FedNat Holding Company

Good morning and welcome to the Fed Nat Holdings Company second quarter 2021 conference call. My name is Pasha and I'll be your conference operator this morning. At this time, all participants will be in a listen-only mode. Before we begin today's call, I'd like to remind everyone that this conference call is being recorded as well as broadcast live via webcast. Additionally, today's call will be available via webcast replay later this afternoon. and accessible by visiting the Investor Relations section of FedNet's website at www.fednet.com. Now, I'd like to turn the call over to Bernie Kilkelly for FedNet Investor Relations. Bernie?

Thank you. Good morning, and thank you to everyone for joining FedNet's second quarter 2021 conference call. Our earnings release, and prepared remarks include references to non-GAAP measures, such as adjusted operating income. We use these non-GAAP measures to provide greater transparency and a more meaningful, efficient comparison to prior year's results. Our non-GAAP and reconciliations from the GAAP measures to the non-GAAP measures are available in our earnings release. Statements in this conference call that are not historical facts are forward-looking statements. Words such as anticipate, estimate, expect, predict, project, and other similar words or phrases are intended to identify forward-looking statements. The matters discussed on this call that are forward-looking statements are based on current management expectations involving risks and uncertainties that may result in those expectations not being realized. Actual events, outcomes, and results may differ materially from what is expressed or forecasted in forward-looking statements made on this call due to numerous risks and uncertainties, including but not limited to the risks and uncertainties described in this conference call, our press release issued yesterday, and other filings made by the company with the SEC from time to time. Forward-looking statements made during this conference call speak only as of today's date, and FedNAT specifically disclaims any obligation to update or revise any forward-looking statements to reflect new information, future events, or circumstances or otherwise. Now I will turn the call over to FedNAT's Chief Executive Officer, Mike Braun.

Thank you. Good morning, and welcome to our second quarter 2021 conference call. Juan Jordan, our Chief Financial Officer, and Eric Hernandez, our Chief Accounting Officer, are on the call with me today. After my remarks, Juan will go into more detail on the final financial results for the quarter, and then we will take questions. Our second quarter 2021 results were significantly impacted by three factors. The first was higher-than-expected catastrophe losses given by 15 separate weather events. These events are primarily convective storms and hail events impacting Texas, Florida, and Louisiana. The pre-tax impact of these CAT losses was approximately $23.5 million net of reinsurance recoveries and fee income. The quarter's results were also impacted by higher than expected expenses from additional reinsurance purchases and reinstatement premiums as we worked to minimize the impact of CAT losses on our statutory capital. As you may recall, we communicated this item at the time of our first quarter earnings fall. These increased our expenses on a pre-tax basis of $17.3 million. The third factor was a one-time non-cash charge of $17 million for the recording of a valuation allowance against our net deferred tax assets. Ron will discuss this item in more detail, but as I stated in our earnings release yesterday, We expect these deferred tax assets to be realized in the future. However, the timing of this recognition will depend on the timing of pre-tax income as we earn it in future quarters. Turning back to the extra purchases and reinstatement premiums in the second quarter, those were made under our 2020-2021 reinsurance program. As you know, this program was stressed by a record high number of severe weather events in the second half of 2020, along with Winter Storm URI in Texas in February, which drove backup purchases and additional reinstatement premiums. We started with a clean slate on July 1 with our new reinsurance tower for 2021-2022. This new tower has a lower overall cost compared to the previous year's total expense, resulting from a progress we have in our initiatives to reduce our total insurance values and overall size of our book. With the growth of our non-Florida business, we also benefited from separating the overall program into two reinsurance towers. We continue to work with a large number of our long-term, high-quality reinsurance partners, and we appreciate their continued support. The overall cost of the new 2021-2022 program is is expected to be approximately $288 million. This compares to overall cost for last year's program of $311 million, which included approximately $41 million in additional purchases. The new program provides a total of $1.4 billion of single event coverage, which is approximately $100 million higher than last year's program. We also have a lower retention of $10 million per event in our main reinsurance program and a separate $8 million retention in our Sage Shore book of business, compared with $25 million in last year's program. We now have $2.25 billion of aggregate reinsurance coverage within our two reinsurance towers, versus $1.9 billion in last year's single tower. As I mentioned, a major reason for the expected reduction in our reinsurance costs is the progress made in our initiatives to reduce our total insured exposure and raising rates and restricting business in both our Florida and non-Florida markets until rates more adequately reflect our increased cost of doing business, including reinsurance costs. Looking at the Florida homeowner's market, the environment has been challenging, but we are encouraged by portions of SB 76 reform legislation that was signed by the governor on June 11th and became effective on July 1. In particular, we are pleased with the measures to reduce the time limits for filing certain claims from three years to two years, and more significantly, initiatives to better control plaintiff attorney fees. We are cautiously optimistic that some of the issues driving increased costs have been addressed. At the same time, we believe the significant rate increases that have rolled into our book much better reflect the increased costs and have enabled us to achieve improved attritional loss ratios. In the current environment in Florida, we continue to focus on reducing the number of policies we have while keeping in-force premiums relatively flat through rate increases. Our Florida policies in-force decreased to 180,000 at the end of the second quarter, down 9% sequentially from 197,000 at the end of the first quarter. This represents a significant reduction of over one-third on the book of business since 2017, and we had 272,000 policies enforced. Our rate increases in Florida include a recent 6.7 percent increase that took effect in March, a 7 percent increase that was implemented in April, and an additional 3.9 increase that is expected to take effect in September. As a result of these initiatives, our average premium for policy increased by $177 in the second quarter compared to the first quarter of 2021. This was also $432 higher than the second quarter of 2020. This increase translates into approximately $72 million more in premiums on the 180,000 policies in force in the second quarter of 2021 as compared to last year with decreased risk. Turning to our non-Florida bucket business, we are continuing to manage our total insured exposure, including concentrations in key areas such as Houston, New Orleans, and Charleston. Our non-Florida policies and force continue to decline as well, as shown by a 3% decrease sequentially, $244,000 at June 30 from $149,000 at March 31. We continue to file rate increases to pass through our increased cost of doing business. Business written through our Sage Shore managing general underwriting partner includes Inflation Guard, which is currently producing a 5 percent increase in all states due to the increase of primarily labor costs. Sage Shore also implemented a 6.9 percent rate increase in South Carolina effective in April on new business and in May on renewal business. Also expecting to take an additional 6.9 percent in South Carolina in the near future. and more rate filings thereafter. Texas has a recent rate increase of 9.5% to be effective in August on new business and November on renewal business. This is in addition to a recent 9% increase in Texas effective in April on new and on renewal business in May. For Louisiana, an increase of 15% to be effective in September on new business and in October on renewal business. This is in addition to the 9.9% increase that was affected in December of 2020 on new business and in January on renewal business. For Maison, a rate increase of 15.9% took effect in Louisiana in December of 2020, followed by an additional rate increase of 11.1% in July of 2021, and an 18.9% increase expected to take effect in November. A 12.3% increase took effect for Maison in Texas in February and we expect to file for additional rate increases later in 2021. Our non-Florida markets continue to have more favorable operating environment, including less litigation. Excluding the impact of severe weather events, we continue to be pleased with our underlying performance and profitability of our non-Florida homeowner's business. Our non-Florida traditional loss ratio, excluding capacities, is generally in the mid-20s compared to approximately 40% for Florida. As a result of our expansion and more favorable non-Florida markets, our non-Florida insured exposure is now just under 50% of our total on the basis of total insured value. Our overall rate increases in Florida and non-Florida are a track to generate over $75 million in incremental gross earned premiums in 2021 as compared to 2020, based on our fourth quarter 2020 book of business. We anticipate that when fully earned out in the second half of 2022, these increases will contribute over $224 million of cumulative increases in premium in 2021 and 2022, and $156 million of incremental premium annually thereafter, as compared to the fourth quarter of 2020 book. We continue to be proactive to maintain appropriate capital position within our three carriers, through additional reinsurance purchases and capital infusions. At the same time, we maintained approximately $40 million of liquidity at the holding company level heading into the third quarter. This was in large part due to the capital raises we completed in March and April, including a common stock offering of $17 million and a convertible notes offering of $21 million. As you know, last November, our board of directors formed a special board committee to oversee a review of strategic alternatives, including exploring options to strengthen the company's capital position. The work of the committee is ongoing, and the committee continues to work with Piper Sandler as a financial advisor. Before I turn the call over to Ron, I want to briefly mention Hurricane Elsa, which was a third quarter event making landfall in Florida on July 7th. This event has not had a significant impact to date. We have received approximately 150 claims, totaling approximately $1 million, with about 65% of the claims in Florida and the remainder mostly in South Carolina. We will need additional claims history to estimate our total losses from the storm, which we'll report after we close on the third quarter. I'll now turn the call over to Rod for more details on our second quarter financial results.

Thanks, Mike, and good morning, everyone. As Mike mentioned, our second quarter 2021 results were significantly impacted by higher-than-expected CAT losses, expenses from additional reinsurance purchases, including reinstatement premiums, and the recording of a valuation allowance against the company's deferred tax assets. Second quarter also includes approximately $5 million of net adverse impact from reserve strengthening, primarily related to winter storm URIE. Our net loss in the second quarter was $50.4 million or $2.89 per share compared to a net loss of $21.5 million or $1.57 per share in last year's second quarter, which was also impacted by a high number of severe weather events. Adjusted operating loss in the second quarter was $50.5 million or $2.90 per share compared to adjusted operating loss of $28.1 million or $2.05 per share in the second quarter of 2020. Looking more closely at the two most meaningful pre-tax impacts on the quarter, our pre- and post-tax earnings were reduced by 23.5 million of catastrophe losses, net of all recoveries, including reinsurance and affiliated claims handling fees, and 10.7 million of recoveries presented in net realized and unrealized gains losses as described in more detail in our press release and in our 10Q. There were 15 separate events, including convective storms and hail, primarily in Texas, Louisiana, and Florida. Aggregate gross losses from these events are estimated to be approximately 90 million. These gross losses were reduced by recoveries of approximately 62 million, consisting of 55 million related to reinsurance treaties, excess of loss reinsurance treaties, and $7 million under quota share treaties. Net of related affiliate claims handling fees, these CAAT events added approximately 96 points to our loss ratio and combined ratio in the quarter and reduced our earnings by $1.35 per share. Now I'll turn to the second large impact, which was the extra costs we incurred in the quarter from additional reinsurance purchases and reinstatement premiums. All of these expenses related to our 2020-2021 catastrophe reinsurance program, which ended on June 30. Given the terms and conditions of the 2020-2021 program, combined with the record number of retention events that occurred in that treaty year, We made numerous backup purchases to replace utilized limit and minimize exposure to subsequent events. In addition, we had co-participations on reinstatement premium in portions of the tower. In the second quarter, these purchases and reinstatement premiums added a total of $17.3 million in incremental excess of loss seeded premium expense. This extra spend in the quarter added 94 points to our combined ratio by reducing the net earned premium denominator of that calculation. Of course, our reinsurance program reset on July 1, which gives us a clean slate starting in the third quarter, along with reduced costs for the new 21-22 treaty year program. As Mike mentioned, the initial overall cost of the new program is $288 million or $72 million per quarter. $85 million of seeded XOL costs was recognized here during the second quarter, which is $13 million higher than our expectations for the third quarter of $72 million that I just cited. The third major impact in the quarter was the booking of a valuation allowance against our deferred tax assets, which increased the quarter's loss by $17 million. As Mike said, management expects these deferred tax assets to be fully realizable over time. However, generally accepted accounting principles set the bar pretty high when there is a recent history of losses, and thus we had to set up a valuation allowance this quarter. This amount the amount of the charge consists of the tax benefit foregone on the second quarter operating loss and the reversal of the tax benefit recorded during the first quarter. Staying high level, this non-cash charge is accounting driven and at the end of the day amounts to a timing difference with respect to when tax benefits and tax expenses will be recorded. Here in 2021, We are foregoing the recording of tax benefits against our losses, but when we generate taxable income in the future, we'll be able to forego recording any tax expense against that income until we are made whole on our 2021 loss. Lastly, I'll mention one smaller impact in the quarter, which was the reserve development from first quarter 21 and prior. In the second quarter, we increased ultimate loss estimates by $162 million across numerous catastrophe retention events, including the five named storms from the second half of 2020. Approximately 90 percent of the increase was covered by related catastrophe reinsurance coverages. After all recoveries and offsets, including estimated catastrophe claims handling fees, the net impact on our second quarter 2021 earnings was approximately $5 million. If one were to adjust our second quarter operating loss by the four impacts that I just discussed, which were CATS, extra XOL expense, the tax charge, and then the catastrophe reserve strengthening, and then apply the federal tax rate to that result, it indicates that FedNAT's adjusted operating income in the quarter would have been approximately $10 million absent the items named. With the additional gross earned premium that we expect to realize from the rate increases that Mike described, we anticipate FedNet will achieve ex-cat earnings growth in the second half of 2021 as the approved and pending rate increases roll into our book. We continue to see ourselves as a low double-digit ROE company in years where catastrophe losses approximate the models. With higher ROEs attainable, when CAT losses come in favorably as compared to the models. We continue to make strong progress in reducing the size of our book and the related total insured value, enabling us to reduce our total catastrophe reinsurance costs. This is reflected in the decline of our Florida policy count and total insured value, which are down 22 percent and 18 percent respectively when comparing June 30, 2021 to June 30, 2020. We are continuing to shrink our book of business in Florida until rates are adequate and are managing our exposure in both Florida and non-Florida markets by raising rates. Non-Florida policies in force were 144,000 at June 30 compared to 149,000 just three months ago, reflecting our desire to limit growth in these states at this time. Our geographic mix on a policy count basis at June 30 was approximately 56% Florida and 44% non-Florida, as compared to a 61-39 split at June 30 of last year. Despite these intentional reductions in our book, gross earned premiums were flat with 2Q20, as Mike has already mentioned, indicating strong growth in average premium per policy, an indicator that the profitability of our book is improving. Net premiums earned in the second quarter declined to $35 million from $111 million in the prior year due primarily to a $75 million increase in seeded premiums, including the extra XOL reinsurance costs I have described. The remainder of the seeded premium increase was driven by additional quota share sessions in both Florida and non-Florida, which we entered in during the second half of 2020. In FNIC's Florida book, 40% quota share continues to be in effect, representing 28 million of seeded premiums in the quarter, compared to just 8 million in the second quarter of 2020, when only 10% quota share coverage was in place. For non-Florida markets, our 80% quota share treaty on FNIC's non-Florida book remains in place, as compared to 0% quota share during the second quarter of 2020, driving a $24 million increase in seeded premium. Note that these seeded quota share premium figures are net of CAT reinsurance allowances that are built into the various treaties, and of course, losses and operating expenses in our results are also lower as a result of corresponding sessions and or allowances pursuant to the treaties. Turning now to our balance sheet and capital position, We maintained our commitment to ensuring appropriate statutory capital in our insurance companies and liquidity at the holding company. We continue to maintain surplus in our three insurance carriers consistent with RBC ratios of 300% or above. We have made capital infusions to our insurance companies of approximately $40 million, effective as of June 30. And we currently estimate that holding company liquidity is approximately $40 million heading into the third quarter. we expect the inception of our new reinsurance tower with its lower per-storm retentions to be of notable benefit in terms of conserving capital going forward, along with the lower quarterly cost of the XOL program and the continued earn-out of our rate increases. At the end of the second quarter, we held total investments of approximately $424 million. In addition, we ended the quarter with total cash and equivalents of approximately $111 million, We continue to maintain our discipline to invest in higher quality liquid bonds and a handful of preferred securities with no common stock exposure in the portfolio. And overall, the portfolio has a duration of 4.0 and a composite credit rating of A-. And with that, I will turn the call back over to Mike. Thanks, Ron.

And with that, operator, if you can open up the microphone. the line to any questions.

Ladies and gentlemen, at this time, if you would like to ask a question, please press star followed by the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Again, that's star one. And your first question is from the line of Paul Newsome with Piper Sandler.

Good morning. On the DTA, am I correct that effectively In the future, we should assume an effective tax rate that's close to zero now that the DTA has been written off?

Yes, that's correct, Paul.

But would there be a couple points of state taxes, or is that also part of the DTA rental?

There's also valuation allowances against the state income taxes, so zero on that side as well. And again, in both cases, zero if we have future losses, but also zero for a time when we begin to generate earnings again.

Great. Could you talk a little bit and explain a little bit more about the holding company liquidity and how that's precisely constructed? Is it just all cash or is there debt capability? How do you think of the holding company liquidity piece?

Sure. It's not all cash. There are short-term working capital types of components to it as well. Those would primarily consist of short-term receivables that convert into cash in the near term. We certainly exclude anything that's not cash in the near term, such as deferred tax assets, for example, or long-term tax receivables, buildings, equipment, et cetera. And we talk about this in the capital and liquidity section of our 10-Q, which was filed last night. But as of 6-30, as the calendar crossed 6-30 and we closed the books, we had $80 million of liquidity in our holdco as we define it. And as we say there in the 10-Q, that included $59 million of cash and investments and so you can see that the other $21 million would have been working capital that converts the cash in the near term going forward. So then, as we close the books and record the results, we determined the surplus infusions that were needed, so that $80 million figure would be reduced by the $40 million of infusions, gets us to the ending $40 million number.

Is the... Is the DTA an asset for statutory purposes?

We have valuation allowances up for statutory reporting as well.

Great. I'll let some other folks ask questions, but thank you for the help. Yes.

As a reminder, if you would like to ask a question, please press star followed by the number 1 on your telephone keypad. Again, that's star 1. We'll pause again. for a moment to compile the Q&A roster.

And thank you, operator. With that, what we'll do is go ahead and conclude the call today. Just a brief overview once again. Over the last four quarters, we incurred six major weather events. Our main reinsurance program had a $25 million retention. That is massive. We had two in the third quarter, three in the fourth quarter, and then one in the first quarter. So you combine those up, that's $150 million. There were some benefits on there, some fees, et cetera, that brought that down a bit, some quota share. But nonetheless, a huge number. And then on top of that, we had subsequent XOL reinsurance purchases of $40 million. And it was a massive expense that we've incurred, and that's behind us. We now have a new reinsurance program that is lower as a percentage of total dollars and lower as a percentage of premium. We're also seeing favorable movement in Florida on our attritional loss ratio, down year over year in excess of five points. I would say that's also occurring while some of the headwinds remain in Florida in the first half of the year where a lot of lawsuits were pushed in before insurance reform. But we expect to continue to see the Florida attritional loss ratio drop. And the reason for that is primarily driven by rate. I would call it a tsunami of rate that we have that's rolling into the book That's in excess of, let's call it roughly $25 million per quarter with all the different lines of business that we have. So with that, we'll go ahead and conclude. So I just wanted to recognize our FedNet team as well for providing the highest quality service to all of our policyholders and our partner agents. We did transition to a remote environment about 14, 15 months ago and have converted back to a hybrid environment. So the health and safety of our team and our policyholders is a top priority. So with that, if there's follow-up questions or comments, please do reach out to us, and everyone have a great day. Thank you.

Thank you, ladies and gentlemen. This concludes today's conference call. We thank you for participating and ask that you now disconnect your lines.