Heritage Insurance Holdings, Inc. (HRTG) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a super-regional property and casualty insurance holding company that primarily provides personal and commercial residential insurance products across our multi-state footprint. We provide personal residential insurance in Alabama, California, Connecticut, Delaware, Florida, Georgia, Hawaii, Maryland, Massachusetts, Mississippi, New Jersey, New York, North Carolina, Rhode Island, South Carolina, and Virginia and commercial residential insurance in Florida, New Jersey, and New York. We provide personal residential insurance in Florida on both an admitted and non-admitted basis and in California on a non-admitted basis. As a vertically integrated insurer, we control or manage substantially all aspects of risk management, underwriting, claims processing and adjusting, actuarial rate making and reserving, customer service, and distribution. Our financial strength ratings are important to us in establishing our competitive position and can impact our ability to write policies.

Trends

Inflation, Underwriting and Pricing

We continue to address rising reinsurance and loss costs in the property insurance sector through continued implementation of increased rates and inflation guard factors resulting in an increase in the average premium per policy of 18.1% for the year ended December 31, 2022 as compared to the prior year 2021. New rates, which are subject to approval by our regulators, become effective when a policy is written or renewed, and the premium is earned pro rata over the policy period of one year. As a result of this timing, it can take up to twenty-four months for the complete impact of a rate change to be fully earned in our financial statements. For that reason, we account for inflation in our rate indications and filings with our regulators.

We invest in data analytics, using software and experienced personnel, to continuously evaluate our underwriting criteria and manage exposure to catastrophe and other losses. Our retention has remained steadily in the range of 90% despite the rate increases we have implemented, in large part due to a challenging property insurance market in many of the regions in which we operate. Weather losses and a higher cost of reinsurance have impacted these markets. While we believe our rates are generally competitive with private market insurers operating in our space, we are focused on managing exposure and achieving rate adequacy throughout our book of business.

We continue to experience rising inflation in the form of increased labor and material costs, which drive up claim costs throughout all states in which we conduct business. Our Florida personal lines market is also seeing claim costs impacted by litigated claims, which substantially increases loss costs thereby driving up rates for the insurance buying public. Our response to this phenomenon is a combination of raising rates and reducing exposure. Claims abuse has extended throughout much of Florida, generated from assignment of benefits, excessive roof claims, and unwarranted litigated claims which far exceeds levels experienced in other states. Correspondingly, our exposure reduction plan expanded to personal lines business throughout the state of Florida.

Our industry experienced higher reinsurance costs and more constrained availability for catastrophe excess of loss reinsurance in the Spring 2022 renewals. We anticipate continued cost increases and availability constraints for the 2023 renewal season. As described herein, we are carefully managing exposure by reducing new business written in certain geographies, non-renewing unprofitable business in compliance with regulatory requirements, increasing rates, where permitted by regulators, and narrowing our underwriting requirements.

While we see improvement in the geographic distribution of our business, which is becoming more rate adequate, our Florida loss costs have continued to increase from a combination of adverse weather and exacerbation of losses on weather and other claims resulting from the litigated claims environment.

Recent legislative changes have been made in Florida in each of the last three years, which we believe is making some progress toward reducing losses from abusive claim reporting practices.

The special legislative session of December 2022 included a number of additional provisions aimed at driving down claims abuses and stabilizing the Florida property insurance market. We plan to evaluate the impact of this legislation before growing exposures in the Florida personal lines market.

The table below provides policy count, premiums-in-force, and TIV for Florida and all other states. Our goal is to reduce exposure in Florida given historical abusive claims practices. Florida policies-in-force and TIV have each declined from the prior year but premiums in force increased as a result of rate actions taken. For markets outside of Florida, the premiums-in-force increased while the policy count decreased due to rate actions taken.

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Strategic Profitability Initiatives

The following provides an update to our strategic initiatives that we expect will enable us to achieve consistent long-term quarterly earnings and drive shareholder value.

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Generate underwriting profit though rate adequacy and more selective underwriting.

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Significant rating actions throughout the book of business resulting in an increase in average premium per policy of 18.1% over fourth quarter 2021 and 5.6% over third quarter 2022.

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Premiums-in-force of $1.3 billion are up 9.6% from fourth quarter 2021 while policy count is down 7.2% through more selective underwriting.

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Continued focus on timely rate actions, tightening underwriting criteria, and expanding restrictions on new business written in over-concentrated markets or products.

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Optimize capital allocation toward products and geographies that maximize long-term returns.

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Increased commercial residential premium by 41.1% year over year while TIV only increased 21.5% and policies in force increased by only 0.4%.

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Reduced policy count for Florida personal lines business by 16.2% as compared fourth quarter 2021. The disciplined underwriting and rating actions have reduced Florida personal lines TIV by 11.1% while reducing premiums in force by only 1.9%.

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This disciplined underwriting approach resulted in a policy count reduction of 2.5% in other states while generating a 11.9% increase in premiums in force.

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Improve portfolio diversity.

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No state represents over 26% of the Company’s TIV.

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The top four states grew TIV by an average 2.2% while the smallest five states grew by 56.7%.

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As a result of diversification efforts, the top five personal lines states represented 79.2% of all TIV at fourth quarter 2022 compared to 79.8% of all TIV at fourth quarter 2021.

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Provide coverages suitable to the market and return targets.

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Offering Excess & Surplus lines (“E&S”) policies in California and Florida.

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Expanding E&S to South Carolina during second quarter of 2023.

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Continue to evaluate other states for E&S and other products.

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Key Components of our Results of Operations

Revenue

Gross premiums written represent, with respect to a period, the sum of direct premiums written (premiums from policies written during the period, net of any midterm cancellations and renewals of voluntary policies) and assumed premiums written (primarily premiums from state fair plan policies), in each case prior to ceding premiums to reinsurers.

Gross premiums earned represent the total premiums earned during a period from policies written. Premiums associated with new and renewal policies are earned ratably over the twelve-month term of the policy and premiums associated with assumed policies are earned ratably over the remaining term of the policy.

Ceded premiums represent the cost of our reinsurance during a period. We recognize the cost of our reinsurance program ratably over term of the arrangement, which is typically twelve months. Our catastrophe excess of loss reinsurance generally incepts June 1 and runs through May 31 of the following year. Our net quota share treaty incepts December 31. Our other reinsurance programs may be purchased on a calendar or fiscal year basis.

Net premiums earned reflect gross premiums earned less ceded premiums during the period.

Net investment income represents interest earned on fixed maturity securities, short term securities and other investments, dividends on equity securities.

Net realized and unrealized gains or losses represent gains or losses on investment sales and unrealized gains or losses on equity securities.

Other revenue includes rental income due under non-cancelable leases for space at the Company’s commercial property in Clearwater, Florida, and all policy and pay-plan fees. Our regulators have approved a policy fee on each policy written for certain states; to the extent these fees are not subject to refund, the Company recognizes the income immediately when collected. The Company also charges pay-plan fees to policyholders that pay premiums in more than one installment and record the fees as income when collected.

Expenses

Losses and loss adjustment expenses (“LAE”) reflect losses paid, expenses paid to resolve claims, such as fees paid to adjusters, attorneys and investigators, and changes in our reserves for unpaid losses and loss adjustment expenses during the period, in each case net of losses ceded to reinsurers. Our reserves for unpaid losses and loss adjustment expenses represent the estimated ultimate cost of resolving all reported claims plus all losses we incurred related to insured events that we assume have occurred as of the reporting date, but that policyholders have not yet reported to us (which are commonly referred to as incurred but not reported, or “IBNR”). We estimate our reserves for unpaid losses using individual case-based estimates for reported claims and actuarial estimates for IBNR losses. We continually review and adjust our estimated losses as necessary based on our evolving claims experience, new information obtained and industry development trends. If our unpaid losses and loss adjustment expenses are considered deficient or redundant, we increase or decrease the liability in the period in which we identify the difference and reflect the change in our current period results of operations.

Policy acquisition costs (“PAC”) consist of: (i) commissions paid to outside agents at the time of policy issuance, (ii) policy administration fees paid to a third-party administrator at the time of policy issuance, (iii) premium taxes and (iv) inspection fees. We recognize policy acquisition costs ratably over the term of the underlying policy. We earn ceding commissions on our net quota share reinsurance contract and certain other reinsurance contracts, which are reported as a reduction to policy acquisition costs and general and administrative expenses based upon the proportion these costs bear to production of new business. Refer to Note 11 “Deferred Policy Acquisition Costs” to our consolidated financial statements under Item 8 of this Annual Report on Form 10K. Ceding commission income is deferred and earned over the contract period. The amount and rate of ceding commissions earned on the net quota share contract can slide within a prescribed minimum and maximum, depending on loss performance and how future losses develop.

General and administrative expenses (“G&A”) include compensation and related benefits, professional fees, office lease and related expenses, information system expenses, corporate insurance, and other general and administrative costs. As noted above, a certain portion of our ceding commissions are allocated to general and administrative expenses.

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Provision for income taxes consists of federal and state corporate level income taxes. The effective tax rate can fluctuate throughout the year as estimates used in the quarterly tax provision are updated with additional information throughout the year. The effective tax rate can vary from the 26.5% statutory federal and state blended rate depending on the amount of pretax income in proportion to permanent tax differences as well as state tax apportionment. The 2022 and 2021 effective tax rates were adversely impacted by the mostly non-deductible goodwill impairment reported of $92.0 million and $60.5 million, respectively. At December 31, 2022, the Company recognized a valuation allowance of $6.4 million against the net deferred tax asset generated at its foreign domiciled captive reinsurer, Osprey Re. The Company can only realize those net deferred tax assets to the extent Osprey Re generates future taxable income.

Ratios

Ceded premium ratio represents ceded premiums earned as a percentage of gross premiums earned.

Net loss ratio represents net losses and LAE as a percentage of net premiums earned.

Net expense ratio represents PAC and G&A expenses as a percentage of net premiums earned. Ceding commission income is reported as a reduction of policy acquisition costs and G&A expenses.

Net combined ratio represents the sum of the net loss and expense ratio. The net combined ratio is a key measure of underwriting performance traditionally used in the property and casualty insurance industry. A net combined ratio under 100% generally reflects profitable underwriting results.

Recent Developments

Economic and Market Factors

We continue to monitor the effects of general changes in economic and market conditions on our business. As a result of general supply chain disruptions and inflationary pressures, we have experienced, and may continue to experience, increased cost of materials and labor needed for repairs and to otherwise remediate claims.

Goodwill impairment Charge

We evaluate goodwill and other intangible assets for impairment annually, or whenever events or changes in circumstances indicate that it is likely that the carrying amount of goodwill and other intangible assets may exceed the implied fair value. Any impairment is charged to operations in the period that the impairment is identified. The evaluation of goodwill impairment requires considerable management judgment and includes a review of a variety of factors as described in Note 3, Goodwill and Other Intangible assets to our consolidated financial statements. Any adverse change in those factors could have a significant impact on the recoverability of goodwill and a material impact on our financial results. During the second quarter of 2022, we concluded it was appropriate to perform an interim evaluation of goodwill for potential impairment given a variety of market trends. As a result of the analysis, management determined the entire amount of remaining goodwill was impaired, which reduced our carrying value of goodwill from $92.0 million to $0 based on the following factors: (i) disruptions in the equity markets, specifically for property and casualty insurance companies, largely due to recent weather-related catastrophe events; (ii) elevated loss ratios for property insurers in our markets; and (iii) trading of our stock below book value. These factors reduced our previously modeled fair value of the Company and resulted in a $92.0 million non-cash goodwill impairment charge, most of which is not tax deductible.

Overview of 2022 Financial Results

In the following section, we discuss our financial condition and results of operations for the year ended December 31, 2022 compared to the year ended December 31, 2021. For a discussion of the year ended December 31, 2021 compared to the year ended December 31, 2020, please Refer to Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2021, which was filed with the SEC on March 14, 2022.

The discussion of our financial condition and results of operations that follows provides information that will assist the reader in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, including certain key performance indicators such as net combined ratio, ceded premium ratio, net expense ratio and net loss ratio, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our consolidated financial statements. This discussion should be read in conjunction with our consolidated financial statements and the related notes included under Part II, Item 8 of this Annual Report on Form 10-K.

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Net loss for the year ended December 31, 2022 was $154.4 million or $5.86 per diluted share, compared to a net loss of $74.7 million or $2.69 per diluted share in the prior year, with the increase stemming from a $90.8 million, net of income tax, non-cash goodwill impairment charge in the second quarter contributing a $3.45 loss per share, compared to a $60.5

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million, non-cash goodwill impairment charged reported in the fourth quarter of 2021 contributing a $2.18 loss per share; combined with higher losses and loss adjustments expenses incurred for the year ended December 31, 2022, which included net losses associated with Hurricanes Ian and Nicole. In addition, the Company recorded a $6.4 million valuation allowance against our net deferred tax asset related to certain tax elections made by Osprey Re, our captive reinsurer domiciled in Bermuda. The total amount of these expenses exceeded the increase in total revenue as described below.

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Gross premiums written of $1.3 billion, up 9.5% from $1.2 billion in the prior year, driven primarily by rate actions taken in all states with a policy count reduction of 7.2% driven substantially by a reduction in the number of Florida personal lines policies. Rate increases continued to meaningfully benefit written premiums throughout the book of business.

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Gross premiums earned of $1.2 billion, up 5.7% from $1.1 billion in the prior year, reflecting higher gross premiums written over the last twelve months driven by a higher average premium per policy.

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Net premiums earned of $637.1 million, up 4.3% from $611.1 million in the prior year, reflecting the higher gross earned premium outpacing the increase in ceded premiums for the year.

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Losses and loss adjustment expenses incurred of $501.2 million, up 17.3% from $427.4 million in the prior year. The increase primarily stems from retained losses from Hurricanes Ian and Nicole in 2022 as well as an increase in attritional losses. Additionally, we experienced $3.7 million of adverse prior year development compared to $3.5 million of favorable prior year development in the prior year.

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Ceded premium ratio of 47.3%, up 0.7 points from 46.6% in the prior year driven by a higher cost of the 2022-2023 catastrophe excess of loss program, stemming primarily from higher costs, which was partly offset by a higher cost for severe convective storm coverage in 2021 which did not recur in 2022. The ceded premium ratio change was dampened by the increase in gross premiums earned which exceeded the increase in the cost of the reinsurance program.

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Net loss ratio of 78.7%, 8.8 points higher than the prior year of 69.9%, driven by higher losses incurred and higher ceded premium as described above.

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Net expense ratio of 35.6%, up 0.9 points from the prior year amount of 34.7%, driven by a higher ceded premium ratio as described above, as well as higher policy acquisition associated with the increase in gross premiums written.

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Net combined ratio of 114.3%, up 9.7 points from 104.6% in the prior year, driven by higher net loss and net expense ratios as described above.

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Effective tax rate was 7.1% compared to 1.7% in the prior year. The effective tax rate for 2022 was significantly lower than the statutory rate due to a non-cash, mostly tax non-deductible goodwill impairment of $92.0 million recorded in the second quarter as well as a $6.4 million valuation allowance against our Osprey Re net deferred tax assets whose utilization may be limited under the Internal Revenue Code. The effective tax rate for 2021 was lower than the statutory rate primarily due to a mostly non-deductible non-cash goodwill impairment of $60.5 million. The effective tax rate can also vary driven by the impact of permanent differences in relation to the pre-tax income or loss each year.

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Consolidated Results of Operations

The following table summarizes our results of operations for the years indicated:

NM – not meaningful

Total revenue

Total revenue was $662.5 million for the year ended December 31, 2022, up 4.9% compared to $631.6 million in the prior year. The increase primarily stems from higher net premiums earned and investment income partly offset by a reduction in policy fee income, as described below.

Gross premiums written

Gross premiums written of $1.3 billion, up 9.5% year-over-year from $1.2 billion. We experienced premiums written growth of 12.1% outside Florida and 7.1% in Florida. Growth throughout our book of business was largely driven by rate increases resulting in a higher average premium per policy. Premiums-in-force were $1.3 billion as of December 31, 2022, representing a 9.6% increase from the prior year due to continued proactive underwriting and rate actions despite a reduction in policy count reduction of approximately 40,000. The reduction in policies-in-force from the fourth quarter of 2021 reflects our intentional exposure management initiatives.

Gross premiums earned

Gross premiums earned were $1.2 billion for the year ended December 31, 2022, up 5.7% compared to $1.1 billion in the prior year. The increase in gross premiums earned reflects higher gross premiums written over the last twelve months driven by rate increases, which resulted in higher average premium per policy, as described above.

Ceded premiums

Ceded premiums were $571.8 million for the year ended December 31, 2022, up 7.3% compared to $533.1 million in the prior year. The increase is primarily attributable to a higher cost of catastrophe excess of loss reinsurance coupled with higher ceded premiums for our quota share coverage due to the higher gross premiums written in the northeast, partly offset by a lower cost for our severe convective storm coverage from the prior year.

Net premiums earned

Net premiums earned were $637.1 million for the year ended December 31, 2022, up 4.3% compared to $611.1 million in the prior year. The increase primarily stems from higher gross premiums earned, partly offset by higher ceded premiums as described above.

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Net investment income

Net investment income, inclusive of realized investment gains (losses) and unrealized gains (losses) on equity securities, was $11.7 million for the year ended December 31, 2022, up 109.0% compared to $5.6 million in the prior year. The increase stems from a higher interest rate environment in 2022 as compared to the prior year.

Other revenue

Other revenue was $13.7 million for the year ended December 31, 2022, down 7.9% compared to $14.9 million in the prior year. The decrease was driven largely by lower policy fee income as a result of the reduction in policy count in Florida.

Total operating expenses

Total operating expenses were $819.8 million, or 17.2% from $699.6 million in the prior year. As described below, the drivers included the increase in losses and loss adjustment expenses, an increase in acquisition costs, and additional goodwill impairment.

Losses and loss adjustment expenses (LAE)

Losses and LAE were $501.2 million for the year ended December 31, 2022, up 17.3% compared to $427.4 million in the prior year. The increase was driven primarily by more severe catastrophe weather activity in 2022 than in 2021. The remainder was driven by higher attritional losses, as well as unfavorable loss development of $3.7 million in 2022 compared to favorable loss development of $3.5 million in 2021.

Policy acquisition costs

Policy acquisition costs were $156.3 million for the year ended December 31, 2022, up 7.1% compared to $146.0 million in the prior year. Higher acquisition costs were driven by the increase in gross premiums written.

General and administrative expenses

General and administrative expenses were $70.4 million for the year ended December 31, 2022, up 7.0% compared to $65.8 million in the prior year. The increase is primarily attributable to higher human capital costs, mostly driven by employee benefits costs, as well as the non-recurrence of a $1.5 million state tax credit recorded in 2021.

Goodwill impairment

We evaluate goodwill and other intangible assets for impairment at least on an annual basis or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed their implied fair value. Goodwill is evaluated at the reporting unit level, for which we have one reporting unit level. Any impairment is charged to operations in the period that the impairment is identified. The Goodwill impairment evaluation includes a review of a variety of factors as described below, which require considerable management judgment. Any adverse change in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on our consolidated financial statements.

As a result of our analysis for goodwill impairment, we impaired $60.5 million of goodwill in the fourth quarter of 2021 and impaired the entire amount of remaining goodwill in the second quarter of 2022, reducing our carrying value of goodwill from $92.0 million at December 31, 2021 to $0 at December 31, 2022. See the section titled “Goodwill Impairment Charge” above and Note 3 of the notes to our consolidated financial statements for more detail on our impairment of goodwill.

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Net loss

Net loss for the year ended December 31, 2022 was $154.4 million, up 106.6% from net loss of $74.7 million in the prior year. The increase primarily relates to a goodwill impairment charge as described in Note 3 to the consolidated financial statements coupled with higher catastrophe weather losses described above and a $6.4 million valuation allowance against our net deferred tax asset as described above, partly offset by higher total revenue as described above.

Interest expense, net

Interest expense was $8.8 million for the year ended December 31, 2022, above the prior year by 10.5% as a result of rising interest rates.

Benefit for income taxes

The benefit for income taxes was $11.8 million for the year ended December 31, 2022 compared to a benefit for income taxes of $1.3 million for the year ended December 31, 2021. The effective tax rate for the current year is 7.1% compared to 1.7% for the prior year. Our effective tax rate for both years was impacted by the non-deductible goodwill impairment of $92.0 million recognized during the second quarter of 2022 and $60.5 million during the fourth quarter of 2021. See further discussion of the goodwill impairment in the Note 3 of the Notes to our consolidated financial statements. The effective tax rate for the year ended December 31, 2022 was also impacted by a $6.4 million valuation allowance against our net deferred tax asset related to certain tax elections made by Osprey Re, our captive reinsurer domiciled in Bermuda, whose utilization may be limited under the Internal Revenue Code. Finally, the effective tax rate can fluctuate throughout the year as estimates used in the quarterly tax provision are updated with additional information throughout the year, including changes to pre-tax income and from the impact of permanent differences on pre-tax income or loss.

Ratios

Net combined ratio

The net combined ratio was 114.3% for the year ended December 31, 2022, up 9.7 points from 104.6% in the prior year. The increase stems primarily from a higher net loss and net expense ratios, described below.

Ceded premium ratio

The ceded premium ratio was 47.3% for the year ended December 31, 2022, up 0.7 points from 46.6% in the prior year. The increase primarily stems from ceded premium growth that was partly offset by growth in gross premiums earned as described above.

Net loss and LAE ratio

The net loss and LAE ratio was 78.7% for the year ended December 31, 2022, up 8.8 points from 69.9% in the prior year. The increase primarily relates to higher weather and attritional losses in the current year as a percentage of net premium earned, mostly driven by Hurricanes Ian and Nicole and $3.7 million of unfavorable prior year reserve development in 2022 compared to $3.5 million of favorable prior year reserve development in 2021, as a percentage of net premiums earned.

Net expense ratio

The net expense ratio was 35.6% for the year ended December 31, 2022, up 0.9 points from 34.7% in the prior year. The increase primarily stems from the impact of a higher ceded premium ratio as well as higher policy acquisition associated with the increase in gross premiums written.

Liquidity and Capital Resources

Our principal sources of liquidity include cash flows generated from operations, our cash, cash equivalents, our marketable securities balances and borrowings available under our credit facilities. As of December 31, 2022, we held $280.9 million in cash and cash equivalents and $653.6 million in investments, compared to $359.3 million and $694.7 million as of December 31, 2021. The decrease in cash and cash equivalents was primarily driven by payment of reinsurance premiums, claim payment, stock repurchases,

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and payment of dividends. The decrease in investments was driven by higher unrealized losses on our fixed income securities caused by rising interest rates.

We generally hold substantial cash balances to meet seasonal liquidity needs including amounts to pay quarterly reinsurance installments as well as meet the collateral requirements of Osprey, our captive reinsurance company, which is required to maintain a collateral trust account equal to the risk that it assumes from our insurance company affiliates.

We believe that our sources of liquidity are adequate to meet our cash requirements for at least the next twelve months.

We may continue to pursue the acquisition of complementary businesses and make strategic investments. We may increase capital expenditures consistent with our investment plans and anticipated growth strategy. Cash and cash equivalents may not be sufficient to fund such expenditures. As such, in addition to the use of our existing Credit Facilities, we may need to utilize additional debt to secure funds for such purposes.

Statement of Cash Flows

The net increases (decreases) in cash and cash equivalents are summarized in the following table:

Operating Activities

Net cash used in operating activities for the year ended December 31, 2022 was $34.3 million compared to net cash provided by of $60.1 million during the prior year. The decrease in cash from operating activities relates primarily to timing of cash flows associated with claim and reinsurance payments as well as reinsurance reimbursements during the year ended December 31, 2022 compared to the year ended December 31, 2021.

Investing Activities

Net cash used in investing activities for the year ended December 31, 2022 was $37.9 million compared to net cash used of $124.5 million in the prior year. The change in cash used in investing activities relates primarily to allocations of funds for investment in each period. Strategic sales of investments to yield realized gains in 2020 produced proceeds which were re-invested in 2021, driving up the cash used for investing activities for that period.

Financing Activities

Net cash used in financing activities for the year ended December 31, 2022 was $5.1 million, compared to net cash used of $17.3 million in the prior year. The decrease in cash used for financing activities was primarily driven by draws from our Revolving Credit Facility (defined below) totaling $35 million to purchase and retire $22.5 million of Convertible Notes and contribute capital to our captive reinsurer, Osprey Re.

Credit Facilities

The Company is party to a Credit Agreement by and among the Company, as borrower, certain subsidiaries of the Company from time to time party thereto as guarantors, the lenders from time to time party thereto (the “Lenders”), Regions Bank, as Administrative Agent and Collateral Agent, BMO Harris Bank N.A., as Syndication Agent, Hancock Whitney Bank and Canadian Imperial Bank of Commerce, as Co-Documentation Agents, and Regions Capital Markets and BMO Capital Markets Corp., as Joint Lead Arrangers and Joint Bookrunners (as amended from time to time, the “Credit Agreement”).

Based on the Company’s results for the third quarter of 2022, management considered it likely at that time that the Company would be out of compliance with certain financial covenants in the Credit Agreement. In order to avoid a covenant violation, on November 7, 2022, the Company and its subsidiary guarantors entered into an amendment to the Credit Agreement to, among other things, (i) decrease the Revolving Credit Facility commitments from $75 million to $50 million, (ii) establish a new $25 million Term Loan Facility (defined below) to refinance loans outstanding under the existing Revolving Credit Facility and to pay fees, costs and expenses related thereto, (iii) reduce, from $50 million to $25 million, the aggregate amount of potential future increases to the Revolving Credit Facility commitments and/or Term Loan Facility commitments, (iii) modify the amortization of the existing term loan facility and new term loan facility to 10% per annum, paid quarterly, and (iv) increase the applicable margin for loans under the

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Credit Agreement to a range from 2.75% to 3.25% per annum for SOFR loans (plus a 0.10% credit adjustment spread) and based on a leverage ratio (an increase from the prior range of 2.50% to 3.00%). The amendment also modified certain financial covenants in the Credit Agreement which may limit the Company’s flexibility in connection with future financing transactions and in the allocation of capital in the future, including the Company’s ability to pay dividends and make stock repurchases, and contribute capital to its insurance subsidiaries that are not parties to the Credit Agreement.

The Credit Agreement, as amended, provides for (1) a five-year senior secured term loan facility in an aggregate principal amount of $100 million (the “Term Loan Facility”) and (2) a five-year senior secured revolving credit facility in an aggregate principal amount of $50 million (inclusive of a sublimit for the issuance of letters of credit equal to the unused amount of the revolving credit facility and a sublimit for swingline loans equal to the lesser of $25 million and the unused amount of the revolving credit facility) (the “Revolving Credit Facility” and together with the Term Loan Facility, the “Credit Facilities”).

Term Loan Facility. The principal amount of the Term Loan Facility amortizes in quarterly installments, which began with the close of the fiscal quarter ending March 31, 2019, in an amount equal to $1.9 million per quarter, payable quarterly, decreasing to $875,000 per quarter commencing with the quarter ending December 31, 2021, and increasing to $2.4 million per quarter commencing with the quarter ending December 31, 2022, with the remaining balance payable at maturity. The Term Loan Facility matures on July 28, 2026. As of November 7, 2022, after giving effect to the additional term loan advance that was used to refinance amounts outstanding under the Revolving Credit Facility and to pay fees, costs and expenses related thereto, there was $73.9 million in aggregate principal outstanding under the Term Loan Facility. As of December 31, 2022, there was $89.1 million in aggregate principal outstanding under the Term Loan Facility.

Revolving Credit Facility. The Revolving Credit Facility allows for borrowings of up to $50 million inclusive of a sublimit for the issuance of letters of credit equal to the unused amount of the Revolving Credit Facility and a sublimit for swingline loans equal to the lesser of $25 million and the unused amount of the Revolving Credit Facility. As of September 30, 2022, we had $25.0 million in borrowings and a $22.6 million letters of credit outstanding under the Revolving Credit Facility. In connection with the incurrence of additional amounts under the Term Loan Facility pursuant to the amendment, the borrowings under the Revolving Credit Facility were repaid in full. On December 23, 2022, the Company borrowed $10.0 million under the Revolving Credit facility. At December 31, 2022, the Company had unused letters of credit totaling $32.6 million.

At our option, borrowings under the Credit Facilities bear interest at rates equal to either (1) a rate determined by reference to SOFR, plus an applicable margin (described below) and a credit adjustment spread equal to 0.10% or (2) a base rate determined by reference to the highest of (a) the “prime rate” of Regions Bank, (b) the federal funds rate plus 0.50%, and (c) the adjusted term SOFR in effect on such day for an interest period of one month plus 1.00%, plus an applicable margin (described below).

The applicable margin for loans under the Credit Facilities varies from 2.75% per annum to 3.25% per annum (for SOFR loans) and 1.75% to 2.25% per annum (for base rate loans) based on our consolidated leverage ratio ranging from 1.25-to-1 to greater than 2.25-to-1. Interest payments with respect to the Credit Facilities are required either on a quarterly basis (for base rate loans) or at the end of each interest period (for SOFR loans) or, if the duration of the applicable interest period exceeds three months, then every three months. As of December 31, 2022, the borrowings under the Term Loan Facility and Revolving Credit Facility accruing interest at a rate of 7.32% and 7.42% per annum, respectively.

In addition to paying interest on outstanding borrowings under the Revolving Credit Facility, we are required to pay a quarterly commitment fee based on the unused portion of the Revolving Credit Facility, which is determined by our consolidated leverage ratio.

We may prepay the loans under the Credit Facilities, in whole or in part, at any time without premium or penalty, subject to certain conditions including minimum amounts and reimbursement of certain costs in the case of prepayments of SOFR loans. In addition, we are required to prepay the loan under the Term Loan Facility with the proceeds from certain financing transactions, involuntary dispositions or asset sales (subject, in the case of asset sales, to reinvestment rights).

All obligations under the Credit Facilities are or will be guaranteed by each existing and future direct and indirect wholly owned domestic subsidiary of the Company, other than all of the Company’s current and future regulated insurance subsidiaries (collectively, the “Guarantors”).

The Company and the Guarantors are party to a Pledge and Security Agreement, (as amended from time to time the “Security Agreement”), in favor of Regions Bank, as collateral agent. Pursuant to the Security Agreement, amounts borrowed under the Credit Facilities are secured on a first priority basis by a perfected security interest in substantially all of the present and future assets of the Company and each Guarantor (subject to certain exceptions), including all of the capital stock of the Company’s domestic subsidiaries, other than its regulated insurance subsidiaries.

The Credit Agreement contains, among other things, covenants, representations and warranties and events of default customary for facilities of this type. The Company is required to maintain, as of each fiscal quarter (1) a maximum consolidated leverage ratio of 2.50 to 1.00, stepping down to 2.25 to 1.00 as of the second quarter of 2024 and 2.00 to 1.00 as of the second quarter of 2025, (2) a minimum consolidated fixed charge coverage ratio of 1.20 to 1.00 and (3) a minimum consolidated net worth for the Company and its subsidiaries, which is required to be not less than $100 million plus 50% of positive quarterly net income (including its subsidiaries

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and regulated subsidiaries) plus the net cash proceeds of any equity transactions. Events of default include, among other events, (i) nonpayment of principal, interest, fees or other amounts; (ii) failure to perform or observe certain covenants set forth in the Credit Agreement; (iii) breach of any representation or warranty; (iv) cross-default to other indebtedness; (v) bankruptcy and insolvency defaults; (vi) monetary judgment defaults and material nonmonetary judgment defaults; (vii) customary ERISA defaults; (viii) a change of control of the Company; and (ix) failure to maintain specified catastrophe retentions in each of the Company’s regulated insurance subsidiaries.

Convertible Notes

On August 10, 2017, the Company and Heritage MGA, LLC (the “Notes Guarantor”) entered into a purchase agreement (the “Purchase Agreement”) with Citigroup Global Markets Inc., as the initial purchaser (the “Initial Purchaser”), pursuant to which the Company agreed to issue and sell, and the Initial Purchaser agreed to purchase, $125.0 million aggregate principal amount of the Company’s 5.875% Convertible Senior Notes due 2037 (the “Convertible Notes”) in a private placement transaction pursuant to Rule 144A under the Securities Act, as amended (the “Securities Act”). The Purchase Agreement contained customary representations, warranties and agreements of the Company and the Notes Guarantor and customary conditions to closing, indemnification rights and obligations of the parties and termination provisions. The net proceeds from the offering of the Convertible Notes, after deducting discounts and commissions and estimated offering expenses payable by the Company, were approximately $120.5 million. The offering of the Convertible Notes was completed on August 16, 2017.

The Company issued the Convertible Notes under an Indenture (the “Convertible Note Indenture”), dated August 16, 2017, by and among the Company, as issuer, the Notes Guarantor, as guarantor, and Wilmington Trust, National Association, as trustee (the “Trustee”).

The Convertible Notes bear interest at a rate of 5.875% per year. Interest is payable semi-annually in arrears, on February 1 and August 1 of each year. The Convertible Notes are senior unsecured obligations of the Company that rank senior in right of payment to the Company’s future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to the Company’s unsecured indebtedness that is not so subordinated; effectively junior to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness or other liabilities incurred by the Company’s subsidiaries other than the Notes Guarantor, which fully and unconditionally guarantee the Convertible Notes on a senior unsecured basis.

The Convertible Notes mature on August 1, 2037, unless earlier repurchased, redeemed or converted.

Holders may convert their Convertible Notes at any time prior to the close of business on the business day immediately preceding February 1, 2037, other than during the period from, and including, February 1, 2022 to the close of business on the second business day immediately preceding August 5, 2022, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2017, if the closing sale price of the Company’s common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the calendar quarter immediately preceding the calendar quarter in which the conversion occurs, is more than 130% of the conversion price of the Convertible Notes in effect on each applicable trading day; (2) during the ten consecutive business-day period following any five consecutive trading-day period in which the trading price for the Convertible Notes for each such trading day was less than 98% of the closing sale price of the Company’s common stock on such date multiplied by the then-current conversion rate; (3) if the Company calls any or all of the Convertible Notes for redemption, at any time prior to the close of business on the second business day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events.

During the period from and including February 1, 2022 to the close of business on the second business day immediately preceding August 5, 2022, and on or after February 1, 2037 until the close of business on the second business day immediately preceding August 1, 2037, holders may surrender their Convertible Notes for conversion at any time, regardless of the foregoing circumstances.

The conversion rate for the Convertible Notes was initially 67.0264 shares of common stock per $1,000 principal amount of Convertible Notes (equivalent to an initial conversion price of approximately $14.92 per share of common stock). The conversion rate is subject to adjustment in certain circumstances and is subject to increase for holders that elect to convert their Convertible Notes in connection with certain corporate transactions (but not, at the Company’s election, a public acquirer change of control (as defined in the Convertible Note Indenture)) that occur prior to August 5, 2022.

Upon the occurrence of a fundamental change (as defined in the Convertible Note Indenture) (but not, at the Company’s election, a public acquirer change of control (as defined in the Convertible Note Indenture), holders of the Convertible Notes may require the Company to repurchase for cash all or a portion of their Convertible Notes at a fundamental change repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date.

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At any time prior to February 1, 2037, the Company may redeem for cash all or any portion of the Convertible Notes, at the Company’s option, at a redemption price equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. No sinking fund is provided for the Convertible Notes, which means that the Company is not required to redeem or retire the Convertible Notes periodically. Holders of the Convertible Notes are able to cause the Company to repurchase their Convertible Notes for cash on any of August 1, 2022, August 1, 2027 and August 1, 2032, in each case at 100% of their principal amount, plus accrued and unpaid interest to, but excluding, the relevant repurchase date.

The Convertible Note Indenture contains customary terms and covenants and events of default. If an Event of Default (as defined in the Convertible Note Indenture) occurs and is continuing, the Trustee by notice to the Company, or the holders of at least 25% in aggregate principal amount of the Convertible Notes then outstanding by notice to the Company and the Trustee, may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the Convertible Notes to be immediately due and payable. In the case of certain events of bankruptcy, insolvency or reorganization (as set forth in the Convertible Note Indenture) with respect to the Company, 100% of the principal of, and accrued and unpaid interest, if any, on, the Convertible Notes automatically become immediately due and payable.

In January 2022, the Company repurchased $11.7 million principal amount of outstanding Convertible Notes. As of December 31, 2022, there was $885,000 principal amount of outstanding Convertible Notes, net of $21.1 million of Convertible Notes held by an insurance company subsidiary.

As discussed above, holders of the Convertible Notes issued by the Company had an optional put right, pursuant to the indenture governing the Convertible Notes, to require the Company to repurchase the aggregate principal amount of Convertible Notes that are validly tendered. The Company received notice from the Depositary for the Convertible Notes that, on July 29, 2022, $10.9 million aggregate principal amount of the Convertible Notes has been validly tendered in accordance with the terms of the indenture and the Company’s notice with respect to the optional put right of the Convertible Notes, and the Company has requested that the Trustee cancel the Convertible Notes tendered. The outstanding balance as of December 31, 2022 of non-affiliated Notes was $885,000. On August 1, 2022, the Company made payments for the principal amount of the Convertible Notes tendered and unpaid interest in the aggregate amounts of $10.9 million and $320,041, respectively. The Company has drawn $10.0 million from the Revolving Credit Facility to replenish the cash used to pay the $10.9 million for the purchase of the tendered Convertible Notes.

FHLB Loan Agreements

In December 2018, a subsidiary of the Company pledged U.S. government and agency fixed maturity securities with an estimated fair value of $24.3 million as collateral and received $19.2 million in a cash loan under an advance agreement with the FHLB Atlanta. The loan originated on December 12, 2018 and bears a fixed interest rate of 3.094% with interest payments due quarterly commencing in March 2019. The principal balance on the loan has a maturity date of December 13, 2023. In connection with the agreement, the subsidiary became a member of FHLB. Membership in the FHLB required an investment in FHLB’s common stock which was purchased on December 31, 2018 and valued at $1.4 million. As of December 31, 2022, the common stock was valued at $1.5 million. The subsidiary is permitted to withdraw any portion of the pledged collateral over the minimum collateral requirement at any time, other than in the event of a default by the subsidiary. The proceeds from the loan were used to prepay the Company’s Senior Secured Notes due 2023 in 2018.

Contractual Obligations and Commitments

The following table summarizes our material contractual obligations and commitments as of December 31, 2022:

(1)
Amounts represent principal and interest payments to debt obligations. Debt obligations are classified based on their stated maturity date. For further information on long-term debt, Refer to Note 14 “Long Term Debt” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.

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The expected timing of payments of the obligations in the preceding table is estimated based on current information. Timing of payments and actual amounts paid may be different due to changes to agreed-upon amounts for some obligations.

Critical Accounting Policies and Estimates

The following discussion and analysis presents the more significant factors that affected our financial conditions as of December 31, 2022 and 2021 and results of operations for each of the years then ended. The preparation of financial statements in conformity with accounting principles of generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While we base estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.

We consider accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimates in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our consolidated financial statements. When we prepare our condensed consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles (GAAP), we must make estimates and assumptions about future events that affect the amounts we report. Certain of these estimates result from judgments that can be subjective and complex. As a result of that subjectivity and complexity, and because we continuously evaluate these estimates and assumptions based on a variety of factors, actual results could materially differ from our estimates and assumptions if changes in one or more factors require us to make accounting adjustments.

Premiums. We recognize direct and assumed premiums written as revenue, net of ceded amounts, on a daily pro rata basis over the contract period of the related policies that are in force. For any portion of premiums not earned at the end of the reporting period, we record an unearned premium liability.

Premiums receivable represents amounts due from our policyholders for billed premiums and related policy fees. Our billing system is equity based such that policies are canceled if the unpaid premium exceeds the amount of premium earned. When we receive payments on amounts previously charged off, we credit bad debt expense in the period we receive the payment. Balances in premiums receivable and the associated allowance account are removed upon cancellation of the policy due to non-payment. We recorded bad debt expense of approximately $0, $0 and $161,300 in 2022, 2021, 2020, respectively.

When we receive premium payments from policyholders prior to the effective date of the related policy, we record an advance premium liability. On the policy effective date, we reduce the advance premium liability and record the premiums as described above.

Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and loss adjustment expenses, also referred to as loss reserves, represent the most significant accounting estimate inherent in the preparation of our financial statements. These reserves represent management’s best estimate of the amount we will ultimately pay for losses and loss adjustment expenses and we base the amount upon the application of various actuarial reserve estimation techniques as well as considering other material facts and circumstances known at the balance sheet date. We establish two categories of loss reserves as follows: Case reserves—When a claim is reported, we establish an initial estimate of the losses that will ultimately be paid on the reported claim. Our initial estimate for each claim is based upon the judgment of our claims professionals who are familiar with property and liability losses associated with the coverage offered by our policies. Then, our claims personnel perform an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss and adjust the reserve, as necessary. As claims mature, we increase or decrease the reserve estimates as deemed necessary by our claims department based upon additional information we receive regarding the loss, the results of on-site reviews and any other information we gather while reviewing the claims. IBNR reserves—Our IBNR reserves include true IBNR reserves plus “bulk” reserves. True IBNR reserves represent amounts related to claims for which a loss occurred on or before the date of the financial statements, but which have not yet been reported to us. Bulk reserves represent additional amounts that cannot be allocated to particular claims, but which are necessary to estimate ultimate losses on known claims. We estimate our IBNR reserves by projecting our ultimate losses using industry accepted actuarial methods and then deducting actual loss payments and case reserves from the projected ultimate losses. We review and adjust our IBNR reserves on a quarterly basis based on information available to us at the balance sheet date.

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When we establish our reserves, we analyze various factors such as the evolving historical loss experience of the insurance industry as well as our experience, claims frequency and severity, our business mix, our claims processing procedures, legislative enactments, judicial decisions and legal developments in imposition of damages, and general economic conditions, including inflation. A change in any of these factors from the assumptions implicit in our estimates will cause our ultimate loss experience to be better or worse than indicated by our reserves, and the difference could be material. Due to the interaction of the foregoing factors, there is no precise method for evaluating the impact of any one specific factor in isolation, and an element of judgment is ultimately required. Due to the uncertain nature of any future projections, the ultimate amount we will pay for losses will be different from the reserves we record.

We determine our ultimate loss reserves by selecting an estimate within a relevant range of indications that we calculate using generally accepted actuarial techniques. Our selection of the point estimate is influenced by the analysis of our paid losses and incurred losses since inception.

Our external reserving actuaries evaluated the adequacy of our reserves as of December 31, 2022 and concluded that our reported loss reserves would meet the requirements of the insurance laws of the states in which our insurance subsidiaries are domiciled, be consistent with reserves computed in accordance with accepted loss reserving standards and principles, and make a reasonable provision for all unpaid loss and loss adjustment expense obligations under the terms of our contracts and agreements. In addition to $300.6 million of recorded case reserves, we recorded $831.2 million of IBNR reserves as of December 31, 2022 to achieve overall gross reserves of $1.1 billion. At December 31, 2022, ceded IBNR and net IBNR were $546.0 million and $285.2 million, respectively.

The process of establishing our reserves is complex and inherently imprecise, as it involves using judgment that is affected by many variables. We believe a reasonably likely change in almost any of the factors we evaluate as part of our loss reserve analysis could have an impact on our reported results, financial position and liquidity.

The following table quantifies the pro forma impact of hypothetical changes in our net loss reserves on our net income and stockholders’ equity as of and for the year ended December 31, 2022 (in thousands):

(1)
Estimated cash, cash equivalents and investments is intended to reflect the impact of loss reserves, net of taxes.

Policy Acquisition Costs. We incur policy acquisition costs that vary with, and are directly related to, the production of new business. Policy acquisition costs consist of the following four items: (i) commissions paid to outside agents at the time of policy issuance, (ii) policy administration fees paid to a third-party administrator at the time of policy issuance, (iii) premium taxes and (iv) inspection fees. We capitalize policy acquisition costs to the extent recoverable, then we amortize those costs over the contract period of the related policy. We also earn ceding commission on our quota share reinsurance contracts, which is presented as a reduction of policy acquisition costs with any unearned ceding commission recognized as a liability. Ceding commission income is deferred and earned over the contract period. The amount and rate of ceding commissions earned on the net quota share contract can slide within a prescribed minimum and maximum, depending on loss performance and how future losses develop.

Our accounting policy is to allocate ceding commission between policy acquisition costs and general and administrative expenses for financial reporting purposes based upon the proportion these costs bear to production of new business. For the years ended December 31, 2022, 2021 and 2020, we earned ceding commission income of $61.8 million, $62.7 million and $57.1 million of which $46.5 million, $47.1 million and $43.0 million was allocable to policy acquisition costs.

Deferred taxes. At December 31, 2022, we assessed our deferred tax position and hold a $6.4 million valuation against our net deferred tax assets. We intend to continue maintaining the valuation allowance on our net deferred tax asset until there is sufficient evidence to support the reversal of all or some portion of the allowance.

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Provision for Premium Deficiency. At each reporting date, we determine whether we have a premium deficiency. A premium deficiency would result if the sum of our expected losses, deferred policy acquisition costs and policy maintenance costs (such as costs to store records and costs incurred to collect premiums and pay commissions) exceeded our related unearned premiums plus investment income. Should we determine that a premium deficiency exists, we would write off the unrecoverable portion of deferred policy acquisition costs. No accruals for premium deficiency were considered necessary as of December 31, 2022 and 2021.

Reinsurance. We follow industry practice of reinsuring a portion of our risks. Reinsurance involves transferring, or “ceding”, all or a portion of the risk exposure on policies we write to another insurer, known as a reinsurer. 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.

Our reinsurance agreements are prospective contracts. We record an asset, prepaid reinsurance premiums, and a liability, reinsurance payable, for the entire contract amount upon commencement of our new reinsurance agreements. We amortize our prepaid reinsurance premiums over the 12-month contract period.

In the event that we incur losses recoverable under our reinsurance program, we record amounts recoverable from our reinsurers on paid losses plus an estimate of amounts recoverable on unpaid losses. The estimate of amounts recoverable on unpaid losses is a function of our liability for unpaid losses associated with the reinsured policies; therefore, the amount changes in conjunction with any changes to our estimate of unpaid losses. In the event that we incur losses recoverable under the reinsurance program, the estimate of amounts recoverable from reinsurers on unpaid losses may change at any point in the future because of its relation to our reserves for unpaid losses.

We estimate uncollectible amounts receivable from reinsurers based on an assessment of factors including the creditworthiness of the reinsurers and the adequacy of collateral obtained, where applicable. We had no uncollectible amounts under our reinsurance program or bad debt expense related to reinsurance for the years ended December 31, 2022, 2021 and 2020.

Recent Accounting Pronouncements Not Yet Effective

The Company describes the recent pronouncements that have had or may have a significant effect on its financial statements or on its disclosures. The Company does not discuss recent pronouncements that a) are not anticipated to have an impact on, or b) are unrelated to its financial condition, results of operations, or related disclosures. For accounting pronouncements not yet adopted, Refer to Note 1 “Basis of Presentation, Nature of Business and Significant Accounting Policies and Practices” to our consolidated financial statements included in this Annual Report on Form 10-K, for further information.