HCI Group, Inc. quarterly report, Q2 FY2017

HCI Group, Inc. — Form 10-Q Summary

Business context and reporting period

HCI Group is primarily a Florida property and casualty insurer through Homeowners Choice Property & Casualty Insurance Company, with additional reinsurance, real estate and information-technology operations. The report covers the three and six months ended June 30, 2017; financial statements are unaudited. Insurance operations represented approximately 96.7% of segment revenue in the quarter and 96.6% year to date.

During the quarter, the insurance subsidiary received approval to write residential property and casualty insurance in Arkansas and Pennsylvania. Management also reported approvals covering South Carolina and expects to begin writing flood policies in those states during 2017.

Key financial metrics

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Total revenue	$67.6 million	$61.5 million	$135.3 million	$122.3 million
Net premiums earned	$61.8 million	$58.5 million	$124.9 million	$117.0 million
Net investment income	$2.8 million	$1.7 million	$5.6 million	$3.2 million
Income before taxes	$14.3 million	$11.2 million	$33.4 million	$20.9 million
Net income	$9.5 million	$7.0 million	$21.6 million	$13.1 million
Diluted EPS	$0.93	$0.71	$2.07	$1.31
Net income margin	14.1%	11.4%	15.9%	10.7%
Combined ratio on net premiums	86.1%	85.9%	81.6%	86.6%
Combined ratio on gross premiums	59.1%	53.0%	56.1%	52.3%

Gross premiums earned declined 5.1% in Q2 and 6.2% year to date, reflecting policy attrition and rate decreases. Premiums ceded declined 22.4% in Q2 and 26.0% year to date, primarily because of lower reinsurance costs. Net premiums earned therefore increased 5.7% in Q2 and 6.8% year to date.

Losses and loss adjustment expenses were $27.7 million in Q2 and $53.2 million year to date. The company recorded unfavorable prior-period development of $5.5 million in Q2 and $7.8 million year to date, substantially related to 2016 claims and trends involving assignment of insurance benefits and related litigation.

At June 30, 2017, total assets were $792.7 million, cash and cash equivalents were $296.5 million, available-for-sale securities were $304.8 million, and stockholders’ equity was $238.4 million. Total liabilities were $554.3 million, including $234.8 million of carrying-value long-term debt.

Cash flow, debt and liquidity

Operating cash flow was $31.4 million for the first six months of 2017, compared with $70.4 million in the prior-year period.
Investing cash flow was negative $74.9 million, primarily reflecting $114.1 million of purchases of available-for-sale securities, partially offset by investment sales and $11.8 million of limited-partnership distributions.
Financing cash flow was positive $59.5 million, principally from the $143.8 million issuance of 4.25% convertible senior notes. Uses included redemption of $40.3 million of 8% senior notes, $32.2 million of share repurchases, issuance costs and dividends.
Cash increased from $280.5 million at December 31, 2016 to $296.5 million at June 30, 2017.
Principal long-term debt increased from $148.0 million to $260.6 million. The company issued $143.8 million of 4.25% convertible notes, redeemed the 8% senior notes and converted its revolving credit facility into a 3.95% promissory note.
Contractual obligations totaled $338.4 million, including $306.2 million of long-term debt payments, $19.4 million of minimum reinsurance premiums and $12.1 million of unfunded limited-partnership commitments.
The company had approximately $18.4 million remaining under its $20.0 million share-repurchase authorization at June 30, 2017. The board declared a $0.35-per-share quarterly dividend payable September 15, 2017.

Material changes versus the prior comparable period

Q2 net income increased 35.8%, while six-month net income increased 64.8%.
Q2 total revenue increased 9.8%; six-month revenue increased 10.7%, despite lower gross premiums earned.
Investment results improved materially: net investment income increased by $1.1 million in Q2 and $2.4 million year to date, supported by limited-partnership income versus losses in 2016. Realized investment gains also increased.
Q2 net premiums benefited from lower reinsurance costs, but the gross-premium base and policies in force declined. Policies in force were approximately 143,000 at June 30, 2017 versus 150,000 a year earlier.
The six-month net combined ratio improved to 81.6% from 86.6%, although the Q2 ratio was broadly unchanged. The gross-premium combined ratio worsened to 59.1% in Q2 and 56.1% year to date from 53.0% and 52.3%, respectively.
Interest expense increased to $4.4 million in Q2 and $7.9 million year to date from $2.6 million and $5.4 million, respectively, due primarily to higher debt and non-cash debt discount amortization.
Share count declined from 9.66 million shares at year-end 2016 to 9.17 million at June 30, 2017, reflecting repurchases and forward share-repurchase transactions.

Outlook, risks, contingencies and unusual items

Management expects liquidity needs to be funded primarily by insurance premiums, investment income and operating cash flow, while retaining the option to raise additional debt or equity.
Florida hurricane and tropical-storm exposure is seasonal, with the principal catastrophe period from June 1 through November 30. A major catastrophe could materially affect results and operations.
Loss reserves totaled $73.1 million, including $49.9 million of estimated incurred-but-not-reported losses. Management considers reserves adequate but emphasizes that reserve estimates are inherently uncertain and may change materially.
Reinsurance contracts with retrospective provisions generated accrued benefits and deferred ceded premiums. At June 30, 2017, related accrued benefits were $11.3 million and deferred ceded premiums were $3.6 million; these amounts could be charged to earnings if catastrophe losses exceed applicable coverage.
The company remains liable if reinsurers fail to perform. Management states that reinsurer credit risk was not significant, but accrued benefits are concentrated with one reinsurer, including related-party reinsurer Oxbridge.
The company recorded a $0.7 million loss on early redemption of the 8% senior notes and $0.4 million of net other-than-temporary investment impairment losses year to date.
An IRS examination of the company’s 2015 federal income tax return was expected to begin in the third quarter of 2017.
The company’s insurance subsidiary paid an $18.0 million dividend to HCI during the first six months. Future subsidiary dividends are subject to Florida insurance-law surplus and regulatory limitations.
The filing reports no material changes to previously disclosed risk factors and no pending legal proceedings expected to have a material adverse effect.
Adoption of future accounting guidance for equity securities could increase earnings volatility by requiring subsequent unrealized gains and losses to flow through net income.

Important facts for investors to verify

Whether policy attrition, rate reductions and expansion into new states offset pressure on gross premiums earned.
Whether unfavorable claims development, assignment-of-benefits litigation and catastrophe activity require additional reserve strengthening.
The sustainability of lower reinsurance costs and the collectability of retrospective reinsurance benefits.
Debt repayment and refinancing requirements, particularly the 3.875% convertible notes due in 2019 and the assumed early-call treatment of the 4.25% convertible notes.
The effect of increased leverage and non-cash debt amortization on future interest expense and diluted EPS.
Investment portfolio sensitivity to interest rates, credit losses and equity-market declines; a 100-basis-point rate increase was estimated to reduce fixed-maturity fair value by approximately $8.0 million.
Regulatory capital and dividend restrictions applicable to the Florida insurance subsidiary.
The outcome of the IRS examination and any resulting tax exposure.