Form 10KSB for UNIVERSAL INSURANCE HOLDINGS INC
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3-Apr-2006
Annual Report
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
A NUMBER OF STATEMENTS CONTAINED IN THIS REPORT ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 THAT INVOLVE RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN THE APPLICABLE STATEMENTS. THESE RISKS AND UNCERTAINTIES INCLUDE BUT ARE NOT LIMITED TO THE COSTS AND THE UNCERTAINTIES ASSOCIATED WITH THE RISK FACTORS SET FORTH IN ITEM 1 ABOVE. INVESTORS ARE CAUTIONED THAT THESE FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE OR RESULTS.
OVERVIEW
UPCIC's application to become a Florida licensed property and casualty insurance company was filed with the OIR on May 14, 1997 and approved on October 29, 1997. UPCIC's proposal to begin operations through the acquisition of homeowner insurance policies issued by the JUA was approved by the JUA on May 21, 1997, subject to certain minimum capitalization and other requirements. One of the requirements imposed by the OIR was to limit the number of policies UPCIC could assume from the JUA to 30,000.
The OIR requires applicants to have a minimum capitalization of $5.0 million to be eligible to operate as an insurance company in the State of Florida. Upon being issued an insurance license, companies must maintain capitalization of at least $4 million. If an insurance company's capitalization falls below $4 million, then the company will be deemed out of compliance with OIR requirements, which could result in revocation of the participant's license to operate as an insurance company in the State of Florida.
The Company has continued to implement its plan to become a financial services company and, through its wholly-owned insurance subsidiaries, has sought to position itself to take advantage of what management believes to be profitable business and growth opportunities in the marketplace.
The Company entered into an agreement with the JUA whereby during 1998, UPCIC assumed approximately 30,000 policies from the JUA. In addition, UPCIC received bonus incentive funds from the JUA for assuming the policies. The bonus funds were maintained in an escrow account for three years. These bonus payments were not included in the Company's assets until receipt at the end of the three-year period. UPCIC could not cancel the policies from the JUA for this three-year period at which point UPCIC received the bonus funds. The Company will not be receiving any additional bonus payments.
The Company expects that premiums from renewals and new business will be sufficient to meet the Company's working capital requirements beyond the next twelve months.
The policies obtained from the JUA provided the opportunity for UPCIC to solicit future renewal premiums. The majority of the policies obtained from the JUA renewed with UPCIC. In an effort to further grow its insurance operations, in 1998 the Company began to solicit business actively in the open market. Through renewal of JUA business combined with business solicited in the market through independent agents, UPCIC is currently servicing approximately 89,000 homeowners insurance policies. To improve underwriting and manage risk, the Company utilizes standard industry modeling techniques for hurricane and windstorm exposure. To diversify UPCIC's product lines, UPCIC underwrites inland marine policies. Management may consider underwriting other types of policies in the future. Any such program will require OIR approval. See Item 1, Competition under "Factors Affecting Operation Results and Market Price of Stock" for a discussion of the material conditions and uncertainties that may affect UPCIC's ability to obtain additional policies.
CRITICAL ACCOUNTING POLICIES
USE OF ESTIMATES. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The Company's primary areas of estimate are described below.
RECOGNITION OF PREMIUM REVENUES. Property and liability premiums are recognized as revenue on a pro rata basis over the policy term. The portion of premiums that will be earned in the future are deferred and reported as unearned premiums. The Company believes that its revenue recognition policies conform to Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements.
INSURANCE LIABILITIES. Claims and claim adjustment expenses are provided for as claims are incurred. The provision for unpaid claims and claim adjustment expenses includes: (1) the accumulation of individual case estimates for claims and claim adjustment expenses reported prior to the close of the accounting period; (2) estimates for unreported claims based on industry data; and (3) estimates of expenses for investigating and adjusting claims based on the experience of the Company and the industry.
Inherent in the estimates of ultimate claims are expected trends in claim severity, frequency and other factors that may vary as claims are settled. The amount of uncertainty in the estimates for casualty coverage is significantly affected by such factors as the amount of claims experience relative to the development period, knowledge of the actual facts and circumstances and the amount of insurance risk retained. In the case of UPCIC, this uncertainty is compounded by UPCIC's limited history of claims experience. In addition, UPCIC's policyholders are currently concentrated in South Florida, which is periodically subject to adverse weather conditions such as hurricanes and tropical storms. The methods for making such estimates and for establishing the resulting liability are continually reviewed, and any adjustments are reflected in earnings currently.
DEFERRED POLICY ACQUISITION COSTS/DEFERRED CEDING COMMISSIONS. Commissions and other costs of acquiring insurance that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they are related. Determination of costs other than commissions that vary with and are primarily related to the production of new and renewal business requires estimates to allocate certain operating expenses. When determining the maximum amount of deferred policy acquisition costs, investment income to be earned over the remaining policy period is estimated and taken into consideration. Estimates of the costs of losses, catastrophic reinsurance and policy maintenance are also required in the determination of the maximum amount of deferred policy acquisition costs. Deferred reinsurance commissions have reduced net deferred policy acquisition costs to $0 as of December 31, 2005; deferred ceding commission is $1,043,544 as of December 31, 2005.
PROVISION FOR PREMIUM DEFICIENCY. It is the Company's policy to evaluate and recognize losses on insurance contracts when estimated future claims and maintenance costs under a group of existing contracts will exceed anticipated future premiums and investment income. The determination of the provision for premium deficiency requires estimation of the costs of losses, catastrophic reinsurance and policy maintenance to be incurred and investment income to be earned over the remaining policy period.
REINSURANCE. In the normal course of business, the Company seeks to reduce the risk of loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. While ceding premiums to reinsurers reduces the Company's risk of exposure in the event of catastrophic losses, it also reduces the Company's potential for greater profits should such catastrophic events fail to occur. The Company believes that the extent of its reinsurance is typical of a company of its size in the homeowners insurance industry. Amounts recoverable from reinsurers are estimated in a manner consistent with the provisions of the reinsurance agreement and consistent with the establishment of the liability of the Company. The Company's reinsurance policies do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible.
OFF-BALANCE SHEET ARRANGEMENTS
The Company had no off-balance sheet arrangements during 2005.
RELATED PARTIES
All underwriting, rating, policy issuance, reinsurance negotiations and certain administration functions for UPCIC are performed by UPCIC, Universal Risk Advisors and unaffiliated third parties. Claims adjusting functions are performed by Universal Adjusting Corporation, a wholly owned subsidiary of the Company and unaffiliated third parties.
Dennis Downes and Associates, a multi-line insurance adjustment corporation based in Deerfield Beach, Florida performs certain claims adjusting work for UPCIC. Dennis Downes and Associates is owned by Dennis Downes, who is the father of Sean P. Downes, COO and Senior Vice President of the Company. During 2005 and 2004, the Company expensed claims adjusting fees of $1,075,188 and $1,092,851, respectively, to Dennis Downes and Associates. As of December 31, 2005, the Company had accrued adjusting fees of $95,221 to Dennis Downes and Associates.
During 2005, Sean P. Downes filed a claim on his homeowner's policy issued by UPCIC as a result of damage incurred during Hurricane Wilma. UPCIC handled the claim in the ordinary course of its business and has made a loss payment to Mr. Downes in the amount of $214,409.
In July 2004, the Company borrowed monies from a private investor in the amount of $175,000 for working capital. In August 2005, this individual's son, Michael P. Moran, became UPCIC's Vice President of Claims. The loan was paid off in January 2006.
RESULTS OF OPERATIONS - YEAR ENDED DECEMBER 31, 2005 AND YEAR ENDED DECEMBER 31,
2004.
The fiscal year ended December 31, 2005 marked a significant improvement in the Company's operating results over recent past fiscal years. This improvement was primarily attributable to volume and rate increases, restructuring the homeowners' coverage offered, restructuring the Company's reinsurance coverage and working to control general and administrative expenses.
Gross premiums written increased 115.7% to $88,701,123 for the year ended December 31, 2005 from $41,120,962 for the year ended December 31, 2004. The increase in gross premiums written is primarily attributable to an approximate 107.9% increase in new business as well as an overall 7.8% premium rate increase. The increase in new business is partly attributable to the recent Florida windstorm catastrophes which has provided an opportunity in the otherwise competitive marketplace as certain companies are not accepting new business, as well as marketing initiatives the Company has undertaken.
Net premiums written increased 282.5% to $21,606,878 for the year ended December 31, 2005 from $5,648,548 for the year ended December 31, 2004. The increase in net premiums written reflects the impact of reinsurance, since
$67,094,245 or 75.6% of premiums written were ceded to reinsurers for the year ended December 31, 2005 as compared to $35,472,414 or 86.3% for the year ended December 31, 2004. The increase in net premiums written is attributable to an increase in new business, premium rate increases and changes to the Company's reinsurance program. Under the Company's quota share reinsurance treaty, the Company elected to cede 90% of gross written premiums, losses and loss adjustment expenses during the first five months of 2004 for all policies except for new and renewal without wind risk business with policy effective dates of June 1, 2003 and after versus 80% of policies with coverage for wind risk during the remaining seven months of 2004. The Company continued to cede 80% of policies with coverage for wind risk during the first five months of 2005 versus 55% of policies with coverage for wind risk during the subsequent six months of 2005 and 80% of policies with coverage for wind risk during the remaining month of 2005. The Company believes that the extent of its reinsurance is typical of a company of its size in the homeowners' insurance industry.
Net premiums earned increased 283.6% to $15,825,982 for the year ended December 31, 2005 from $4,125,757 for the year ended December 31, 2004. The increase in net premiums earned is attributable to an increase in new business, premium rate increases and changes in the reinsurance program noted above.
Commission revenue increased 67.2% to $2,525,168 for the year ended December 31, 2005 from $1,510,345 for the year ended December 31, 2004. Commission income is comprised mainly of the Managing General Agent's policy fee income on all new and renewal insurance policies and commissions generated from agency operations. The increase is primarily due to increased policy fee income attributable to an increase in new and renewal business.
Investment income consists of net investment income and net realized gains (losses). Investment income increased 285.5% to $687,085 for the year ended December 31, 2005 from $178,246 for the year ended December 31, 2004. The increase is primarily due to higher investment balances and a higher interest rate environment during 2005.
Transaction fees consist of revenue from the selling of insurance leads. Transaction fee revenue decreased 82.1% to $298,310 for the year ended December 31, 2005 from $1,662,743 for the year ended December 31, 2004. The decrease is primarily due to the Company's decision to stop generating new business from Internet sales operations during the fourth quarter of 2005 and focus on core operations.
Other revenue decreased 37.6% to $325,272 for the year ended December 31, 2005 from $521,682 for the year ended December 31, 2004. Other revenue is comprised of fee revenue from direct sales and service revenue from other operations. The decrease is primarily attributable to the fact that there was less activity in the direct sales and service operations in 2005.
Losses and loss adjustment expenses ("LAE") incurred increased 322.1% to $9,597,984 for the year ended December 31, 2005 from $2,274,035 for the year ended December 31, 2004 as compared to net premiums earned which increased 283.6% to $15,825,982 for the year ended December 31, 2005 from $4,125,757 for the year ended December 31, 2004. Losses and LAE, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. Losses and LAE are influenced by loss severity and frequency. Losses and LAE increased due to an increase in insured exposures and changes to the Company's reinsurance program discussed above. The Company's direct loss ratio for the year ended December 31, 2005 was 148.4% compared to 464.1% for the year ended December 31, 2004. The Company's direct loss ratio decreased principally due to the lower frequency and severity of claims in 2005. During 2005, Florida experienced three windstorm catastrophes (Hurricanes Dennis, Katrina and Wilma) which resulted in losses. As a result of these storms, the Company currently estimates it incurred $64,267,953 in losses prior to reinsurance and $4,050,000 net of reinsurance. The losses from these storms resulted in 104.2% of direct loss ratio. During 2004, Florida experienced 4 windstorms catastrophes (Hurricanes Charley, Frances, Ivan and Jeanne) which resulted in losses. As a result of these storms, the Company currently estimates it incurred $164,344,684 in losses prior to reinsurance and $4,175,976 net of reinsurance. Except for catastrophe claims, the Company believes that the severity and frequency of claims remained relatively stable for the periods under comparison. The Company's net loss ratio for the year ended December 31, 2005 was 60.6% compared to 55.1% for the year ended December 31, 2004. The net loss ratio increased due to the increase in net losses incurred in conjunction with changes to the Company's reinsurance program discussed above as well as higher than expected hurricane losses related to the 2004 catastrophes.
Catastrophes are an inherent risk of the property-liability insurance business, particularly in the geographic area where the Company does business, which may contribute to material year-to-year fluctuations in UPCIC's results of operations and financial position. The level of catastrophe loss experienced in any year cannot be predicted and could be material to the results of operations and financial position. While management believes its catastrophe management strategies will reduce the severity of future losses, UPCIC continues to be exposed to similar or greater catastrophes.
The reserve for direct unpaid losses and LAE at December 31, 2005 is $66,999,956. Based upon consultations with the Company's independent actuarial consultants and their statement of opinion on losses and LAE, the Company believes that the liability for unpaid losses and LAE is adequate to cover all claims and related expenses which may arise from incidents reported. The range of direct loss reserve estimates as determined by the Company's independent actuarial consultants is a low of $55,978,393 and a high of $76,285,129. The key assumption used to arrive at management's best estimate of loss reserves in relation to the actuary's range and the specific factors that led to management's best estimate is that the liability is based on management's estimate of the ultimate cost of settling each loss and an amount for losses incurred but not reported. However, if losses exceed direct loss reserve estimates there could be a material adverse effect on the Company's financial statements. Also, if there are regulatory initiatives, legislative enactments or case law precedents which change the basis for policy coverage, in any of these events, there could be an effect on direct loss reserve estimates having a material adverse effect on the Company's financial statements.
As a result of the Company's review of its liability for losses and loss adjustment expenses, which includes a re-evaluation of the adequacy of reserve levels for prior year claims, the Company's liabilities for unpaid losses and LAE, net of related reinsurance recoverables, as of December 31, 2005 were increased in the current year by $2,549,050 for claims that had occurred on or before the prior year balance sheet date. This unfavorable loss emergence resulted principally from higher than expected hurricane losses in 2004. The Company's liabilities for unpaid losses and LAE, net of related reinsurance recoverables, as of December 31, 2004 were increased by $55,480 for claims that had occurred on or before the previous year balance sheet date. This unfavorable loss emergence resulted principally from settling homeowners' losses established in the prior year for amounts that were more than expected. There can be no assurance concerning future adjustments of reserves, positive or negative, for claims through December 31, 2005.
General and administrative expenses decreased 33.0% to $4,012,391 for the year ended December 31, 2005 from $5,984,871 for the year ended December 31, 2004. General and administrative expenses have decreased primarily due to higher ceding commissions on premiums ceded to reinsurers as well as ceding commissions recognized as a result of a change in the quota share ceding percentage from 55% to 80% at December 1, 2005. The Company's ceding commission for the incremental 25% ceding percentage at December 1 is 35%. The ceding commission on the previous 55% ceding percentage is 31%.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of cash flow are premium revenues, commission income and investment income.
For the year ended December 31, 2005, cash flows provided by operating activities were $26,974,611. Cash flows from operating activities are expected to be positive in both the short-term and reasonably foreseeable future. In addition, the Company's investment portfolio is highly liquid as it consists almost entirely of readily marketable securities. Cash flows from investing activities are primarily comprised of purchases and sales of debt and equity securities. Cash flows from financing activities primarily relate to Company borrowings.
During 2003, the Company purchased software for $520,000. Management believes the software will assist it in reducing overall management expenses versus the previous outside vendor agreement. The final installment payment on the software of $150,000 was paid in March 2005. In addition, the Company has outstanding loans in the amount of $119,186 to finance several vehicles and a boat, all acquired for business use and marketing of the Company's products and in the amount of $1,032,901 for working capital needs. The amounts will become due during the years 2006 through 2011.
In July 2004 the Company borrowed monies from a vendor and two private investors in the amounts of $175,000, $150,000 and $100,000 for working capital. The terms of the notes evidencing such loans require interest payments at a rate of 10% through January 2005 with equal monthly payments of principal plus interest thereafter until January 2006, the maturity date of the notes. The notes were
paid off in January 2006. In connection with the loans, in July 2004, the Company granted to the vendor and two private investors warrants to purchase 175,000, 150,000 and 100,000, shares of restricted Common Stock each at an exercise price of $.05 per share. The warrants vested over the payment terms and each expires in July 2009. These transactions were approved by the Company's Board of Directors.
In September 2004, the Company borrowed $50,000 from each of Bradley I. Meier, President and Chief Executive Officer of the Company, and Sean P. Downes, Senior Vice President and Chief Operating Officer of the Company. The monies were used to make an additional capital contribution to UPCIC to ensure that UPCIC met regulatory surplus requirements and to allow for continued development of UPCIC's business. The principal amount of these loans was repaid in October 2004. Also in September 2004, the Company borrowed $100,000 from a private investor, which loan, plus interest of $10,000, was repaid in October 2004. The funds were used to make an additional capital contribution to UPCIC to ensure that UPCIC met regulatory surplus requirements and to allow for continued development of UPCIC's business. In connection with this loan, the Company granted in 2004 and subsequently issued in February 2005 100,000 shares of restricted Common Stock to the private investor. These transactions were approved by the Company's Board of Directors.
Also in September 2004, the Company's reinsurance intermediary advanced the Company $250,000 which was used as an additional capital contribution to UPCIC.
In June 2005, the Company borrowed monies from two private investors and issued two promissory notes for the aggregate principal sum of $1,000,000 payable in five monthly installments of $200,000. Payment on one note commences on June 30, 2006 and commences on the other note on November 30, 2006. The loan amount subsequently was contributed to UPCIC as additional paid-in-capital. In conjunction with the notes, the Company granted a warrant to one of the investors to purchase 200,000 shares of restricted Common Stock at an exercise price of $.05 per share, expiring in June 2010. These transactions were approved by the Company's Board of Directors.
The following table represents the Company's total contractual obligations for which cash flows are fixed or determinable.
Total 2006 2007 2008 2009 2010 2010+
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(Millions in Dollars)
Contractual obligations
Long-term debt $ 1,152 $ 767 $ 324 $ 16 $ 15 $ 17 $ 13
Operating leases 349 178 114 57 - - -
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Total contractual obligations $ 1,501 $ 945 $ 438 $ 73 $ 15 $ 17 $ 13
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The balance of cash and cash equivalents as of December 31, 2005 was $48,038,736. Most of this amount, including the $10,546,045 cash received from reinsurers in advance of catastrophe claims, is available to pay claims in the event of a catastrophic event pending reimbursement for any aggregate amount in excess of $1,350,000 up to the 100 year PML which would be currently covered by reinsurers. Catastrophic reinsurance is recoverable upon presentation to the reinsurer of evidence of claim payment.
Accounting principles generally accepted in the United States of America differ in some respects from reporting practices prescribed or permitted by the Florida Office of Insurance Regulation. To retain its certificate of authority, the Florida insurance laws and regulations require that UPCIC maintain capital and surplus equal to the statutory minimum capital and surplus requirement defined in the Florida Insurance Code. The Company is also required to adhere to prescribed premium-to-capital surplus ratios. The Company is in compliance with these requirements.
The maximum amount of dividends which can be paid by Florida insurance companies without prior approval of the Florida Commissioner is subject to restrictions relating to statutory surplus. The maximum dividend that may be paid by UPCIC to the Company without prior approval is limited to the lesser of statutory net income from operations of the preceding calendar year or 10.0% of statutory unassigned capital surplus as of the preceding year end.
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. The primary assets of the Company are monetary in nature. As a result, interest rates have a more significant impact on the Company's performance than the effects of the general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the cost of paying losses and LAE.
Insurance premiums are established before the Company knows the amount of loss and LAE and the extent to which inflation may affect such expenses. Consequently, the Company attempts to anticipate the future impact of inflation when establishing rate levels. While the Company attempts to charge adequate rates, the Company may be limited in raising its premium levels for competitive and regulatory reasons. Inflation also affects the market value of the Company's investment portfolio and the investment rate of return. Any future economic changes which result in prolonged and increasing levels of inflation could cause . . .
