The table below shows the total premiums earned on a gross and net basis for the respective six-month periods:
Reconciliation of Non-GAAP Financial Measures
Underwriting income
We define underwriting income as income before taxes excluding net investment income, investment revaluation gains, net realized capital gains or losses, intangible asset amortization, noncash stock compensation, gains and losses on embedded derivatives, interest expense, other revenue, interest expense and other income.income and expenses. Underwriting income represents the pre-tax profitability of our underwriting operations and allows us to evaluate our underwriting performance without regard to investment income, intangible asset amortization, noncash stock compensation, interest expense, and other revenue, and income.other income and expenses. We use this metric asbecause we believe it gives our management and other users of our financial information useful insight into our underlyingunderwriting business performance.performance by adjusting for these expenses and sources of income. Underwriting income should not be viewed as a substitute for net income calculated in accordance with GAAP, and other companies may define underwriting income differently.
| | | | | | | | | | | | | |
| Three Months Ended June 30, | | |
| (in thousands, except percentages) | 2022 | | 2021 | |
| Net income | $ | 5,491 | | | $ | 2,126 | | | |
| Income tax expense | 1,457 | | | 414 | | | |
| | | | | |
| Income before taxes | 6,948 | | | 2,540 | | | |
| Other revenue | (1,804) | | | (1,229) | | | |
| Gains (losses) on embedded derivatives | (3,356) | | | 686 | | | |
| Net investment income | 391 | | | (2,103) | | | |
| | | | | |
| Net realized gains | (1,349) | | | (10) | | | |
| Other expenses | 268 | | | 845 | | | |
| Interest expense | 467 | | | 425 | | | |
| Intangible asset amortization | 1,500 | | | 1,413 | | | |
| Noncash stock compensation | 403 | | | 419 | | | |
| Other income | (24) | | | (35) | | | |
| Underwriting income | $ | 3,444 | | | $ | 2,951 | | | |
| | | | | |
|
| | | | | | | | | | | | | |
| Six Months Ended June 30, | | |
| (in thousands, except percentages) | 2022 | | 2021 | |
| Net income | $ | 17,831 | | | $ | 11,568 | | | |
| Income tax expense | 4,727 | | | 3,019 | | | |
| | | | | |
| Income before taxes | 22,558 | | | 14,587 | | | |
| Other revenue | (5,005) | | | (5,884) | | | |
| Gains (losses) on embedded derivatives | (9,592) | | | (1,990) | | | |
| Net investment income | (2,185) | | | (4,375) | | | |
| | | | | |
| Net realized gains | (302) | | | (23) | | | |
| Other expenses | 268 | | | 845 | | | |
| Interest expense | 875 | | | 852 | | | |
| Intangible asset amortization | 2,999 | | | 2,827 | | | |
| Noncash stock compensation | 559 | | | 630 | | | |
| Other income | (47) | | | (156) | | | |
| Underwriting income | $ | 10,128 | | | $ | 7,313 | | | |
| | | | | |
|
|
| | | | | | | | | | |
| | Three Months Ended June 30, | | Percentage Change |
| (in thousands, except percentages) | 2020 | | 2019 | |
| Net income | $ | 3,720 |
| | $ | 6,391 |
| | (41.8 | )% |
| Income tax expense | 979 |
| | 1,690 |
| | (42.1 | )% |
| Equity earnings in affiliates, net of tax | (1,230 | ) | | (865 | ) | | 42.2 | % |
| Income before taxes | 3,469 |
| | 7,216 |
| | (51.9 | )% |
| Other revenue | (1,530 | ) | | (1,893 | ) | | (19.2 | )% |
| Net investment income | (1,524 | ) | | (1,570 | ) | | (2.9 | )% |
| Net realized capital (gains) losses | 4 |
| | (111 | ) | | (103.6 | )% |
| Interest expense | 501 |
| | 561 |
| | (10.7 | )% |
| Other income | (40 | ) | | (33 | ) | | 21.2 | % |
| Underwriting income | $ | 880 |
| | $ | 4,170 |
| | (78.9 | )% |
|
| | | | | | | | | | |
| | Six Months Ended June 30, | | Percentage Change |
| (in thousands, except percentages) | 2020 | | 2019 | |
| Net income | $ | 13,326 |
| | $ | 14,842 |
| | (10.2 | )% |
| Income tax expense | 3,891 |
| | 3,009 |
| | 29.3 | % |
| Equity earnings in affiliates, net of tax | (1,932 | ) | | (1,473 | ) | | 31.2 | % |
| Income before taxes | 15,285 |
| | 16,378 |
| | (6.7 | )% |
| Other revenue | (5,922 | ) | | (5,488 | ) | | 7.9 | % |
| Net investment income | (4,796 | ) | | (2,857 | ) | | 67.9 | % |
| Net realized capital gains | (3,230 | ) | | (723 | ) | | 346.7 | % |
| Interest expense | 962 |
| | 1,185 |
| | (18.8 | )% |
| Other income | (54 | ) | | (126 | ) | | (57.1 | )% |
| Underwriting income | $ | 2,245 |
| | $ | 8,369 |
| | (73.2 | )% |
Adjusted net income
We define adjusted net income as net income excluding the impact of various unusual events,certain items, including the consummationnoncash intangible asset amortization and stock compensation, noncash changes in fair value of the reorganization transactions in connection with our IPO, orembedded derivatives, other expenses and gains or losses that we don't believe do not reflect our core operating performance, which items may have a disproportionate effect in a given period, affecting comparability of our results.results across periods. We calculate the tax impact only on adjustments whichthat would be included in calculating our income tax expense using thean expected effective tax rate atfor the end of each period.applicable years. We use adjusted net income as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance.performance by eliminating the effects of these items. Adjusted net income should not be viewed as a substitute for net income calculated in accordance with GAAP, and other companies may define adjusted net income differently.
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, | | |
| (in thousands, except percentages) | 2022 | | 2021 | | 2022 | | 2021 | |
| Net income | $ | 5,491 | | | $ | 2,126 | | | $ | 17,831 | | | $ | 11,568 | | | |
| Intangible asset amortization | 1,500 | | | 1,413 | | | 2,999 | | | 2,827 | | | |
| Noncash stock compensation | 403 | | | 419 | | | 559 | | | 630 | | | |
| Change in fair value of embedded derivative | (4,140) | | | 167 | | | (11,036) | | | (3,189) | | | |
| Unrealized losses on equity securities | 3,441 | | | — | | | 3,441 | | | — | | | |
| Realized gain on sale of investment | (1,400) | | | — | | | (1,400) | | | — | | | |
| Other expenses | 268 | | | 845 | | | 268 | | | 845 | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| Total adjustments | 72 | | | 2,844 | | | (5,169) | | | 1,113 | | | |
| Tax impact of adjustments | (17) | | | (654) | | | 1,188 | | | (256) | | | |
| Adjusted net income | $ | 5,546 | | | $ | 4,316 | | | $ | 13,850 | | | $ | 12,425 | | | |
| | | | | | | | | |
|
|
| | | | | | | | | | |
| | Three Months Ended June 30, | | Percentage Change |
| (in thousands, except percentages) | 2020 | | 2019 | |
| Net income | $ | 3,720 |
| | $ | 6,391 |
| | (41.8 | )% |
| Expenses associated with Altaris management fee, including cash bonuses paid to unit holders | 442 |
| | 441 |
| | 0.2 | % |
| Expenses associated with IPO and other one-time legal and consulting expenses | 788 |
| | 215 |
| | 266.5 | % |
| Expenses related to debt issuance costs | 135 |
| | 25 |
| | 440.0 | % |
| Total adjustments | 1,365 |
| | 681 |
| | 100.4 | % |
| Tax impact of adjustments | (314 | ) | | (138 | ) | | 127.5 | % |
| Adjusted net income | $ | 4,771 |
| | $ | 6,934 |
| | (31.2 | )% |
|
| | | | | | | | | | |
| | Six Months Ended June 30, | | Percentage Change |
| (in thousands, except percentages) | 2020 | | 2019 | |
| Net income | $ | 13,326 |
| | $ | 14,842 |
| | (10.2 | )% |
| Expenses associated with Altaris management fee, including cash bonuses paid to unit holders | 883 |
| | 882 |
| | 0.1 | % |
| Expenses associated with IPO and other one-time legal and consulting expenses | 1,200 |
| | 442 |
| | 171.5 | % |
| Expenses related to debt issuance costs | 135 |
| | 50 |
| | 170.0 | % |
| FMV adjustment of remaining investment in affiliate | (2,000 | ) | | — |
| | 100.0 | % |
| Net gain on purchase & disposal of affiliates | (3,115 | ) | | (634 | ) | | 391.3 | % |
| Total adjustments | (2,897 | ) | | 740 |
| | (491.5 | )% |
| Tax impact of adjustments | 666 |
| | (279 | ) | | (338.7 | )% |
| Adjusted net income | $ | 11,095 |
| | $ | 15,303 |
| | (27.5 | )% |
Adjusted return on equity
We define adjusted return on equity as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending member’sstockholders' equity during the period. We use adjusted return on equity as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance.performance by adjusting for items that we believe do not reflect our core operating performance and that may diminish comparability across periods. Adjusted return on equity should not be viewed as a substitute for return on equity calculated in accordance with GAAP, and other companies may define adjusted return on equity differently.
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| (in thousands, except percentages) | 2022 | | 2021 | | 2022 | | 2021 |
| Adjusted return on equity calculation: | | | | | | | |
| Numerator: adjusted net income | $ | 5,546 | | | $ | 4,316 | | | $ | 13,850 | | | $ | 12,425 | |
| Denominator: average equity | 413,258 | | | 415,159 | | | 416,014 | | | 413,725 | |
| Adjusted return on equity | 5.4 | % | | 4.2 | % | | 6.7 | % | | 6.0 | % |
| Return on equity | 5.3 | % | | 2.0 | % | | 8.6 | % | | 5.6 | % |
|
| | | | | | | | | | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, |
| | 2020 | | 2019 | | 2020 | | 2019 |
| Adjusted return on equity calculation: | | | | | | | |
| Numerator: adjusted net income | $ | 4,771 |
| | $ | 6,934 |
| | $ | 11,095 |
| | $ | 15,303 |
|
| Denominator: average members' equity | 144,733 |
| | 121,292 |
| | 140,450 |
| | 114,742 |
|
| Adjusted return on equity | 13.2 | % | | 22.9 | % | | 15.8 | % | | 26.7 | % |
| Return on equity | 10.3 | % | | 21.1 | % | | 19.0 | % | | 25.9 | % |
Return on tangible equity and adjusted return on tangible equity
We define tangible members’stockholders' equity as members’stockholders' equity less goodwill and other intangible assets. We define return on tangible equity as net income expressed on an annualized basis as a percentage of average beginning and ending tangible members’stockholders' equity during the period. We define adjusted return on tangible equity as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending tangible members’stockholders' equity during the period. We regularly evaluate acquisition opportunities and have historically made acquisitions that affect members’stockholders' equity. We use return on tangible equity and adjusted return on tangible equity as internal performance measures in the management of our
operations because we believe they give our management and other users of our financial information useful insight into our results of operations and our underlying business performance.performance by adjusting for the effects of acquisitions on our stockholders' equity and, in the case of adjusted return on tangible equity, by adjusting for the items that we believe do not reflect our core operating performance and that may diminish comparability across periods. Return on tangible equity and adjusted return on tangible equity should not be viewed as a substitute for return on equity or return on tangible equity, respectively, calculated in accordance with GAAP, and other companies may define return on tangible equity and adjusted return on tangible equity differently.
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| (in thousands, except percentages) | 2022 | | 2021 | | 2022 | | 2021 |
| Return on tangible equity calculation: | | | | | | | |
| Numerator: net income | $ | 5,491 | | | $ | 2,126 | | | $ | 17,831 | | | $ | 11,568 | |
| Denominator: | | | | | | | |
| Average stockholders' equity | 413,258 | | | 415,159 | | | 416,014 | | | 413,725 | |
| Less: average goodwill and other intangible assets | 213,213 | | | 213,836 | | | 213,962 | | | 214,543 | |
| Average tangible stockholders' equity | 200,045 | | | 201,323 | | | 202,052 | | | 199,182 | |
| Return on tangible equity | 11.0 | % | | 4.2 | % | | 17.6 | % | | 11.6 | % |
| Return on equity | 5.3 | % | | 2.0 | % | | 8.6 | % | | 5.6 | % |
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| (in thousands, except percentages) | 2022 | | 2021 | | 2022 | | 2021 |
| Adjusted return on tangible equity calculation: | | | | | | | |
| Numerator: adjusted net income | $ | 5,546 | | | $ | 4,316 | | | $ | 13,850 | | | $ | 12,425 | |
| Denominator: average tangible equity | 200,045 | | | 201,323 | | | 202,052 | | | 199,182 | |
| Adjusted return on tangible equity | 11.1 | % | | 8.6 | % | | 13.7 | % | | 12.5 | % |
| Return on equity | 5.3 | % | | 2.0 | % | | 8.6 | % | | 5.6 | % |
|
| | | | | | | | | | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, |
| | 2020 | | 2019 | | 2020 | | 2019 |
| Return on tangible equity calculation: | | | | | | | |
| Numerator: net income | $ | 3,720 |
| | $ | 6,391 |
| | $ | 13,326 |
| | $ | 14,842 |
|
| Denominator: | | | | | | | |
| Average members' equity | 144,733 |
| | 121,292 |
| | 140,450 |
| | 114,742 |
|
| Less: average goodwill and other intangible assets | 3,453 |
| | 3,006 |
| | 3,459 |
| | 3,012 |
|
| Average tangible members' equity | 141,280 |
| | 118,286 |
| | 136,991 |
| | 111,730 |
|
| Return on tangible equity | 10.5 | % | | 21.6 | % | | 19.5 | % | | 26.6 | % |
| Return on equity | 10.3 | % | | 21.1 | % | | 19.0 | % | | 25.9 | % |
|
| | | | | | | | | | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, |
| | 2020 | | 2019 | | 2020 | | 2019 |
| Adjusted return on tangible equity calculation: | | | | | | | |
| Numerator: adjusted net income | $ | 4,771 |
| | $ | 6,934 |
| | $ | 11,095 |
| | $ | 15,303 |
|
| Denominator: average tangible members' equity | 141,280 |
| | 118,286 |
| | 136,991 |
| | 111,730 |
|
| Adjusted return on tangible equity | 13.5 | % | | 23.4 | % | | 16.2 | % | | 27.4 | % |
| Return on equity | 10.3 | % | | 21.1 | % | | 19.0 | % | | 25.9 | % |
Financial Condition, Liquidity and Capital Resources
Sources and Uses of Funds
We are organized as a holding company with our operations conducted through our subsidiaries, including our wholly owned insurance subsidiaries,subsidiaries: Benchmark, which is domiciled in Kansas and commercially domiciled in California, andCalifornia; ALIC, which is domiciled in Utah.Utah; 7710, which is domiciled in South Carolina; and BSIC, which is domiciled in Arkansas. Accordingly, the holding company may receive cash throughthrough: (i) loans from banks,banks; (ii) draws on a revolving loan agreement,agreement; (iii) issuance of equity and debt securities,securities; (iv) corporate service fees from our operating subsidiaries,subsidiaries; (v) payments from our subsidiaries pursuant to our consolidated tax allocation agreement and other transactionstransactions; and (vi) dividends from our non-insurance subsidiaries and, subject to certain limitations discussed below, dividends from our insurance subsidiaries. We also may use the proceeds from these sources to contribute funds to the insurance subsidiaries in order to support premium growth, reduce our reliance on reinsurance, retire indebtedness on preferred stock, pay taxes, and for other general business purposes.
State insurance laws restrict the ability of insurance companies to declare stockholder dividends without prior regulatory approval. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus.
Under Kansas and California law, dividends payable from Benchmark without the prior approval of the applicable insurance commissioner are limited tomust not exceed the greater of (i) 10% of Benchmark’sBenchmark's surplus as shown on the last statutory financial statement on file with the Kansas Insurance Department and the California Department of Insurance, respectively,respectively; or (ii) 100% of statutory net income during the applicable twelve-month period. period (not including realized gains). Dividends shall not include pro rata distributions of any class of Benchmark's own securities.
Under Utah law, dividends payable from ALIC without the prior approval of the applicable insurance commissioner are limited tomust not exceed the lesser ofof: (i) 10% of ALIC’sALIC's surplus as shown on the last statutory financial statement on file with the Utah
Insurance DepartmentDepartment; or (ii) 100% of net income during the applicable twelve-monthtwelve- month period (not including realized capital gains). Dividends shall not include pro rata distributions of any class of ALIC's own securities.
Under South Carolina law, dividends payable from 7710 without the prior approval of the applicable insurance commissioner are limited to the following during the preceding twelve months: (a) when paid from other than earned surplus must not exceed the lesser of: (i) 10% of 7710's surplus as regards policyholders as shown in 7710's most recent annual statement; or (ii) the net income, not including net realized gains or losses as shown in 7710's most recent annual statement; or (b) when paid from earned surplus must not exceed the greater of: (i) 10% of 7710's surplus as regards policyholders as shown in 7710 Insurance Company's most recent annual statement; or (ii) the net income, not including net realized gains or losses as shown in 7710's most recent annual statement. Dividends shall not include pro rata distributions of any class of 7710's own securities.
Under Arkansas law, dividends payable from BSIC without the prior approval of the applicable insurance commissioner must not exceed the lesser of (i) 10% of BSIC’s surplus as shown on the last statutory financial statement on file with the Arkansas Insurance Department; or (ii) 100% of net income during the applicable twelve- month period (not including realized gains). Dividends shall not include pro rata distributions of any class of BSIC's own securities.
The maximum amount of dividends the insurance subsidiaries can pay us during 20202022 without regulatory approval is $14.0 million.approximately $21,000. Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by the insurance subsidiaries may adopt statutory provisions more restrictive than those currently in effect.
Our insurance subsidiaries are also required to by state law to maintain a minimum level of policyholder'spolicyholders' surplus. Kansas, Utah, Arkansas, and UtahSouth Carolina utilize a risk-based capital requirementsrequirement as promulgated by the National Association of Insurance Commissioners. Such requirements are designed to identify the various business risks (e.g., investment risk, underwriting profitability risk, etc.) of insurance companies and their subsidiaries. As of June 30, 20202022 and December 31, 2019,2021, the total adjusted capital of our insurance subsidiaries was in excess of their respective prescribed risk-based capital requirements.
As of June 30, 2020,2022, we had $97,326$100,716 in cash and cash equivalents, compared to $74,268$129,577 as of December 31, 2019.2021.
Management believes that we have sufficient liquidity available to meet our operating cash needs and obligations and committed capital expenditures for the next 12twelve months.
Cash Flows
Our most significant source of cash is from premiums received from insureds, net of the related commission amount for the policies. Our most significant cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that generally earn interest and dividends. The table below summarizes our net cash flows.
| | | | | | | | | | | |
| Six Months Ended June 30, |
| 2022 | | 2021 |
| Cash, cash equivalents and restricted cash provided by (used in): | | | |
| Operating activities | $ | 40,075 | | | $ | 22,820 | |
| Investing activities | (68,212) | | | (65,599) | |
| Financing activities | (832) | | | (625) | |
| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | (28,969) | | | $ | (43,404) | |
|
| | | | | | | |
| | Six Months Ended June 30, |
| (in thousands) | 2020 | | 2019 |
| Cash, cash equivalents and restricted cash provided by (used in): | | | |
| Operating activities | $ | 31,783 |
| | $ | 14,692 |
|
| Investing activities | 6,107 |
| | (7,780 | ) |
| Financing activities | (8,886 | ) | | (4,585 | ) |
| Net increase in cash, cash equivalents and restricted cash | $ | 29,004 |
| | $ | 2,327 |
|
Operating Activities: Net cash provided by operating activities for the six months ended June 30, 20202022 was $31,783$40,075, compared to $14,692$22,820 for the same period in 2019. The $17,091 increase in2021. Net cash provided by operating activities is drivenincludes net income as adjusted for depreciation and amortization, stock compensation, unrealized gains and losses on embedded derivatives, net realized gains and losses on investments, unrealized gains and losses on equity securities, bond amortization and accretion, the change
in deferred income taxes, and amortization of deferred financing costs. Net cash provided by operating activities for the six months ended June 30, 2022 primarily reflects increased unpaid loss and loss adjustment expenses of $33,366, decreased prepaid reinsurance premiums of $13,952, increased funds held under reinsurance agreements of $11,963, partially offset by increases in premiums and other receivables of $11,902, an increase in reinsurance recoverables of $11,560, a decrease in accounts payable and accrued expenses of $5,616, and an increase in other assets of $5,101. Unpaid loss and loss adjustment expenses increased primarily due to an increase in gross written premiums and an increase in our retention. The decrease in prepaid reinsurance premiums was the result of increased retention, partially offset by the increase in ceded premiums. Funds held under reinsurance agreements increased due a reduction in the derivatives, partially offset by an increase in ceded premiums. The increases in premiums and other receivables and reinsurance recoverables were primarily a result of an increase in gross written premiums during the period. The decrease in accounts payable and accrued expenses is due to reductions in the accrued bonus, accrued 401(k) match and accrued premium taxes paid in the first quarter of 2022. Other assets increased as a result of increases in our deferred acquisition costs and contract asset balances.
Net cash provided by operating activities for the six months ended June 30, 2021 reflects increases in unpaid loss and loss adjustment expenses of $44,742, unearned premiums of $36,401 and funds held under reinsurance agreements of $3,080; partially offset by increases in premiums and other receivables of $22,714, reinsurance recoverables of $18,730, prepaid reinsurance premiums of $13,033, other assets of $6,623 and decreases in reinsurance premiums payable of $5,388, accounts payable and accrued expenses of $4,011 and income taxes payable of $3,791. Unpaid loss and loss adjustment expenses and unearned premiums increased primarily due to an increase in gross written premiums. The increases in premiums and other receivables and reinsurance recoverables were primarily a result of an increase in gross written premiums during the period. Other assets increased as a result of increases in our deferred acquisition costs and contract asset balances. Funds held under reinsurance agreements decreased due to an arbitration settlement in the fourth quarter of 2020, resulting in the non-cash transfer of certain investments held as collateral. Excluding non-cash transfers, funds held under reinsurance agreements increased as a result of an increase in gross written premium. Net cash provided by operating activities for the six months ended June 30, 2020 resultingreflects distributions received from (i) an increaseequity method investments and incremental cash received for operating assets and liabilities.
Investing Activities: Net cash used in accounts payable and accrued expensesinvesting activities for the six months ended June 30, 2022 was $68,212, compared to net cash used in investing activities of $14,320, (ii) a decrease$65,599 for the same period in 2021. Net cash used in investing activities for the six months ended June 30, 2022 includes $67,873 net cash used in the changepurchase and sale of investments and $339 in premiums and other receivables of $6,681 and (iii) an increase in the change in unearned premiums of $5,037. This increase is partially offset by a reduction in underwriting income of $6,124, an increase in the change in other assets of $1,893 and $1,339 paid for deferred offering costs during 2020.
Investing Activities:capital expenditures. Net cash provided by investing activities for the six months ended June 30, 2020 was $6,107 compared to2021 includes $65,758 net cash used of $7,780 for the same period in 2019. The $13,887 increase in cash used in investing activities is driven by (i) $6,435 net cash provided by the purchase and sale of investments; (ii) $3,000investments, $73 in capital expenditures, and $232 in cash received fromfor the sale of TRI in 2020; and (iii) the incremental $4,398 used in 2019 for the acquisitions of First Choice Casualty Insurance Company and the remaining 25% of American Liberty Insurance Company.equity method investments.
Financing Activities: Net cash used in financing activities for the six months ended June 30, 20202022 was $8,886$832, compared to $4,585net cash used in financing activities of $625 for the same period in 2019. The increase in2021. Net cash used is driven by an increase in distributions to members of $19,183, partially offset byfinancing activities for the cash provided bysix months ended June 30, 2022 and 2021 primarily includes the principal payments made on the Company's long-term debt, net of principle payments, of $14,755.debt.
Debt and Credit Agreements
First Horizon Credit Agreement
In April 2018, Trean Corporation and Trean Compstar entered into a credit agreement with First Horizon Bank (formerly, First Tennessee Bank National Association) (the 2018 First Horizon Credit Agreement), which includes a term loan facility totaling $27.5 million and a revolving credit facility of $3.0 million. Borrowings are secured by substantially all of the assets of Trean Holdings LLC and its subsidiaries.
On May 26,July 16, 2020, the Company entered into a newan Amended and Restated Credit Agreement with First Horizon Bank, which, among other things, extended the Company's credit facility for a period of five years through May 26, 2025 and increased its term loan facility by $11,707, resulting in a total term loan debt amount of $33,000 and a revolving credit facility of $2,000. Borrowings under the new facility are secured by substantially all of the assets of Trean Holdings LLC and its subsidiaries (other than equity interests of Compstar and Compstar Insurance Services, LLC), and after giving effect to the July reorganization transactions, borrowings will be secured by substantially all of the assets of Trean Insurance Group, Inc.Company other than Benchmark Holding Company and its subsidiaries. The loan has a variable interest rate of 3-month LIBOR plus 3.50%4.50%, which was 5.95%5.51% as of June 30, 20202022 and 6.33%4.64% as of December 31, 20192021 (under the 2018 First Horizon Credit Agreement). The outstanding principal balance of the loan is to be repaid in quarterly installments that escalate from approximately $206 to $825 until March 2025. All equity securities of the subsidiaries of Trean Holdings LLC have been pledged as collateral, and after giving effect to the July reorganization transactions, all equity securities of the subsidiaries of Trean Insurance Group, Inc.Company (other than Benchmark Holding Company and its subsidiaries) will behave been pledged as collateral.
In addition, and in conjunction with, the executionReinsurance
We cede a portion of the Amended and Restated Credit Agreement, the Company made dividend distribution payments to Trean members totaling $18,154 in May 2020.
2006 Subordinated Notes
In June 2006, Trean Capital Trust I (the Trust) issued 7,500 shares of preferred capital securities to Bear Stearns Securities Corp. and 232 common securities to Trean Corporation. The proceeds of such issuances were invested by the Trust in $7,732 aggregate principal amount of the Subordinated Notes. The Subordinated Notes represents the sole assets of the Trust. The Subordinated Notes maturerisk we accept on July 7, 2036. The interest rate was a fixed rate of 9.167% until July 7, 2011, at which time a variable interest rate of 3-month LIBOR (1.22% and 1.99% as of June 30, 2020 and December 31, 2019, respectively) plus 3.50% is in effect. The interest rate totaled 4.72% and 5.49% as of June 30, 2020 and December 31, 2019, respectively. There are optional dates for redemption of the Subordinated Notes, at the option of the Company, on any January 7, April 7, July 7, or October 7 following July 7, 2011. There are no funding requirements for Trean Corporation to the Trust except for the necessary quarterly interest payments. Trean Corporation is the guarantor of the debt.
The preferred capital securities issued by the Trust in turn paid quarterly cash distributions at an annual rate of 9.167% per annum of the liquidation amount of $1 per security until July 7, 2011, and thereafter pay at a variable rate per annum, reset quarterly, equal to 3-month LIBOR plus 3.50%. The preferred capital securities do not have a stated maturity date, although they are subject to mandatory redemption upon maturity of the Subordinated Notes on July 7, 2036, or upon earlier redemption. These preferred securities are fully guaranteed by us.
Reinsurance
We use reinsurance to convert underwriting risk to credit risk, protect theour balance sheet reduce earnings volatilityto third-party reinsurers through a variety of reinsurance arrangements. We manage these arrangements to align risks with our Program Partners, optimize our net retention relative to our financial objectives, balance sheet size and increase overall premium writing capacity.ratings requirements, as well as to limit our maximum loss resulting from a
single program or a single event. We utilize both quota share and excess of lossXOL reinsurance as tools in our overall risk management strategy to achieve these goals.goals, usually in conjunction with each other. Quota share reinsurance involves the proportional sharing of premiums and losses. Under excesslosses of loss reinsurance, losses in excess of a retention level are paid by the reinsurer, subject to a limit.
Quota share reinsurance
each defined program. We utilize quota share reinsurance to:for several purposes, including (i) to cede premiumrisk to Program Partners, (non-professional reinsurers)which allows us to transfer underwriting riskshare economics and align incentives, and (ii) to cede premiumrisk to professionalthird-party reinsurers in order to increase the amount of grossmanage our net written premiums we can write while managing net premiums written leverage appropriately based on itsour financial objectives, capital base, A.M. Best financial strength rating, and risk appetite. It is a core pillar of our underwriting philosophy that Program Partners retain a significant portion of the underwriting risk of their program. We believe this best aligns interests, attracts higher quality programs, and leads to better underwriting results.
Excess of loss and catastrophe Under XOL reinsurance,
We purchase losses in excess of lossa retention level are paid by the reinsurer, subject to a limit, and catastropheare customized per program or across multiple programs. We utilize XOL reinsurance from professional reinsurers to protect against catastrophic large loss and/or other unforeseen extreme loss activity that could otherwise negatively impact Benchmark’sour profitability and capital base. The majority of our exposure to catastrophe risk stems from the workers’ compensation premium we retain net of premiums ceded to Program Partners and professional reinsurers.retain. Potential catastrophic events include an earthquake, terrorism, or another event that could cause more than one covered employee working at the same location to be injured in the event. This catastrophic exposure is generally amelioratedWe believe we mitigate this risk by the type of accounts we underwrite. Due to our focus on small- to mid-sized accounts, (i.e., few employees per policy and location),which means that we generally do not have concentrated employee counts at single locations that can serve as the basis forcould be exposed to a catastrophic loss. The limited catastrophic risk that does exist is cededcost and limits of the reinsurance coverage we purchase vary from year to large, professional reinsurers through excessyear based on the availability of lossquality reinsurance contracts.at an acceptable price and our desired level of retention.
Ratings
We have a financial strength rating of “A”"A" (Excellent) from A.M. Best. A.M. Best assigns 16 ratings to insurance companies, which currently range from “A+"A++”" (Superior) to “S”"S" (Rating Suspended). “A”"A" (Excellent) is the third highest rating issued by A.M. Best. The “A”"A" (Excellent) rating is assigned to insurers that have, in A.M. Best’sBest's opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligation to policyholders and is not an evaluation directed at investors. See also “Risk factors"Risk Factors — Risks related to our business and industry — A downgrade in the A.M. Best financial strength ratings of our insurance company subsidiaries may negatively affect our business.”" in our 2021 Form 10-K.
The financial strength ratings assigned by A.M. Best have an impact on the ability of the insurance companies to attract and retain agents and brokers and on the risk profiles of the submissions for insurance that the insurance companies receive. The “A”"A" (Excellent) rating obtained by us is consistent with our business plan and allows us to actively pursue relationships with the agents and brokers identified in our marketing plan.
Contractual Obligations and Commitments
Other than the $11,707 increase in our credit facility, thereThere have been no material changes in the Company's contractual obligations as of June 30, 20202022 compared to December 31, 2019.2021.
Financial condition
Members'Stockholders' Equity
As of June 30, 2020,2022, total members'stockholders' equity was $139,284,$410,118, compared to $141,615$421,909 as of December 31, 2019,2021, a decrease of $2,331.$11,791. The decrease in members'stockholders' equity over the period was driven primarily by distributions to members totaling $18,043 during the six months ended June 30, 2020. This was offset by$12,342 of net income of $13,326 earned during the period and unrealized gains on available-for-sale investments of $3,882 during the period. comprehensive loss.
We had $157$3,269 of unrecognized stock compensation as of June 30, 20202022 related to non-vested stock-basedstock compensation granted. WeThe Company recognized approximately $20 and $40$559 of stock based compensation expense forduring the three and six months ended June 30, 2020, respectively.2022.
Investment Portfolio
Our invested asset portfolio consists of fixed maturities, equity securities, other investments, and short-term investments. The majority of the investment portfolio was comprised of fixed maturity securities of $375,705$466,819 at June 30, 2020,2022, that were classified as available-for-sale. Available-for-sale investments are carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income.
Our investment portfolio objectives are to maintain liquidity, facilitating financial strength and stability and ensuring regulatory and legal compliance. Our investment portfolio consists of available-for-sale fixed maturities and other equity investments, all of which are carried at fair value. We seek to hold a high-quality portfolio of investments that is managed by a professional investment advisory management firm in accordance with the Company's investment policy and routinely reviewed by our management team. Our investments, however, are subject to general economic conditions and market risks as well as risks inherent to particular securities. The Company's investment portfolio has the following objectives:
Meet•meet insurance regulatory requirements with respect to investments under the applicable insurance laws;
Maintain•maintain an appropriate level of liquidity to satisfy the cash requirements of current operations and long-term obligations;
Adjust•adjust investment risk to offset or complement insurance risk based on our total corporate risk tolerance; and
Realize•realize the highest possible levels of investment income while generating superiorand after-tax total rates of return.
The composition of our investment portfolio is shown in the following table as of June 30, 20202022 and December 31, 2019.2021.
| | | | | | | | | | | |
| June 30, 2022 |
| Cost or
Amortized Cost | | Fair Value |
| Fixed maturities: | | | |
| U.S. government and government securities | $ | 53,592 | | | $ | 51,678 | |
| Foreign governments | 400 | | | 392 | |
| States, territories and possessions | 11,102 | | | 10,274 | |
| Political subdivisions of states, territories and possessions | 39,098 | | | 35,925 | |
| Special revenue and special assessment obligations | 107,939 | | | 99,528 | |
| Industrial and public utilities | 106,575 | | | 102,514 | |
| Commercial mortgage-backed securities | 110,538 | | | 98,807 | |
| Residential mortgage-backed securities | 20,076 | | | 19,087 | |
| Other loan-backed securities | 44,880 | | | 43,830 | |
| Hybrid securities | 5,344 | | | 4,784 | |
| Total fixed maturities | 499,544 | | | 466,819 | |
| | | |
| | | |
| | | |
| Equity securities | 34,248 | | | 30,698 | |
| Total investments | $ | 533,792 | | | $ | 497,517 | |
| | | | | | | | December 31, 2021 |
| | June 30, 2020 | | Cost or
Amortized Cost | | Fair Value |
| (in thousands) | Cost or Amortized Cost | | Fair Value | |
| Fixed maturities: | | | | Fixed maturities: | | | |
| U.S. government and government securities | $ | 15,778 |
| | $ | 16,248 |
| U.S. government and government securities | $ | 41,490 | | | $ | 41,434 | |
| Foreign governments | 300 |
| | 305 |
| Foreign governments | 2,500 | | | 2,490 | |
| States, territories and possessions | 7,299 |
| | 7,544 |
| States, territories and possessions | 10,593 | | | 10,766 | |
| Political subdivisions of states, territories and possessions | 27,684 |
| | 28,915 |
| Political subdivisions of states, territories and possessions | 39,170 | | | 40,002 | |
| Special revenue and special assessment obligations | 68,065 |
| | 71,875 |
| Special revenue and special assessment obligations | 93,664 | | | 95,991 | |
| Industrial and public utilities | 122,814 |
| | 129,892 |
| Industrial and public utilities | 100,774 | | | 103,257 | |
| Commercial mortgage-backed securities | 16,400 |
| | 17,908 |
| Commercial mortgage-backed securities | 119,378 | | | 118,218 | |
| Residential mortgage-backed securities | 57,787 |
| | 59,412 |
| Residential mortgage-backed securities | 16,549 | | | 17,368 | |
| Other loan-backed securities | 42,871 |
| | 43,250 |
| Other loan-backed securities | 41,236 | | | 41,425 | |
| Hybrid securities | 357 |
| | 356 |
| Hybrid securities | 105 | | | 110 | |
| Total fixed maturities | 359,355 |
| | 375,705 |
| Total fixed maturities | 465,459 | | | 471,061 | |
| Equity securities: | | | | |
| Preferred stock | 332 |
| | 325 |
| |
| Common stock | 1,554 |
| | 3,428 |
| |
| Total equity securities | 1,886 |
| | 3,753 |
| |
| | Equity securities | | Equity securities | 984 | | | 969 | |
| Total investments | $ | 361,241 |
| | $ | 379,458 |
| Total investments | $ | 466,443 | | | $ | 472,030 | |
|
| | | | | | | |
| | December 31, 2019 |
| (in thousands) | Cost or Amortized Cost | | Fair Value |
| Fixed maturities: | | | |
| U.S. government and government securities | $ | 15,965 |
| | $ | 16,129 |
|
| Foreign governments | 299 |
| | 302 |
|
| States, territories and possessions | 4,789 |
| | 4,923 |
|
| Political subdivisions of states, territories and possessions | 24,444 |
| | 25,104 |
|
| Special revenue and special assessment obligations | 59,149 |
| | 61,405 |
|
| Industrial and public utilities | 119,735 |
| | 123,207 |
|
| Commercial mortgage-backed securities | 15,586 |
| | 16,312 |
|
| Residential mortgage-backed securities | 53,467 |
| | 54,109 |
|
| Other loan-backed securities | 35,849 |
| | 36,011 |
|
| Hybrid securities | 357 |
| | 363 |
|
| Total fixed maturities | 329,640 |
| | 337,865 |
|
| Equity securities: | | | |
| Preferred stock | 337 |
| | 343 |
|
| Common stock | 492 |
| | 492 |
|
| Total equity securities | 829 |
| | 835 |
|
| Total investments | $ | 330,469 |
| | $ | 338,700 |
|
The following table shows the percentage of the total estimated fair value of our fixed maturity securities as of June 30, 20202022 and December 31, 20192021 by credit rating category, using the lower of ratings assigned by Moody's Investor Service or S&P.
| | | | | | | | | | | |
| June 30, 2022 |
| (in thousands, except percentages) | Fair Value | | % of Total |
| AAA | $ | 77,745 | | | 16.7 | % |
| AA | 272,331 | | | 58.3 | % |
| A | 83,549 | | | 17.9 | % |
| BBB | 29,786 | | | 6.4 | % |
| BB | 3,382 | | | 0.7 | % |
| Below investment grade | 26 | | | 0.0 | % |
| Total fixed maturities | $ | 466,819 | | | 100.0 | % |
|
| | | | | | |
| | June 30, 2020 |
| (in thousands, except percentages) | Fair Value | | % of Total |
| "AAA" | $ | 62,876 |
| | 16.7 | % |
| "AA" | 174,294 |
| | 46.4 | % |
| "A" | 108,488 |
| | 28.9 | % |
| "BBB" | 27,743 |
| | 7.4 | % |
| "BB" | 2,255 |
| | 0.6 | % |
| Below investment grade | 49 |
| | — | % |
| Total fixed maturities | $ | 375,705 |
| | 100.0 | % |
| | | | | | | | | | | |
| December 31, 2021 |
| (in thousands, except percentages) | Fair Value | | % of Total |
| AAA | $ | 80,455 | | | 17.1 | % |
| AA | 278,557 | | | 59.1 | % |
| A | 77,097 | | | 16.4 | % |
| BBB | 33,959 | | | 7.2 | % |
| BB | 947 | | | 0.2 | % |
| Below investment grade | 46 | | | 0.0 | % |
| Total fixed maturities | $ | 471,061 | | | 100.0 | % |
|
| | | | | | |
| | December 31, 2019 |
| (in thousands, except percentages) | Fair Value | | % of Total |
| "AAA" | $ | 52,571 |
| | 15.6 | % |
| "AA" | 153,838 |
| | 45.5 | % |
| "A" | 101,040 |
| | 29.9 | % |
| "BBB" | 30,245 |
| | 9.0 | % |
| "BB" | 119 |
| | — | % |
| Below investment grade | 52 |
| | — | % |
| Total fixed maturities | $ | 337,865 |
| | 100.0 | % |
Critical Accounting Policies and Estimates
The unaudited interim condensed combinedconsolidated financial statements included in this quarterly reportQuarterly Report on Form 10-Q include amounts based on the use of estimates and judgments of management.
We identified the accounting estimates whichthat are critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our condensed combinedconsolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the condensed combinedconsolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. The estimates and judgments that are most critical to the preparation of the condensed combinedconsolidated financial statements include: (a)(i) reserves for unpaid loss and LAE; (b)(ii) reinsurance recoveries; (c)(iii) investment fair value measurements; and; (d)(iv) goodwill and intangible assets. Actual results may differ materially from the estimatesassets; and assumptions used in preparing the condensed combined financial statements.(v) business combinations. For a detailed discussion of our accounting policies, see the “Notes"Notes to the Consolidated and Combined Financial Statements”Statements" included in our registration statement filed with the SEC on2021 Form S-1.10-K.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements as of June 30, 2020.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in interest rates, equity prices, foreign currency exchange rates, and commodity prices. The primary components of market risk affecting us are credit risk, interest rate risk, and interestequity rate risk, which are described in detail in theItem 7A — "Quantitative and qualitative disclosures about market risk" section ofQualitative Disclosures About Market Risk" in our registration statement filed with the SEC on2021 Form S-1.10-K. We do not have exposure to foreign currency exchange rate risk or commodity risk.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
As of the end of the period covered by this report, management conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)). Based on this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures arewere effective as of June 30, 2022 to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principalchief executive and principalchief financial officers,officer, as appropriate, to allow timely decisions regarding required disclosures.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
The effectiveness of any system of controls and procedures is subject to certain limitations, and, as a result, there can be no assurance that our controls and procedures will detect all errors or fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be attained.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
From time-to-time, the Company may be involved in legal proceedings which arise in the ordinary course of business. We believe that the outcome of such matters, individually or in the aggregate, will not have a material adverse effect on our combinedconsolidated financial position.
Item 1A. Risk Factors
A description of the risks and uncertainties associated with our business is set forth below. You should carefully consider the risks and uncertainties described below, together with all the other information contained in this Quarterly Report on Form 10-Q and in our prospectus relating to our registration statement on Form S-1, as amended (File No. 333-239291) (the Prospectus), including our combined financial statements and the related notes. The risks and uncertainties described below are not the only ones facing us. There may be additional risks and uncertainties of which we currently are unaware or that we currently believe to be immaterial. If any of these risks or uncertainties occurs, our business, financial condition and results of operations may be materially adversely affected. In that event, the market price of our common stock could decline.
Risks related to our business and industry
Failure of our Program Partners or our Owned MGAs to properly market, underwrite or administer policies could adversely affect us.
The marketing, underwriting, claims administration and other administration of policies in connection with our issuing carrier services and for business written directly by our Owned MGAs are the responsibility of our Program Partners and our Owned MGAs. Any failure by them to properly handle these functions could result in liability to us. Even though our Program Partners may be required to compensate us for any such liability, there are risks that they do not pay us because they become insolvent or otherwise. Any such failures could create regulatory issues or harm our reputation, which could materially and adversely affect our business, financial condition and results of operations.
We depend on a limited number of Program Partners for a substantial portion of our gross written premiums.
We source a significant amount of our premiums from our Program Partners, which are generally MGAs and insurance companies. Historically, we have focused our business on a limited group of core Program Partners and have sought to grow the business by expanding existing Program Partner relationships and selectively adding new Program Partners.
For the years ended December 31, 2019 and 2018, approximately 34% and 42% of our gross written premiums was derived from our top ten Program Partners.
A significant decrease in business from, or the entire loss of, our largest Program Partners or several of our other Program Partners may materially adversely affect our business, financial condition and results of operations.
More than half of our gross written premiums are written in three key states.
For the year ended December 31, 2019, we derived approximately 49%, 9% and 8%, respectively, of our gross written premiums in the states of California, Michigan and Arizona. As a result, our financial results are subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states, in particular our gross written premiums in California. Adverse developments relating to any of these conditions could materially adversely affect our business, financial condition and results of operations.
A downgrade in the A.M. Best financial strength ratings of our insurance company subsidiaries may negatively affect our business.
A.M. Best financial strength ratings (“FSRs”) are an important factor in establishing the competitive position of insurance companies. Our insurance company subsidiaries are rated for overall financial strength by A.M. Best. These FSRs reflect A.M. Best’s opinion of our insurance company subsidiaries’ financial strength, operating performance, strategic position and ability to meet obligations to policyholders, and are not evaluations directed to investors. Our insurance company subsidiaries’ FSRs are subject to periodic review, and the criteria used in the rating methodologies are subject to change. While our insurance company subsidiaries are rated “A” (Excellent), their FSRs are subject to change. A significant portion of our business is conducted through small- and mid-sized insurance carriers, program managers and other insurance organizations that do not have an A.M. Best financial strength rating or require a highly rated carrier, such as ourselves, to meet their business objectives. A significant downgrade in our insurance company subsidiaries’ FSRs could lead to our Program Partners doing business with other insurance companies and materially adversely affect our business, financial condition and results of operations.
If we are unable to accurately underwrite risks and charge competitive yet profitable rates to our clients and policyholders, our business, financial condition and results of operations may be materially and adversely affected.
In general, the premiums for our insurance policies are established at the time a policy is issued and, therefore, before all of our underlying costs are known. Like other insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate premium rates is necessary, together with investment income, to generate sufficient revenue to offset losses and loss adjustment expenses (“LAE”) and other general and administrative expenses in order to earn a profit. If we do not accurately assess the risks that we assume, we may not charge adequate premiums to cover our losses and expenses, which would adversely affect our results of operations and our profitability. Alternatively, we could set our premiums too high, which could reduce our competitiveness and lead to lower policyholder retention, resulting in lower revenues. Pricing involves the acquisition and analysis of historical loss data and the projection of future trends, loss costs and expenses, and inflation trends, among other factors, for each of our products in multiple risk tiers and many different markets. To accurately price our policies, we must:
collect and properly analyze a substantial volume of data from our insureds;
develop, test and apply appropriate actuarial projections and ratings formulas;
closely monitor and timely recognize changes in trends; and
project both frequency and severity of our insureds’ losses with reasonable accuracy.
We seek to implement our pricing accurately in accordance with our assumptions. Our ability to undertake these efforts successfully and, as a result, accurately price our policies, is subject to a number of risks and uncertainties, including:
insufficient or unreliable data;
incorrect or incomplete analysis of available data;
uncertainties generally inherent in estimates and assumptions;
our failure to implement appropriate actuarial projections and ratings formulas or other pricing methodologies;
regulatory constraints on rate increases;
our failure to accurately estimate investment yields and the duration of our liability for losses and LAE; and
unanticipated court decisions, legislation or regulatory action.
We may be unable to access the capital markets when needed, which may adversely affect our ability to take advantage of business opportunities as they arise and to fund our operations in a cost-effective manner.
Our ability to grow our business, either organically or through acquisitions, depends, in part, on our ability to access capital when needed. Capital markets may become illiquid from time to time, and we cannot predict the extent and duration of future economic and market disruptions or the impact of any government interventions. We may not be able to obtain financing on terms acceptable to us, or at all. If we need capital but cannot raise it or cannot obtain financing on terms acceptable to us, our business, financial condition and results of operations may be materially adversely affected and we may be unable to execute our long-term growth strategy.
Adverse economic factors, including recession, inflation, periods of high unemployment or lower economic activity could result in the sale of fewer policies than expected or an increase in frequency or severity of claims and premium defaults or both, which, in turn, could affect our growth and profitability.
Factors, such as business revenue, economic conditions, the volatility and strength of the capital markets and inflation can affect the business and economic environment. These same factors affect our ability to generate revenue and profits. In an economic downturn that is characterized by higher unemployment, declining spending and reduced corporate revenues, the demand for insurance products is generally adversely affected, which directly affects our premium levels and profitability. Prolonged and high unemployment that reduces the payrolls of our insureds would reduce the premiums that we are able to collect. Negative economic factors may also affect our ability to receive the appropriate rate for the risk we insure and may adversely affect our opportunities to underwrite profitable business.
Negative developments in the workers’ compensation insurance industry could adversely affect our business, financial condition and results of operations.
Although we engage in other businesses, 82.8% of our gross written premiums for the year ended December 31, 2019 were attributable to workers’ compensation insurance policies providing both primary and excess coverage. As a result, negative developments in the economic, competitive or regulatory conditions affecting the workers’ compensation insurance industry could have a material adverse effect on our business, financial condition and results of operations. If one of our larger markets were to enact legislation to increase the scope or amount of benefits for employees under workers’ compensation insurance policies without related premium increases or loss control measures, this could negatively affect our business, financial condition and results of operations.
The insurance industry is cyclical in nature.
The financial performance of the insurance industry has historically fluctuated with periods of lower premium rates and excess underwriting capacity resulting from increased competition followed by periods of higher premium rates and reduced underwriting capacity resulting from decreased competition. Although the financial performance of an individual insurance company depends on its own specific business characteristics, the profitability of many insurance companies tends to follow this cyclical market pattern. Because this market cyclicality is due in large part to the actions of our competitors and general economic factors, we cannot predict the timing or duration of changes in the market cycle. We expect these cyclical patterns will cause our revenues and net income to fluctuate, which may cause the market price of our common stock to be more volatile.
Our failure to accurately and timely pay claims could harm our business.
We must accurately and timely evaluate and pay claims to manage costs and close claims expeditiously. Many factors affect our ability to evaluate and pay claims accurately and timely, including the training and experience of our claims staff, our claims department’s culture and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors. Our failure to accurately and timely pay claims could lead to regulatory and administrative actions or material litigation, undermine our reputation in the marketplace and materially and adversely affect our business, financial condition and results of operations.
If we do not hire and train new claims staff effectively or if we lose a significant number of experienced claims staff, our claims department may be required to handle an increasing workload, which could adversely affect the quality of our claims administration, and our business could be materially and adversely affected.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and economic, legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. Examples of emerging claims and coverage issues include, but are not limited to:
judicial expansion of policy coverage and the impact of new theories of liability;
plaintiffs targeting property and casualty (P&C) insurers in purported class action litigation relating to claims-handling and other practices;
medical developments that link health issues to particular causes, resulting in liability claims; and
claims relating to unanticipated consequences of current or new technologies, including cyber-security related risks and claims relating to potentially changing climate conditions.
In some instances, these emerging issues may not become apparent for some time after we have issued the affected insurance policies. As a result, the full extent of liability under our insurance policies may not be known until many years after the policies are issued.
In addition, the potential passage of new legislation designed to expand the right to sue, to remove limitations on recovery, to extend the statutes of limitations or otherwise to repeal or weaken tort reforms could have an adverse impact on our business.
The effects of these and other unforeseen emerging claim and coverage issues are difficult to predict and could harm our business and materially adversely affect our results of operations.
Our risk management policies and procedures may prove to be ineffective and leave us exposed to unidentified or unanticipated risk.
We have developed and continue to develop enterprise-wide risk management policies and procedures to mitigate risk and loss to which we are exposed. There are inherent limitations to risk management strategies because there may exist, or develop in the future, risks that we have not anticipated or identified. If our risk management policies and procedures are ineffective, we may suffer unexpected losses and could be materially adversely affected. As our business changes and the niches in which we operate evolve, our risk management framework may not evolve at the same pace as those changes. As a result, there is a risk that new products or new business strategies may present risks that are not identified, monitored or managed. In times of market stress, unanticipated market movements or unanticipated claims experience, the effectiveness of our risk management strategies may be limited, resulting in losses to us. In addition, we may be unable to effectively review and monitor all risks and our employees may not follow our risk management policies and procedures.
The National Association of Insurance Commissioners (the NAIC) and state legislatures and regulators have increased their focus on risks within an insurer’s holding company system that may pose enterprise risk to insurers. Our insurance company subsidiaries are subject to regulation in Kansas, the state of domicile of Benchmark, California, where Benchmark is commercially domiciled, and Utah, the state of domicile of ALIC. The Kansas Insurance Department, the California Department of Insurance and the Utah Insurance Department, the primary regulators of our insurance company subsidiaries, have adopted regulations implementing a requirement under the Kansas, California and Utah insurance laws, respectively, for insurance holding companies to adopt a formal enterprise risk management (ERM) function and to file an annual enterprise risk report. The regulations also require domestic insurers to conduct an Own Risk and Solvency Assessment (ORSA) and to submit an ORSA summary report prepared in accordance with the NAIC’s ORSA Guidance Manual. While we operate within an ERM framework designed to assess and monitor our risks, we may not be able to effectively review and monitor all risks, our employees may not all operate within the ERM framework and our ERM framework may not resultdisclosed in our accurately identifying all risks2021 Form 10-K the most significant risk factors that can impact year-to-year comparisons and limiting our exposures based on our assessments.
We are subject to reinsurance counterparty credit risk. Our reinsurers may not pay on losses in a timely fashion, or at all.
We purchase reinsurance to transfer part of the risk we have assumed (known as ceding) to a reinsurance company in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us (the reinsured) of our liability to policyholders. Accordingly, we are exposed to credit risk with respect to our reinsurers to the extent the reinsurance receivable is not sufficiently secured by collateral or does not benefit from other credit enhancements. We also bear the risk that a reinsurer may be unwilling to pay amounts we have recorded as reinsurance recoverable for any reason, including that:
the terms of the reinsurance contract do not reflect the intent of the parties of the contract or there is a disagreement between the parties as to their intent;
the terms of the contract cannot be legally enforced;
the terms of the contract are interpreted by a court or arbitration panel differently than intended;
the reinsurance transaction performs differently than we anticipated due to a flawed design of the reinsurance structure, terms or conditions; or
a change in laws and regulations, or in the interpretation of the laws and regulations, materially affects a reinsurance transaction.
The insolvency of one or more of our reinsurers, or inability or unwillingness to make timely payments under the terms of our contracts, could materially adversely affect our business, financial condition and results of operations.
If we are unable to obtain reinsurance coverage at reasonable prices or on terms that adequately protect us, we may be required to bear increased risks or reduce the level of our underwriting commitments.
Our insurance company subsidiaries purchase reinsurance as part of our overall risk management strategy. While reinsurance does not discharge our insurance company subsidiaries from their obligation to pay claims for losses insured under their insurance policies, it does make the reinsurer liable to them for the reinsured portion of the risk. As part of our strategy for our issuing carrier business, we reinsure underwriting risk to third-party reinsurers. At the inception of a new program, we typically act as an issuing carrier where we reinsure a substantial amount of such risk to third parties. For these reasons, reinsurance is an important tool to manage transaction and insurance risk retention and to mitigate losses. We may be unable to maintain our current reinsurance arrangements or to obtain other reinsurance in adequate amounts and at favorable rates, particularly if reinsurers become unwilling or unable to support our specialized issuing carrier model in the future. Additionally, market conditions beyond our control may impact the availability and cost of reinsurance and could have a material adverse effect on our business, financial condition and results of operations. In recent years, our Program Partners have benefitted from favorable market conditions, including growth in the role of MGAs and of offshore and other alternative sources of reinsurance. A decline in the availability of reinsurance, increases in the cost of reinsurance or a decreased level of activity by MGAs could limit the amount of issuing carrier business we could write and materially and adversely affect our business, financial condition, results of operations and prospects. We may, at certain times, be forced to incur additional costs for reinsurance or may be unable to obtain sufficient reinsurance on terms acceptable to us. In the latter case, we would have to accept an increase in exposure to risk, reduce the amount of business written by our insurance company subsidiaries or seek alternatives in line with our risk limits, all of which could materially adversely affect our business, financial condition and results of operations.
Some of our issuing carrier arrangements contain limits on the reinsurer’s obligations to us.
While we reinsure underwriting risk in our issuing carrier business, including a substantial amount of such risk at the inception of a new program, we have in certain cases entered into programs that contain limits on our reinsurers’ obligations to us, including loss ratio caps or aggregate reinsurance limits. To the extent losses under these programs exceed the prescribed limits, we will be liable to pay the losses in excess of such limits, which could materially and adversely affect our business, financial condition and results of operations.
Retention of business written by our Program Partners could expose us to potential losses.
We retain risk for our own account on business underwritten by our insurance company subsidiaries. The determination to reduce the amount of reinsurance we purchase, or not to purchase reinsurance for a particular risk, customer segment or niche is based on a variety of factors, including market conditions, pricing, availability of reinsurance, our capital levels and loss experience. Retention increases our financial exposure to losses and significant losses could have a material adverse effect on our business, financial condition, liquidity and results of operations.
Our loss reserves may be inadequate to cover our actual losses.
Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the related LAE. Loss reserves are estimates of the ultimate cost of claims and do not represent a precise calculation of any ultimate liability. These estimates are based on historical information and on estimates of future trends that may affect the frequency and severity of claims that may be reported in the future. Estimating loss reserves is a difficult, complex and inherently uncertain process involving many variables and subjective judgments. As partfuture performance of the reserving process,Company's business. On a quarterly basis, we review historical datathese disclosures and considerupdate the impact of variousrisk factors, such as:
loss emergence and cedant reporting patterns;
underlying policy terms and conditions;
business and exposure mix;
trends in claim frequency and severity;
changes in operations;
emerging economic and social trends;
inflation; and
changes in the regulatory and litigation environments.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. It also assumes that adequate historical or other data exists upon which to make these judgments. For more information on the estimates used in the establishment of loss reserves, see “Management’s discussion and analysis of financial condition and results of operations - Critical accounting estimates - Reserves for unpaid losses and loss adjustment expenses” in the Prospectus. There, however, is no precise method for evaluating the impact of any specific factor on the adequacy of reserves and actual results are likely to differ from original estimates, perhaps materially. If the actual amount of insured losses is greater than the amount we have reserved for these losses, our profitability could suffer.
We may not be able to manage our growth effectively.
We intend to grow our business in the future, which could require additional capital, systems development and skilled personnel. We, however, must be able to meet our capital needs, expand our systems and our internal controls effectively, allocate our human resources optimally, identify and hire qualified employees or effectively incorporate any acquisitions we make in our effort to achieve growth. The failure to manage our growth effectively could have a material adverse effect on our business, financial condition and results of operations.
Our ability to grow our business will depend in part on the addition of new Program Partners, and our inability to effectively onboard such new Program Partners could have a material adverse effect on our business, financial condition and results of operations.
Our ability to grow our business will depend in part on the addition of new Program Partners. If we do not effectively onboard our new Program Partners, including assisting such Program Partners to quickly resolve any post-onboarding issues and provide effective ongoing support, our ability to add new Program Partners and our relationships with our existing Program Partners could be adversely affected. Additionally, our reputation with potential new customers could be damaged. If we fail to meet the requirements of our customers, it may be more difficult to execute on our strategy to retain Program Partners, which could have a material adverse effect on our business, financial condition and results of operations.
We could be adversely affected by the loss of one or more key executives or by an inability to attract and retain qualified personnel.
We depend on our ability to attract and retain experienced personnel and seasoned key executives who are knowledgeable about our business. The pool of talent from which we actively recruit is may fluctuate based on market dynamics specific to our industry and independent of overall economic conditions.as appropriate. As such, higher demand for employees having the desired skills and expertise could lead to increased compensation expectations for existing and prospective personnel, making it difficult for us to retain and recruit key personnel and maintain labor costs at desired levels. We do not have employment agreements with our executive officers. Should any of our executives terminate their employment with us, or if we are unable to retain and attract talented personnel, we may be unable to maintain our current competitive position in the specialized markets in which we operate, which could adversely affect our business and results of operations.
Technology breaches or failures of our or our business partners’ systems could adversely affect our business.
Global cybersecurity threats can range from uncoordinated individual attempts to gain unauthorized access to our information technology systems and those of our business partners or service providers to sophisticated and targeted measures known as advanced persistent threats. While we and our business partners and service providers employ measures designed to prevent, detect, address and mitigate these threats (including access controls, data encryption, vulnerability assessments, continuous monitoring of information technology networks and systems and maintenance of backup and protective systems), cybersecurity incidents, depending on their nature and scope, could potentially result in the misappropriation, destruction, corruption or unavailability of critical data (personal or otherwise) and confidential or proprietary information (our own or that of third parties) and the disruption of business operations. In 2020, we discovered that we were subject to a cybersecurity incident that involved a third party obtaining unauthorized access to an employee’s electronic mailbox that was compromised in August 2019 through a phishing email. In conjunction with our cyber insurance carrier, we engaged outside counsel and a consulting firm specializing in digital forensics. While we do not believe the incident will have a material adverse effect on our business, financial performance and reputation, our investigation is ongoing and the ultimate effect of the incident is uncertain. Our evaluation, together with outside counsel,date of whether data breach notifications may be required or appropriate in connection with this incident is ongoing, but we may decide to make such notifications in the future. In addition, cyber incidents that impact the availability, reliability, speed, accuracy or other proper functioning of our technology systems (or the data held by such systems) could affect our operations. We may not have the resources or technical sophistication to anticipate or prevent every type of cyber-attack. A significant cybersecurity incident, including system failure, security breach, disruption by malware or other damage could interrupt or delay our operations, result in a violation of applicable privacy and other laws, expose us to litigation and potential liability, damage our reputation, cause a loss of customers or give rise to monetary fines and other penalties, any or all of which could be material. It is possible that insurance coverage we have in place would not entirely protect us in the event that we experienced a cybersecurity incident, interruption or widespread failure of our information technology systems.
Any significant interruption in the operation of our computer systems could adversely affect our business, financial condition and results of operations.
We rely on multiple computer systems to interact with customers, issue policies, pay claims, run modeling functions, assess insurance risks and complete various important internal processes including accounting and bookkeeping. Our business depends on our ability to access these systems to perform necessary business functions. Additionally, some of these systems may include or rely upon third-party systems not located on our premises. Any of these systems may be exposed to unplanned interruption, unreliability or intrusion from a variety of causes, including among others, storms and other natural disasters, terrorist attacks, utility outages, security breaches or complications encountered as existing systems are replaced or upgraded.
Any such issues could materially affect us including the impairment of information availability, compromise of system integrity or accuracy, misappropriation of confidential information, reduction of our volume of transactions and interruption of our general business. Although we believe our computer systems are securely protected and continue to take steps to ensure they are protected against such risks, such problems may occur. If they do, interruption to our business and damage to our reputation, and related costs, could be significant, which could have a material adverse effect on our business, financial condition and results of operations.
Performance of our investment portfolio is subject to a variety of investment risks.
Our results of operations depend, in part, on the performance of our investment portfolio. We seek to hold a high-quality portfolio of investments that is managed by a professional investment advisory management firm in accordance with our investment policy and routinely reviewed by our management team. Our investments, however, are subject to general economic conditions and market risks as well as risks inherent to particular securities.
Our primary market risk exposures are to changes in interest rates. See “Management’s discussion and analysis of financial condition and results of operations — Quantitative and qualitative disclosures about market risk.” In recent years, interest ratesreport, there have been at or near historic lows. A protracted low interest rate environment would continue to place pressure on our net investment income, which, in turn, may adversely affect our profitability. Future increases in interest rates could cause the values of our fixed income securities portfolios to decline, with the magnitude of the decline depending on the duration of securities included in our portfolio and the amount by which interest rates increase. Some fixed income securities have call or prepayment options, which create possible reinvestment risk in declining rate environments. Other fixed income securities, such as mortgage-backed and asset-backed securities, carry prepayment risk or, in a rising interest rate environment, may not prepay as quickly as expected.
The value of our investment portfolio is subjectno material changes to the risk that certain investments may default or become impaired due to deterioration in the financial condition of one or more issuers of the securities we hold, or due to deterioration in the financial condition of an insurer that guarantees an issuer’s payments on such investments. Downgrades in the credit ratings of fixed maturities also have a significant negative effect on the market valuation of such securities.
Such factors could reduce our net investment income and result in realized investment losses. Our investment portfolio is subject to increased valuation uncertainties when investment markets are illiquid. The valuation of investments is more subjective when markets are illiquid, thereby increasing the risk that the estimated fair value (i.e., the carrying amount) of the securities we holdfrom those disclosed in our portfolio does not reflect prices at which actual transactions would occur.2021 Form 10-K.
Risks for all types of securities are managed through the application of our investment policy, which establishes investment parameters that include maximum percentages of investment in certain types of securities and minimum levels of credit quality, which we believe are within applicable guidelines established by the NAIC, the Kansas Insurance Department, the California Department of Insurance and the Utah Insurance Department. Our investment objectives may not be achieved, and results may vary substantially over time. In addition, although we seek to employ investment strategies that are not correlated with our insurance and reinsurance exposures, losses in our investment portfolio may occur at the same time as underwriting losses.
Any shift in our investment strategy could increase the riskiness of our investment portfolio and the volatility of our results, which, in turn, may adversely affect our profitability.
Our investment strategy has historically been focused on fixed income securities which are subject to less volatility but also lower returns as compared to certain other asset classes. In the future, our investment strategy may include a greater focus on investments in equity securities, which are subject, among other things, to changes in value that may be attributable to market perception of a particular issuer or to general stock market fluctuations that affect all issuers. Investments in equity securities may be more volatile than investments in other asset classes such as fixed income securities. Common stocks generally subject their holders to more risks than preferred stocks and debt securities because common stockholders’ claims are subordinated to those of holders of preferred stocks and debt securities upon the bankruptcy of the issuer. An increase in the riskiness of our investment portfolio could lead to volatility of our results, which, in turn, may adversely affect our profitability.
We could be forced to sell investments to meet our liquidity requirements.
We invest the premiums we receive from our insureds until they are needed to pay policyholder claims. Consequently, we seek to manage the duration of our investment portfolio based on the duration of our losses and loss adjustment expenses reserves to ensure sufficient liquidity and avoid having to liquidate investments to fund claims. Risks such as inadequate losses and loss adjustment expenses reserves or unfavorable trends in litigation could potentially result in the need to sell investments to fund these liabilities. We may not be able to sell our investments at favorable prices or at all. Sales could result in significant realized losses depending on the conditions of the general market, interest rates and credit issues with individual securities.
We may face increased competition in our programs market.
While we believe there are relatively few competitors in the small- and mid-sized programs market that have the broad in-house expertise and wide array of services that we offer to our Program Partners, we may face increased competition if other companies decide to compete with us in our programs market or competitors begin to offer policy administration or other services. Any increase in competition in this market, especially by one or more companies that have greater resources than we have, could materially adversely affect our business, financial condition and results of operations.
We compete with a large number of companies in the insurance industry for underwriting premium.
We compete with a large number of other companies in the insurance industry for underwriting premium. During periods of intense competition for premium, we are exposed to the actions of other companies that may seek to write policies without the appropriate regard for risk and profitability. During these times, it is very difficult to grow or maintain premium volume without sacrificing underwriting discipline and income.
We face competition from a wide range of specialty insurance companies, underwriting agencies and intermediaries, as well as diversified financial services companies that are significantly larger than we are and that have significantly greater financial, marketing, management and other resources. Some of these competitors also have greater market recognition than we do. We may incur increased costs in competing for underwriting revenues. If we are unable to compete effectively in the markets in which we operate or expand our operations into new markets, our underwriting revenues may decline, as well as overall business results.
Our results of operations, liquidity, financial condition and FSRs are subject to the effects of natural and man-made catastrophic events.
Events such as hurricanes, windstorms, flooding, earthquakes, wildfires, solar storms, acts of terrorism, explosions and fires, cyber-crimes, public health crises, illness, epidemics or pandemic health events, product defects, mass torts and other catastrophes may adversely affect our business in the future. Such catastrophic events, and any relevant regulations, could expose us to:
widespread claim costs associated with P&C and workers’ compensation claims;
losses resulting from a decline in the value of our invested assets;
losses resulting from actual policy experience that is adverse compared to the assumptions made in product pricing;
declines in value and/or losses with respect to companies and other entities whose securities we hold and counterparties with whom we transact business to whom we have credit exposure, including reinsurers, and declines in the value of investments; and
significant interruptions to our systems and operations.
Natural and man-made catastrophic events are generally unpredictable. While we have structured our business and selected our niches in part to avoid catastrophic losses, our exposure to such losses depends on various factors, including the frequency and severity of the catastrophes, the rate of inflation and the value and geographic or other concentrations of insured companies and individuals. Vendor models and proprietary assumptions and processes that we use to manage catastrophe exposure may prove to be ineffective due to incorrect assumptions or estimates.
In addition, legislative and regulatory initiatives and court decisions following major catastrophes could require us to pay the insured beyond the provisions of the original insurance policy and may prohibit the application of a deductible, resulting in inflated catastrophe claims.
These and other disruptions could materially and adversely affect our business, financial condition and results of operations.
Disruptions related to COVID-19, including economic impacts of the COVID-19-related governmental actions, could materially and adversely affect our business, financial condition and results of operations.
In December 2019, a novel strain of coronavirus, COVID-19, was reported to have surfaced in Wuhan, China. Since then, COVID-19 has spread to multiple countries, including the U.S., and was declared a pandemic by the World Health Organization on March 11, 2020. The global outbreak of COVID-19 continues to rapidly evolve and has resulted in quarantines, reductions in business activity, widespread unemployment and overall economic and financial market instability. In addition, the ongoing continuation of the COVID-19 pandemic and the economic impacts of COVID-19-related governmental actions may also eventually have an impact on our premium revenue, our loss experience and loss expense, liquidity, or our regulatory capital and surplus, and operations.
It is still too early to determine the ultimate effect that the economic shutdown, resulting from the COVID-19 pandemic, will have on our future revenues or expected claims and losses. Legislative and regulatory initiatives taken, or which may be taken in response to COVID-19, may adversely affect our operations, particularly with respect to our workers’ compensation businesses. Adverse effects could include:
Legislative or regulatory action seeking to retroactively mandate coverage for losses, which our policies would not otherwise cover or have been priced to cover;
Regulatory actions relaxing reporting requirements for claims, which may affect coverage under our claims made and reported policies;
Legislative actions prohibiting us from canceling policies in accordance with our policy terms or non-renewing policies at their expiration date;
Legislative orders to provide premium refunds, extend premium payment grace periods and allow time extensions for past due premium payments;
We may have increased workers’ compensation loss expense and claims frequency if policyholder employees in high risk roles with essential businesses contract COVID-19 in the workplace;
While we have seen through the three and six months ended June 30, 2020 fewer claims reported despite insuring more employees and have not seen a significant impact on the average value of incurred losses due to the COVID-19 pandemic, high unemployment and low interest rates could adversely affect our profitability and declining payrolls could adversely affect our workers' compensation written premiums;
Travel restrictions and quarantines leading to a lack of in-person meetings, which would hinder our ability to establish relationships or originate new business;
Alternative working arrangements, including employees working remotely, which could negatively impact our business should such arrangements remain for an extended period of time;
We may experience elevated frequency and severity in our workers’ compensation lines as a result of legislative or regulatory action to effectively expand workers’ compensation coverage for certain types of workers; and
We may experience delayed reporting of losses, settlement negotiations and disputed claims resolution above our normal claims resolution trends.
The occurrence of any of these events or experiences, individually or collectively, could materially and adversely affect our business, financial condition and results of operations.
Global climate change may in the future increase the frequency and severity of weather events and resulting losses, particularly to the extent our policies are concentrated in geographic areas where such events occur, may have an adverse effect on our business, financial condition and results of operations.
Scientific evidence indicates that man-made production of greenhouse gas has had, and will continue to have, an adverse effect on the global climate. There is a growing consensus today that climate change increases the frequency and severity of extreme weather events and, in recent years, the frequency of extreme weather events appears to have increased. We cannot predict whether or to what extent damage that may be caused by natural events, such as wild fires, severe tropical storms and hurricanes, will affect our ability to write new insurance policies and reinsurance contracts, but, to the extent our policies are concentrated in the specific geographic areas in which these events occur, the increased frequency and severity of such events and the total amount of our loss exposure in the impacted areas of such events may adversely affect our business, financial condition and results of operations. In addition, although we have historically had limited exposure to catastrophic risk, claims from catastrophe events could reduce our earnings and cause substantial volatility in our business, financial condition and results of operations for any period. However, assessing the risk of loss and damage associated with the adverse effects of climate change and the range of approaches to address loss and damage associated with the adverse effects of climate change, including impacts related to extreme weather events and slow onset events, remains a challenge and might adversely affect our business, financial condition and results of operations.
Because our business depends on insurance brokers, we are exposed to certain risks arising out of our reliance on these distribution channels that could adversely affect our results.
Certain premiums from policyholders, where the business is produced by brokers, are collected directly by the brokers and forwarded to our insurance subsidiary. In certain jurisdictions, when the insured pays its policy premium to its broker for payment on behalf of our insurance subsidiary, the premium may be considered to have been paid under applicable insurance laws and regulations. Accordingly, the insured would no longer be liable to us for those amounts, whether or not we have actually received the premium from that broker. Consequently, we assume a degree of credit risk associated with the brokers with whom we work. Where necessary, we review the financial condition of potential new brokers before we agree to transact business with them. Although the failure by any of our brokers to remit premiums to us has not been material to date, there may be instances where our brokers collect premiums but do not remit them to us and we may be required under applicable law to provide the coverage set forth in the policy despite the absence of related premiums being paid to us.
Because the possibility of these events occurring depends in large part on the financial condition and internal operations of our brokers, we monitor broker behavior and review financial information on an as-needed basis. If we are unable to collect premiums from our brokers in the future, our underwriting profits may decline and our financial condition and results of operations could be materially and adversely affected.
Our operating results have in the past varied from quarter to quarter and may not be indicative of our long-term prospects.
Our operating results are subject to fluctuation and have historically varied from quarter to quarter. We expect our quarterly results to continue to fluctuate in the future due to a number of factors, including the general economic conditions in the markets where we operate, the frequency of occurrence or severity of catastrophic or other insured events, fluctuating interest rates, claims exceeding our loss reserves, competition in our industry, deviations from expected renewal rates of our existing policies and contracts, adverse investment performance and the cost of reinsurance coverage.
In particular, we seek to underwrite products and make investments to achieve favorable returns on tangible stockholders’ equity over the long term. In addition, our opportunistic nature and focus on long-term growth in tangible equity may result in fluctuations in gross written premiums from period to period as we concentrate on underwriting contracts that we believe will generate better long-term, rather than short-term, results. Accordingly, our short-term results of operations may not be indicative of our long-term prospects.
Changes in accounting practices and future pronouncements may materially affect our reported financial results.
Developments in accounting practices may require us to incur considerable additional expenses to comply, particularly if we are required to prepare information relating to prior periods for comparative purposes or to apply the new requirements retroactively. The impact of changes in current accounting practices and future pronouncements cannot be predicted but may affect the calculation of net income, stockholders’ equity and other relevant financial statement line items.
Our insurance subsidiaries are required to comply with statutory accounting principles (SAP). SAP and various components of SAP are subject to constant review by the NAIC and its task forces and committees, as well as state insurance departments, in an effort to address emerging issues and otherwise improve financial reporting. Various proposals are pending before committees and task forces of the NAIC, some of which, if enacted, could have negative effects on insurance industry participants. The NAIC continuously examines existing laws and regulations. We cannot predict whether or in what form such reforms will be enacted and, if so, whether the enacted reforms will positively or negatively affect us.
Legal and regulatory risks
We are subject to extensive regulation.
Most insurance regulations are designed to protect the interests of policyholders rather than stockholders and other investors. These regulations, generally administered by a department of insurance in each state and territory in which we do business, relate to, among other things:
approval of policy forms and premium rates;
standards of solvency, including risk-based capital measurements;
licensing of insurers;
challenging our use of fronting arrangements in states in which our Program Partner is not licensed;
imposing minimum capital and surplus requirements for insurance company subsidiaries;
restrictions on agreements with our large revenue-producing agents;
cancellation and non-renewal of policies;
restrictions on the nature, quality and concentration of investments;
restrictions on the ability of our insurance company subsidiaries to pay dividends to us;
restrictions on transactions between our insurance company subsidiaries and their affiliates;
restrictions on the size of risks insurable under a single policy;
requiring deposits for the benefit of policyholders;
requiring certain methods of accounting;
periodic examinations of our operations and finances;
prescribing the form and content of records of financial condition required to be filed; and
requiring reserves for unearned premium, losses and other purposes.
State insurance departments also conduct periodic examinations of the conduct and affairs of insurance companies and require the filing of annual, quarterly and other reports relating to financial condition, holding company issues, ERM and ORSA and other matters. These regulatory requirements could adversely affect or inhibit our ability to achieve some or all of our business objectives, including profitable operations in our various customer segments.
In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations or practices that we believe may be generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could fine us, preclude or temporarily suspend us from carrying on some or all of our activities in certain jurisdictions or otherwise penalize us. This could adversely affect our
ability to operate our business. Further, changes in the laws and regulations applicable to the insurance industry or interpretations by regulatory authorities could adversely affect our ability to operate our business as currently conducted and in accordance with our business objectives.
In addition to regulations specific to the insurance industry, including the insurance laws of our principal state regulators (the Kansas Insurance Department, the California Department of Insurance and the Utah Insurance Department), as a public company we will also be subject to the rules and regulations of the SEC and the securities exchange on which our common stock is listed, each of which regulate many areas such as financial and business disclosures, corporate governance and stockholder matters. Among other laws, we are subject to laws relating to federal trade restrictions, privacy/data security and terrorism risk insurance laws.
We monitor these laws, regulations and rules on an ongoing basis to ensure compliance and make appropriate changes as necessary. Implementing such changes may require adjustments to our business methods, increases to our costs and other changes that could cause us to be less competitive in our industry. For further information on the regulation of our business, see the “Regulation”section of our registration statement filed with the SEC on Form S-1.
Regulators may challenge our use of fronting arrangements in states in which our Program Partners are not licensed.
We enter into fronting, or issuing carrier, arrangements with our Program Partners that require a broadly licensed, highly rated admitted carrier to conduct their business in states in which such Program Partner is not licensed or is not authorized to write particular lines of insurance. We typically act as the reinsurance broker to the program as well as the issuing carrier, which enables us to charge fees for the placement of reinsurance in addition to the fronting fees. We also receive ceding commissions from third-party reinsurers to which we transfer all or a portion of the underwriting risk. Some state insurance regulators may object to our issuing carrier arrangements. In certain states, including Florida and Kentucky, the insurance commissioner has the authority to prohibit an authorized insurer from acting as an issuing carrier for an unauthorized insurer. In addition, insurance departments in states in which there is no statutory or regulatory prohibition against an authorized insurer acting as an issuing carrier for an unauthorized insurer could deem the assuming insurer to be transacting insurance business without a license and the issuing carrier to be aiding and abetting the unauthorized sale of insurance.
If regulators in any of the states where we conduct our issuing carrier business were to prohibit or limit the arrangement, we would be prevented or limited from conducting that business for which a capacity provider is not authorized in those states, unless and until the capacity provider is able to obtain the necessary licenses. This could have a material and adverse effect on our business, financial condition and results of operations. See “- More than half of our gross written premiums are written in three key states.”
Regulation may become more extensive in the future.
Legislators and regulators may periodically consider various proposals that may affect our business practices and product designs, how we sell or service certain products we offer or the profitability of our business. We continually monitor such proposals and assess how they may apply to us or our competitors or how they could impact our business, financial condition, results of operations and ability to compete effectively.
Increasing regulatory focus on privacy issues and expanding laws could affect our business model and expose us to increased liability.
The regulatory environment surrounding information security and privacy is increasingly demanding.
We are subject to numerous U.S. federal and state laws and non-U.S. regulations governing the protection of personal and confidential information of our customers or employees. On October 24, 2017, the National Association of Insurance Commissioners (NAIC) adopted an Insurance Data Security Model Law, which requires licensed insurance entities to comply with detailed information security requirements. The NAIC model law has been adopted by certain states and is under consideration by others. It is not yet known whether or not, and to what extent, states legislatures or insurance regulators where we operate will enact the Insurance Data Security Model Law in whole or in part, or in a modified form. Such enactments, especially if inconsistent between states or with existing laws and regulations could raise compliance costs or increase the risk of noncompliance, with the attendant risk of being subject to regulatory enforcement actions and penalties, as well as reputational harm. Any such events could potentially have an adverse impact on our business, financial condition or results of operations.
As a holding company, we rely on dividends and payments from our subsidiaries to operate our business. Our ability to receive dividends and permitted payments from our insurance company subsidiaries is subject to regulatory constraints.
We are a holding company and, as such, have no direct operations of our own. We do not expect to have any significant assets other than our ownership of equity interests in our operating subsidiaries. We accordingly depend on the payment of funds from our subsidiaries in the form of dividends, distributions or otherwise to meet our obligations and to pay our expenses. The ability of our subsidiaries to make any payments to us depends on their earnings, the terms of their indebtedness, including the terms of any credit facilities and legal restrictions.
In addition, dividends payable from our insurance company subsidiaries without the prior approval of the applicable insurance commissioner are limited to the greater of 10% of Benchmark’s surplus as shown on the last statutory financial statement on file with the Kansas Insurance Department and the California Department of Insurance, respectively, or 100% of net income during the applicable twelve-month period (not including realized capital gains); and in Utah, the lesser of 10% of ALIC’s surplus as shown on the last statutory financial statement on file with the Utah Insurance Department, 100% of net income during the applicable twelve-month period (not including realized capital gains). As of December 31, 2019, the maximum amount of unrestricted dividends that our insurance company subsidiaries could pay to us without approval was $11.6 million. Our insurance company subsidiaries may be unable to pay dividends in the future, and the limitations of such dividends could adversely affect our business, liquidity or financial condition.
The effects of litigation on our business are uncertain and could have an adverse effect on our business.
As is typical in our industry, we continually face risks associated with litigation of various types, including general commercial and corporate litigation, and disputes relating to bad faith allegations which could result in us incurring losses in excess of policy limits. We are party to certain litigation matters throughout the year, mostly with respect to claims. Litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, there exists the possibility of a material adverse impact on our results of operations and financial position in the period in which the outcome occurs. Even if an unfavorable outcome does not materialize, we still may face substantial expense and disruption associated with the litigation.
We may have exposure to losses from acts of terrorism as we are required by law to provide certain coverage for such losses.
U.S. insurers are required by state and federal law to offer coverage for acts of terrorism in certain commercial lines, including workers’ compensation. The Terrorism Risk Insurance Act, as extended by the Terrorism Risk Insurance Program Reauthorization Act of 2015 (TRIPRA) requires commercial P&C insurance companies to offer coverage for acts of terrorism, whether foreign or domestic, and established a federal assistance program through the end of 2020 to help cover claims related to future terrorism-related losses. The likelihood and impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act. Although we reinsure a portion of the terrorism risk we retain under TRIPRA, our terrorism reinsurance does not provide full coverage for an act stemming from nuclear, biological or chemical terrorism. To the extent an act of terrorism, whether a domestic or foreign act, is certified by the Secretary of Treasury, we may be covered under TRIPRA of our losses for certain P&C lines of insurance. However, any such coverage would be subject to a mandatory deductible based on 20% of earned premium for the prior year for the covered lines of commercial P&C insurance. Based on our 2018 earned premiums, our aggregate deductible under TRIPRA during 2019 is approximately $59 million. The federal government will then reimburse us for losses in excess of our deductible, which will be 81% of losses in 2019, and 80% in 2020, up to a total industry program limit of $100 billion.
Assessments and premium surcharges for state guaranty funds, secondary-injury funds, residual market programs and other mandatory pooling arrangements may reduce our profitability.
Most states require insurance companies licensed to do business in their state to participate in guaranty funds, which require the insurance companies to bear a portion of the unfunded obligations of impaired, insolvent or failed insurance companies. These obligations are funded by assessments, which are expected to continue in the future. State guaranty associations levy assessments, up to prescribed limits, on all member insurance companies in the state based on their proportionate share of premiums written in the lines of business in which the impaired, insolvent or failed insurance companies are engaged. Accordingly, the assessments levied on us may increase as we increase our written premiums. Some states also have laws that establish secondary-injury funds to reimburse insurers and employers for claims paid to injured employees for aggravation of prior conditions or injuries. These funds are supported by either assessments or premium surcharges based on incurred losses.
In addition, as a condition to conducting business in some states, insurance companies are required to participate in residual market programs to provide insurance to those who cannot procure coverage from an insurance carrier on a negotiated basis. Insurance companies generally can fulfill their residual market obligations by, among other things, participating in a reinsurance pool where the results of all policies provided through the pool are shared by the participating insurance companies. Although we price our insurance to account for our potential obligations under these pooling arrangements, we may not be able to accurately estimate our liability for these obligations. Accordingly, mandatory pooling arrangements may cause a decrease in our profits. Further, the impairment, insolvency or failure of other insurance companies in these pooling arrangements would likely increase the liability for other members in the pool. The effect of assessments and premium surcharges or increases in such assessments or surcharges could reduce our profitability in any given period or limit our ability to grow our business.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Unregistered Sales of Equity Securities
None.
Use of Proceeds
On July 20, 2020, we closed the sale of 10,714,286 shares of our common stock in our IPO, comprised of 7,142,857 shares issued and sold by us and 3,571,429 shares sold by selling stockholders. On July 22, 2020, we closed the sale of an additional 1,207,142 shares by certain selling stockholders in the IPO pursuant to the exercise of the underwriters’ option to purchase additional shares to cover over-allotments. The IPO terminated upon completion of the sale of the above-referenced shares.
The initial public offering price per share was $15.00. The aggregate initial public offering price for all shares sold by us in the IPO was approximately $107.1 million and the aggregate initial public offering price for all shares sold by the selling stockholders in the IPO was approximately $71.7 million. The offer and sale was pursuant to a registration statement on Form S-1 (File No. 333-239291), which was declared effective by the SEC on July 15, 2020. J.P. Morgan Securities LLC, Evercore Group, L.L.C. and William Blair & Company, L.L.C. acted as joint book-running managers of the IPO, and JMP Securities LLC acted as co-manager.
We received net proceeds from the sale of shares by us in the IPO of approximately $94.9 million after deducting underwriting discounts and commissions of $7.5 million and estimated offering expenses of $4.7 million. We did not receive any proceeds from the sale of shares by the selling stockholders. We used or are in the process of using the net proceeds from the sale of shares by us in the IPO to (i) redeem all $5.1 million aggregate liquidation preference of the Series B Nonconvertible Preferred Stock of our subsidiary Benchmark Holding Company, (ii) pay $7.7 million to redeem all outstanding Subordinated Notes, (iii) use $19.3 million to repay in full all outstanding term loan borrowings under the credit agreement with Oak Street Funding LLC, (iv) pay an aggregate one-time payment of approximately $7.6 million to Altaris Capital Partners, LLC in connection with the termination of our consulting and advisory agreements with Altaris Capital Partners, LLC and (v) pay an aggregate $3.1 million to certain pre-IPO unitholders and other employees in connection with the reorganization transactions and pursuant to the operating agreements for Trean Holdings LLC and BIC Holdings LLC. The remaining net proceeds will be used for general corporate purposes, including to support the growth of our business. There has been no material change in the anticipated use of proceeds from the IPO as described in our final prospectus filed with the SEC on July 17, 2020 pursuant to Rule 424(b)(4).
Item 3. Defaults Upon Senior Securities
None.Not applicable.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
None.Not applicable.
Item 6. Exhibits
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| Exhibit Number | | Description |
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| | Registration Rights Agreement, dated as of July 20, 2020, among Trean Insurance Group, Inc. and the parties named therein |
| | Reorganization Agreement, dated as of July 16, 2020, among Trean Insurance Group, Inc. and the parties named therein |
| | Contribution Agreement, dated as of July 16, 2020, among Trean Insurance Group, Inc., BIC Holdings LLC and Trean Holdings LLC |
| | Contribution Agreement, dated as of July 16, 2020, between Trean Insurance Group, Inc. and Trean Compstar Holdings LLC |
| | Director Nomination Agreement, dated as of July 16, 2020, among Trean Insurance Group, Inc., AHP-BHC LLC, AHP-TH LLC, ACP-BHC LLC and ACP-TH LLC |
| | Trean Insurance Group, Inc. 2020 Omnibus Incentive Plan |
| | Termination Agreement, dated as of July 16, 2020, among Altaris Capital Partners, LLC, BIC Holdings LLC, Trean Holdings LLC and Trean Insurance Group, Inc. |
| | Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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101.INS ** | | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |
| 101.SCH | | XBRL Taxonomy Extension Schema Document |
| 101.CAL | | XBRL Taxonomy Extension Calculation Linkbase Document |
| 101.DEF | | XBRL Taxonomy Extension Definition Linkbase Document |
| 101.LAB | | XBRL Taxonomy Extension Label Linkbase Document |
| 101.PRE | | XBRL Taxonomy Extension Presentation Linkbase Document |
| 104 | | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |
| | |
| * This certification is deemed not filed for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference to any filing under the Securities Act of 1933, as amended, or the Exchange Act. |
** The instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.+ Filed herewith. |
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrantregistrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| | TREAN INSURANCE GROUP, INC. |
| | | |
| Date: | August 8, 2022 | TREAN INSURANCE GROUP, INC. |
| By: | | | |
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Date: | August 28, 2020 | By: | /s/ Andrew M. O'Brien |
| | | Andrew M. O'Brien |
| | | President and Chief Executive Officer |
| | | (Principal Executive Officer) |
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Date: | August 28, 2020 | By: | /s/ Julie A. Baron |
| | | Julie A. Baron |
| | | Chief Executive Officer |
| | | (Principal Executive Officer) |
| | | |
| Date: | August 8, 2022 | By: | /s/ Nicholas J. Vassallo |
| | | Nicholas J. Vassallo |
| | | Chief Financial Officer Treasurer and Secretary |
| | | (Principal Financial and Accounting Officer) |