.3
%
Other underwriting expenses
24,732
44,348
(19,616)
(44.2)
%
Underwriting income (loss) (1)
1,095
(2,698)
3,793
(140.6)
%
Interest expense
—
(1,068)
1,068
(100.0)
%
Net investment income
6,287
4,172
2,115
50.7
%
Net realized and unrealized gains on investments
1,243
3,265
(2,022)
(61.9)
%
Income before income taxes
8,625
3,671
4,954
134.9
%
Income tax expense
523
3,929
(3,406)
(86.7)
%
Net income (loss)
$
8,102
$
(258)
$
8,360
(3,240.3)
%
Adjustments:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
708
2,699
(1,991)
NM
Stock-based compensation expense
1,457
23,677
(22,220)
NM
Expenses associated with retirement of debt
—
1,297
(1,297)
NM
Expenses associated with catastrophe bond
399
—
399
NM
Tax impact
(534)
(994)
460
NM
Adjusted net income (1)
$
10,132
$
26,421
$
(16,289)
(61.7)
%
Key Financial and Operating Metrics
Annualized return on equity
3.7
%
(0.2)
%
Annualized adjusted return on equity (1)
4.7
%
23.1
%
Loss ratio
40.4
%
4.9
%
Expense ratio
58.7
%
99.0
%
Combined ratio
99.1
%
103.9
%
Adjusted combined ratio (1)
96.8
%
64.5
%
Diluted earnings per share
$
0.32
$
(0.01)
Diluted adjusted earnings per share (1)
$
0.40
$
1.27
Catastrophe losses (2)
$
36,512
$
—
Catastrophe loss ratio (1)
31.4
%
—
%
Adjusted combined ratio excluding catastrophe losses (1)
65.4
%
64.5
%
Adjusted net income excluding catastrophe losses (1) (2)
$
39,039
$
26,421
NM- not meaningful
(1) Indicates non-GAAP financial measure; see “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of the non-GAAP financial measures to their most directly comparable financial measures prepared in accordance with GAAP.
(2) Catastrophe losses above are shown before their tax impact. Adjusted net income excluding catastrophe losses excludes catastrophe losses net of the estimated tax effect on them.
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Gross Written Premiums
Gross written premiums increased $79.7 million, or 44.6% to $258.3 million for the nine months ended September 30, 2020 compared to $178.6 million for the nine months ended September 30, 2019. Premium growth was primarily due to an increased volume of policies written across our lines of business which was driven by new business generated with existing partners, strong premium retention rates for existing business, expansion of our products’ distribution footprint, and new partnerships. The following table summarizes our gross written premiums by line of business and shows each line’s percentage of total gross written premiums for each period:
Nine Months Ended September 30,
2020
2019
($ in thousands)
% of
% of
Amount
GWP
Amount
GWP
Change
Change
Product
Residential Earthquake
$
103,503
40.1
%
$
95,005
53.2
%
$
8,498
8.9
%
Commercial Earthquake
40,727
15.8
%
23,020
12.9
%
17,707
76.9
%
Specialty Homeowners
38,461
14.9
%
24,994
14.0
%
13,467
53.9
%
Commercial All Risk
39,765
15.4
%
21,929
12.3
%
17,836
81.3
%
Inland Marine
9,747
3.8
%
1,294
0.7
%
8,453
653.2
%
Hawaii Hurricane
10,296
4.0
%
8,048
4.5
%
2,248
27.9
%
Residential Flood
5,728
2.2
%
3,494
2.0
%
2,234
63.9
%
Other
10,041
3.8
%
835
0.4
%
9,206
NM
Total Gross Written Premiums
$
258,268
100.0
%
$
178,619
100.0
%
$
79,649
44.6
%
NM- not meaningful
During the nine months ended September 30, 2019, we entered into a new Residential Earthquake partnership in which we assumed $6.6 million of unearned premiums. Excluding the impact of this unearned premium assumption, our Residential Earthquake gross written premiums increased by $15.1 million, or 17.1%. Other gross written premiums are comprised of various items including our Assumed Reinsurance program. Changes to other gross written premiums may not be indicative of future trends.
Ceded Written Premiums
Ceded written premiums increased $22.5 million, or 28.5%, to $101.3 million for the nine months ended September 30, 2020 from $78.8 million for the nine months ended September 30, 2019. The increase was primarily due to an increase in excess of loss (“XOL”) reinsurance expense commensurate with growth in exposure. Ceded written premiums as a percentage of gross written premiums decreased to 39.2% for the nine months ended September 30, 2020 from 44.1% for the nine months ended September 30, 2019. This decrease was primarily due to decreased quota share cession on our specialty 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 $57.2 million, or 57.3%, to $157.0 million for the nine months ended September 30, 2020 from $99.8 million for the nine months ended September 30, 2019. The increase was primarily due to an increase in gross written premiums, primarily in our commercial all risk and commercial earthquake lines, offset by increased ceded written premiums.
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Table of Contents
Net Earned Premiums
Net earned premiums increased $46.9 million, or 67.8%, to $116.1 million for the nine months ended September 30, 2020 from $69.2 million for the nine months ended September 30, 2019 due primarily to the earning of increased gross written premiums offset by the earning of ceded written premiums under reinsurance agreements. The table below shows the amount of premiums we earned on a gross and net basis and net earned premiums as a percentage of gross earned premiums in each period presented:
Nine Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Gross earned premiums
$
215,266
$
141,554
$
73,712
52.1
%
Ceded earned premiums
(99,120)
(72,334)
(26,786)
37.0
%
Net earned premiums
$
116,146
$
69,220
$
46,926
67.8
%
Net earned premium ratio
54.0%
48.9%
Commission and Other Income
Commission and other income increased $0.5 million or 23.5% to $2.5 million for the nine months ended September 30, 2020 from $2.0 million for the nine months ended September 30, 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 $43.5 million to $46.9 million for the nine months ended September 30, 2020 from $3.4 million for the nine months ended September 30, 2019. Losses and loss adjustment expenses consisted of the following elements during the respective periods:
Nine Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Catastrophe losses
$
36,512
$
—
$
36,512
NM
Non-catastrophe losses
10,389
3,398
6,991
205.7
%
Total losses and loss adjustment expenses
$
46,901
$
3,398
$
43,503
1,280.3
%
NM- not meaningful
Our catastrophe loss ratio was 31.4% during the nine months ended September 30, 2020. Catastrophe losses primarily included losses from Hurricanes Hanna, Isaias, Laura, Sally and Beta. We did not experience any catastrophe losses during the nine months ended September 30, 2019.
Our non-catastrophe loss ratio was 8.9% for the nine months ended September 30, 2020 compared to 4.9% during the nine months ended September 30, 2019. Non-catastrophe losses increased due mainly to higher attritional loss activity on lines of business subject to attritional losses such as commercial all-risk, specialty homeowners, and inland marine.
Acquisition Expenses
Acquisition expenses increased $19.7 million, or 75.3%, to $45.9 million for the nine months ended September 30, 2020 from $26.2 million for the nine months ended September 30, 2019. The primary reason for the increase was
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higher earned premiums which resulted in higher commissions and premium-related taxes. Acquisition expenses as a percentage of gross earned premiums were 21.3% for the nine months ended September 30, 2020 compared to 18.5% for the nine months ended September 30, 2019. Acquisition expenses as a percentage of gross earned premiums increased due primary to lower earned ceding commissions. Earned ceding commissions decreased due to changes in our specialty homeowners and all risk ceding arrangements which increased the percentage of premiums we retained and decreased our ceding commissions. 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 $19.6 million, or 44.2%, to $24.7 million for the nine months ended September 30, 2020 from $44.3 million for the nine months ended September 30, 2019. This decrease was primarily due to the company incurring significant charges during the prior year nine months associated with an IPO, tax restructuring, secondary offering, 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 11.5% for the nine months ended September 30, 2020 compared to 31.3% for the nine months ended September 30, 2019. Excluding the impact of expenses relating to stock offerings, tax restructuring, and one-time incentive cash bonuses, stock-based compensation, retirement of debt, and catastrophe bond, other underwriting expenses as a percentage of gross earned premiums were 10.3% for the nine months ended September 30, 2020 compared to 12.1% for the nine months ended September 30, 2019. This percentage decreased due to higher gross earned premiums without a proportional increase to expenses.
Interest Expense
Interest expense decreased $1.1 million to zero for the nine months ended September 30, 2020 from $1.1 million for the nine months ended September 30, 2019. Interest expense decreased as we did not have any debt during the nine months ended September 30, 2020 whereas we had outstanding Floating Rate Notes during a portion of the nine months ended September 30, 2019.
Net Investment Income and Net Realized and Unrealized Gains on Investments
Net investment income increased $2.1 million, or 50.7%, to $6.3 million for the nine months ended September 30, 2020 from $4.2 million for the nine months ended September 30, 2019. The increase was primarily due to a higher average balance of investments during the nine months ended September 30, 2020 due primarily to proceeds from our April 2019 IPO, investing of cash generated from operations, and proceeds from our January 2020 and June 2020 stock offerings, partially offset by lower yields on investments due to a lower interest rate environment.
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Table of Contents
Net realized and unrealized gains on investments decreased $2.1 million, or 61.9%, to $1.2 million for the nine months ended September 30, 2020 from $3.3 million for the nine months ended September 30, 2019. We had a higher balance of equity securities during the prior year period and saw appreciation on those equity securities during that period. Currently, we mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds. The following table summarizes the components of our investment income for each period presented:
Nine Months Ended
September 30,
2020
2019
Change
% Change
($ in thousands)
Interest income
$
6,242
$
4,140
$
2,102
50.8
%
Dividend income
354
299
55
18.4
%
Investment management fees and expenses
(309)
(267)
(42)
15.7
%
Net investment income
6,287
4,172
2,115
50.7
%
Net realized and unrealized gains on investments
1,243
3,265
(2,022)
(61.9)
%
Total
$
7,530
$
7,437
$
93
1.3
%
Income Tax Expense
Income tax expense decreased $3.4 million or 86.7% to $0.5 million for the nine months ended September 30, 2020 from $3.9 million for the nine months ended September 30, 2019 as we had lower pre-tax income during the nine months ended September 30, 2020. During the nine months ended September 30, 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 nine months ended September 30, 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 related to the modification of our management incentive plan in March 2019.
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 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:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(in thousands)
(in thousands)
Total revenue
$
44,998
$
30,461
$
126,167
$
78,674
Net investment income
(2,138)
(1,729)
(6,287)
(4,172)
Net realized and unrealized gains on investments
(24)
(361)
(1,243)
(3,265)
Underwriting revenue
$
42,836
$
28,371
$
118,637
$
71,237
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
36
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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 (loss) before income taxes calculated in accordance with GAAP reconciles to underwriting income as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(in thousands)
(in thousands)
Income (loss) before income taxes
$
(21,843)
$
9,449
$
8,625
$
3,671
Net investment income
(2,138)
(1,729)
(6,287)
(4,172)
Net realized and unrealized gains on investments
(24)
(361)
(1,243)
(3,265)
Interest expense
—
—
—
1,068
Underwriting income (loss)
$
(24,005)
$
7,359
$
1,095
$
(2,698)
Adjusted Net Income (Loss)
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.
Net income (loss) calculated in accordance with GAAP reconciles to adjusted net income (loss) as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(in thousands)
(in thousands)
Net income (loss)
$
(15,685)
$
7,454
$
8,102
$
(258)
Adjustments:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
—
2,289
708
2,699
Stock-based compensation expense
551
410
1,457
23,677
Expenses associated with retirement of debt
—
—
—
1,297
Expenses associated with catastrophe bond
—
—
399
—
Tax impact
(101)
(570)
(534)
(994)
Adjusted net income (loss)
$
(15,235)
$
9,583
$
10,132
$
26,421
Annualized 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.
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Table of Contents
Annualized adjusted return on equity is calculated as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
($ in thousands)
($ in thousands)
Annualized adjusted net income (loss)
$
(60,940)
$
38,332
$
13,509
$
35,228
Average stockholders' equity
$
368,568
$
204,049
$
290,225
$
152,377
Annualized adjusted return on equity
(16.5)
%
18.8
%
4.7
%
23.1
%
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.
Adjusted combined ratio is calculated as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
($ in thousands)
($ in thousands)
Numerator: Sum of losses and loss adjustment expenses, acquisition expenses, and other underwriting expenses, net of commission and other income
$
66,025
$
20,303
$
115,050
$
71,918
Denominator: Net earned premiums
$
42,020
$
27,662
$
116,145
$
69,220
Combined ratio
157.1
%
73.4
%
99.1
%
103.9
%
Adjustments to numerator:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
$
—
$
(2,289)
$
(708)
$
(2,699)
Stock-based compensation expense
(551)
(410)
(1,457)
(23,677)
Portion of expenses associated with retirement of debt classified as other underwriting expenses
—
—
—
(897)
Expenses associated with catastrophe bond
—
—
(399)
—
Adjusted combined ratio
155.8
%
63.6
%
96.8
%
64.5
%
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.
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Table of Contents
Diluted adjusted earnings per share is calculated as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(in thousands, except per share data)
(in thousands, except per share data)
Adjusted net income (loss)
$
(15,235)
$
9,583
$
10,132
$
26,421
Weighted-average common shares outstanding, diluted (1)
$
25,492,274
23,885,137
25,384,518
21,035,340
Diluted adjusted earnings per share
$
(0.60)
$
0.40
$
0.40
$
1.26
(1) For the nine months ended September 30, 2019, we had a net loss on a GAAP basis. Therefore, common share equivalents were not included in the denominator for calculating GAAP net loss per share as doing so would be anti-dilutive. The common share equivalents are included in the above denominator as we had adjusted net income during that period.
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.
Catastrophe loss ratio is calculated as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
($ in thousands)
($ in thousands)
Numerator: Losses and loss adjustment expenses
$
41,060
$
2,439
$
46,901
$
3,398
Denominator: Net earned premiums
$
42,020
$
27,662
$
116,145
$
69,220
Loss ratio
97.7
%
8.8
%
40.4
%
4.9
%
Numerator: Catastrophe losses
$
36,512
$
—
$
36,512
$
—
Denominator: Net earned premiums
$
42,020
$
27,662
$
116,145
$
69,220
Catastrophe loss ratio
86.9
%
0.0
%
31.4
%
0.0
%
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 in accordance with GAAP, and other companies may define adjusted combined ratio excluding catastrophe losses differently.
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Table of Contents
Adjusted combined ratio excluding catastrophe losses is calculated as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
($ in thousands)
($ in thousands)
Numerator: Sum of losses and loss adjustment expenses, acquisition expenses, and other underwriting expenses, net of commission and other income
$
66,025
$
20,303
$
115,050
$
71,918
Denominator: Net earned premiums
$
42,020
$
27,662
$
116,145
$
69,220
Combined ratio
157.1
%
73.4
%
99.1
%
103.9
%
Adjustments to numerator:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
$
—
$
(2,289)
$
(708)
$
(2,699)
Stock-based compensation expense
(551)
(410)
(1,457)
(23,677)
Portion of expenses associated with retirement of debt classified as other underwriting expenses
—
—
—
(897)
Expenses associated with catastrophe bond
—
—
(399)
—
Catastrophe losses
(36,512)
—
(36,512)
—
Adjusted combined ratio excluding catastrophe losses
68.9
%
63.6
%
65.4
%
64.5
%
Adjusted Net Income Excluding Catastrophe Losses
Adjusted net income excluding catastrophe losses is defined as adjusted net income excluding catastrophe losses, 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.
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 net income excluding catastrophe losses does not reflect the overall profitability 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 excluding catastrophe losses differently.
Net income (loss) calculated in accordance with GAAP reconciles to adjusted net income excluding catastrophe losses as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(in thousands)
(in thousands)
Net income (loss)
$
(15,685)
$
7,454
$
8,102
$
(258)
Adjustments:
Expenses associated with IPO, tax restructuring, secondary offerings, and one-time incentive cash bonuses
—
2,289
708
2,699
Stock-based compensation expense
551
410
1,457
23,677
Expenses associated with retirement of debt
—
—
—
1,297
Expenses associated with catastrophe bond
—
—
399
—
Catastrophe losses
36,512
—
36,512
—
Tax impact
(7,706)
(570)
(8,139)
(994)
Adjusted net income excluding catastrophe losses
$
13,672
$
9,583
$
39,039
$
26,421
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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:
September 30,
December 31,
2020
2019
(in thousands)
Stockholders' equity
$
361,895
$
218,556
Intangible assets
(744)
(744)
Tangible stockholders' equity
$
361,151
$
217,812
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.
Our insurance company subsidiaries, Palomar Specialty Insurance Company (“PSIC”), and Palomar Excess and Surplus Insurance Company (“PESIC”) are restricted by statute as to the amount of dividends that they may pay without the prior approval of the Arizona, Oregon and/or California Insurance Commissioners. Generally, insurers may pay dividends without advance regulatory approval only from earned surplus and only to the extent that all dividends paid in the twelve months ending on the date of the proposed dividend do not exceed the greater of (i) 10% of their statutory policyholders’ surplus as of December 31 of the preceding year or (ii) 100% of their statutory net income for the calendar year preceding the year in which the value is being determined. In addition, under Oregon Statute which governs PSIC, statutory net income must exclude realized investment gains and losses and a domestic insurer may only declare a dividend from earned surplus. This does not include surplus arising from unrealized capital gains or revaluation of assets. A domestic insurer may declare a dividend from other than earned surplus only if the Insurance Commissioner approves the declaration prior to payment of the dividend. In the future, state insurance regulatory authorities may adopt statutory provisions more restrictive than those currently in effect.
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 PSRE 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.
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Further, under the Companies Act, PSRE 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.
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 equity securities. We use our cash flows primarily to pay reinsurance premiums, 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 subsidiaries may need to make substantial payments within relatively short periods of time, which would have a negative impact on our operating cash flows.
Management believes that our current liquidity and cash receipts from written premiums, investment income, proceeds from investment sales and redemptions, and reinsurance recoveries, if necessary, are sufficient to cover cash outflows for each of the Company’s insurance subsidiaries in the foreseeable future.
The following table summarizes our cash flows for the nine months ended September 30, 2020 and 2019:
Nine months ended
September 30,
2020
2019
($ in thousands)
Cash provided by (used in):
Operating activities
$
44,170
$
35,659
Investing activities
(191,351)
(90,973)
Financing activities
128,028
62,292
Change in cash, cash equivalents, and restricted cash
$
(19,153)
$
6,978
Our cash flow from operating activities has been positive in each period shown above. 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 the nine months ended September 30, 2020 and 2019 related primarily to purchases of fixed income and equity securities in excess of sales and maturities.
Cash provided by financing activities for nine months ended September 30, 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 $1.7 million related to the issuance of common stock via stock option exercises. Cash provided by financing activities for the nine months ended September 30, 2019 was related to the receipt of $87.4 million in net proceeds from our IPO in April 2019, offset by $20.0 million 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.
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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 catastrophe losses. To the extent our future operating cash flows are insufficient to cover our net losses from catastrophic events, we had $450.0 million in cash and investment securities available at September 30, 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
In September 2018, the Company completed a private placement financing of $20.0 million floating rate senior secured notes (“Floating Rate Notes”). These Floating Rate Notes were redeemed in May 2019 pursuant to their terms and the Company did not have any debt subsequent to May 2019.
Stockholders’ Equity
At September 30, 2020 total stockholders’ equity was $361.9 million and tangible stockholders’ equity was $361.2 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 from our equity compensation plans.
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 September 30, 2020, the majority of our investment portfolio, or $390.8 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 $45.0 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 $14.0 million at September 30, 2020. Our fixed maturity securities, including cash equivalents, had a weighted average effective duration of 4.06 and 3.49 years and an average rating of “A1/A” and “A1/A+” at September 30, 2020 and December 31, 2019, respectively. Our fixed income investment portfolio had a book yield of 2.33% as of September 30, 2020, compared to 2.90% as of December 31, 2019.
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At September 30, 2020 and December 31, 2019 the amortized cost and fair value on available-for-sale securities were as follows:
Amortized
Fair
% of Total
September 30, 2020
Cost or Cost
Value
Fair Value
($ in thousands)
Fixed maturities:
U.S. Governments
$
15,809
$
16,652
4.3
%
States, territories, and possessions
4,338
4,672
1.2
%
Political subdivisions
2,286
2,374
0.6
%
Special revenue excluding mortgage/asset-backed securities
36,075
37,093
9.5
%
Industrial and miscellaneous
239,007
247,432
63.3
%
Mortgage/asset-backed securities
80,143
82,588
21.1
%
Total available-for-sale investments
$
377,658
$
390,811
100.0
%
Amortized
Fair
% of Total
December 31, 2019
Cost or Cost
Value
Fair Value
($ in thousands)
Fixed maturities:
U.S. Governments
$
13,371
$
13,679
6.3
%
States, territories, and possessions
2,298
2,445
1.1
%
Political subdivisions
1,913
1,942
0.9
%
Special revenue excluding mortgage/asset-backed securities
18,139
18,436
8.5
%
Industrial and miscellaneous
124,726
129,013
59.4
%
Mortgage/asset-backed securities
50,831
51,636
23.8
%
Total available-for-sale investments
$
211,278
$
217,151
100.0
%
The following tables provide the credit quality of investment securities as of September 30, 2020 and December 31, 2019:
Estimated
% of
September 30, 2020
Fair Value
Total
($ in thousands)
Rating
AAA
$
92,231
23.6
%
AA
48,070
12.3
%
A
152,416
39.0
%
BBB
86,369
22.1
%
BB
10,943
2.8
%
NR
782
0.2
%
$
390,811
100.0
%
Estimated
% of
December 31, 2019
Fair Value
Total
($ in thousands)
Rating
AAA
$
83,821
38.6
%
AA
24,321
11.2
%
A
69,488
32.0
%
BBB
32,138
14.8
%
BB
7,383
3.4
%
$
217,151
100.0
%
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The amortized cost and fair value of our available-for-sale investments in fixed maturity securities summarized by contractual maturity as of September 30, 2020 were as follows:
Amortized
Fair
% of Total
September 30, 2020
Cost
Value
Fair Value
($ in thousands)
Due within one year
$
11,521
$
11,650
3.0
%
Due after one year through five years
144,424
148,032
37.9
%
Due after five years through ten years
104,751
110,836
28.4
%
Due after ten years
36,819
37,705
9.6
%
Mortgage and asset-backed securities
80,143
82,588
21.1
%
$
377,658
$
390,811
100.0
%
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Reinsurance
We purchase a significant amount of reinsurance from third parties that we believe enhances our business by reducing our exposure to potential catastrophe losses, limiting volatility in our underwriting performance, and providing us with greater visibility into our future earnings. Reinsurance involves transferring, or ceding, a portion of our risk exposure on policies that we write to another insurer, the reinsurer, in exchange for a premium. To the extent that our reinsurers are unable to meet the obligations they assume under our reinsurance agreements, we remain liable for the entire insured loss; see “Risk Factors—Risks Related to Our Business and Industry—We may be unable to purchase third-party reinsurance or otherwise expand our catastrophe coverage in amounts we desire on commercially acceptable terms or on terms that adequately protect us, and this inability may materially adversely affect our business, financial condition and results of operations.”
We use treaty reinsurance and, on a limited basis, facultative reinsurance coverage. Treaty coverage refers to a reinsurance contract that is applied to a group or class of business where all the risks written meet the criteria for that class. Our treaty reinsurance program primarily consists of catastrophe excess of loss (“XOL”) coverage, in which the reinsurer(s) agree to assume all or a portion of the ceding company’s losses relating to a group of policies occurring in relation to specified events, subject to customary exclusions, in excess of a specified amount. Additionally, we buy program specific reinsurance coverage for specific lines of business on a quota share, property per risk or a facultative basis. In quota share reinsurance, the reinsurer agrees to assume a specified percentage of the ceding company’s losses arising out of a defined class of business in exchange for a corresponding percentage of premiums, net of a ceding commission. Property per risk coverage is similar to catastrophe XOL coverage except that the treaty applies in individual property losses rather than in the aggregate for all claims associated with a single catastrophic loss occurrence. Facultative coverage refers to a reinsurance contract on individual risks as opposed to a group or class of business. We use facultative reinsurance selectively to supplement limits or to cover risks or perils excluded from other reinsurance contracts.
During the second quarter of 2020, we procured approximately $200 million of incremental limit for California earthquakes, approximately $300 million of incremental limit for all earthquake zones, and approximately $80 million of incremental windstorm limit. Effective June 1, 2020, our reinsurance coverage exhausts at $1.4 billion for earthquake events and $600 million for hurricane events, providing coverage in excess of our 1:250 year peak zone PML. As of June 30, 2020, a modeled earthquake equivalent to the 1906 San Francisco or 1994 Northridge earthquake would generate a gross loss of $883 million or $848 million, respectively. Our catastrophe event retention is currently $10 million for all perils and we retain $3 million as a vertical co-participation in selected layers of our reinsurance program that we believe to present a compelling risk adjusted return. Our reinsurance panel includes approximately 90 reinsurers, all of which have an ‘‘A-’’ (Excellent) (Outlook Stable) or better financial strength rating from A.M. Best or post collateral.
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We divide our catastrophe XOL treaty into multiple layers. At each reinsurance treaty renewal, we consider any plans to change the underlying insurance coverage we offer, our current capital, our risk appetite, and the cost and availability of reinsurance coverage. Many of our reinsurance contracts have additional features, such as expanded coverage windows for catastrophe events, that we believe provide us with significant protection and flexibility should market conditions change. In the event of a catastrophe that impacts our reinsurance contracts, our contracts typically include prepaid reinstatements that limits our net loss to $10 million retention per event. For layers that are not reinstateable (commonly known as “single shot”) we have arranged cascading coverage that drops down in order to eliminate any potential gap in coverage in the catastrophe program for subsequent event(s).
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.
Critical accounting estimates
We identified the accounting estimates which are 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 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 condensed consolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the condensed consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. Our critical accounting policies and estimates are described in our annual consolidated financial statements and the related notes in our 2019 Annual Report on Form 10-K filed with the SEC on February 28, 2020.
There have been no significant changes in our critical accounting policies and estimates as compared to the critical accounting policies and estimates disclosed in Management’s Discussion and Analysis of Financial Condition and Operations included in our 2019 Annual Report on Form 10-K
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.