TREAN INSURANCE GROUP, INC. The following discussion and analysis of financial condition and results of operations for the three and nine months endedSeptember 30, 2022 is qualified by reference to and should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related notes included herein and the audited consolidated financial statements and notes included in our 2021 Form 10-K. The discussion and analysis below are based on comparisons between our historical financial data for different periods and include certain forward-looking statements about our business, operations, and financial performance. These forward-looking statements are subject to risks, uncertainties, assumptions, and other factors described in Item 1A - "Risk Factors" in our 2021 Form 10-K. Our actual results may differ materially from those expressed in, or implied by, those forward-looking statements. See "Forward-Looking Statements." All references to "we," "us," "our," "the Company," "Trean ," or similar terms refer toTrean Insurance Group, Inc. and its subsidiaries, unless the context otherwise requires. The information contained in this quarterly report is not a complete description of our business or the risks associated with an investment in our common stock.
The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial performance or operating performance. In some cases, you can identify forward-looking statements because they contain words such as "may," "will," "should," "expects," "plans," "anticipates," "could," "intends," "target," "projects," "contemplates," "believes," "estimates," "predicts," "would," "potential," or "continue" or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans, or intentions. Forward-looking statements are based on management's current expectations and assumptions about future events. These statements are only predictions and are not guarantees of future performance. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements if the underlying assumptions prove to be incorrect or as a result of risks, uncertainties, and other factors, including the impact of the COVID-19 pandemic, inflationary pressures and other macroeconomic factors on the business and operations of the Company, our program partners and other business relations. Other factors that may cause such differences include the risks described in the Company's filings with theU.S. Securities and Exchange Commission , including the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 . These forward-looking statements speak only as of the date on which they are made. Except as required by applicable securities laws, the Company disclaims any obligation to update or revise any forward-looking statement, whether as a result of new information, future developments, changes in assumptions or otherwise. Investors are cautioned not to place undue reliance on the forward-looking statements contained in this press release or in other filings and public statements of the Company. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and assumptions, which in many cases are beyond our control, as described in "Item 1A - Risk Factors" in our 2021 Form 10-K and in this Quarterly Report on Form 10-Q. Our statements reflecting these risks and uncertainties are not exhaustive, and other risks and uncertainties may currently exist or may arise in the future that could have material effects on our business, operations, and financial condition. We cannot assure you that the results, events, and circumstances reflected in the forward looking statements reflected in this Quarterly Report on Form 10-Q and our other public statements and securities filings will be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward looking statements. These forward-looking statements speak only as of the date on which such statements are made. We undertake no obligation, and do not intend, to update any forward looking statements after the date of this Quarterly Report on Form 10-Q or to conform such statements to actual results or revised expectations, except as required by applicable securities laws or the rules and regulations of theSecurities and Exchange Commission ("SEC"). 26 -------------------------------------------------------------------------------- Table of Contents Overview We are a provider of products and services to the specialty insurance market. We underwrite specialty casualty insurance products both through ourProgram Partners and also through our Owned MGAs. We also provide ourProgram Partners with a variety of services, including issuing carrier services, claims administration, and reinsurance brokerage, from which we generate recurring fee-based revenues. We have one reportable segment. We provide our insurance products and services to ourProgram Partners and Owned MGAs focused on specialty lines. We target a diversified portfolio of small to medium programs, typically with less than$30 million of premiums, that focus on niche segments of the specialty casualty insurance market and that we believe have strong underwriting track records.
Coronavirus ("COVID-19") Impact
We are monitoring the ongoing COVID-19 pandemic on our business, including how it may impact our premium revenue, loss experience and loss expense, liquidity, and our regulatory capital and surplus, and operations. Significant progress has been made to combat the outbreak of COVID-19; however, the global pandemic, including resulting inflationary pressures and other macroeconomic factors on the business and operations of the Company, has adversely impacted both the domestic and foreign economies and could still have a materially adverse impact on the Company. Workforce Operations Following the emergence of the COVID-19 pandemic in early 2020, we took a number of actions to protect the health of the public and our employees and to comply with directives and advice of governmental authorities and public health experts. We responded by developing a Preparedness Plan that outlined both corporate-wide and location-specific modifications to working conditions and operations in our offices. We continue to navigate through these challenges with a sharp focus on and goal of safeguarding our employees, helping our customers and managing impacts on our business. Despite the unprecedented environment, our teams are executing at a high level and we are advancing our strategy.
Premium Revenue, Claims and Losses
We have not experienced a material impact to our premium revenue as a result of the COVID-19 pandemic. During the nine months endedSeptember 30, 2022 , compared to the nine months endedSeptember 30, 2021 , gross written premiums decreased by (0.7)% and net earned premiums increased by 42.9%. The decrease in gross written premiums was driven by the Company's continued focus on maintaining underwriting discipline in an unusually competitive environment. The increase in net earned premiums was primarily driven by increased retention in our existing Program Partner business. Because a majority of our gross written premiums are related to workers' compensation insurance, revenue trends could be impacted in future periods if the COVID-19 pandemic were to continue or significantly get worse. However, a significant portion of our workers' compensation premiums are pay-as-you-go programs, which reduces our downside risk from future premium audits or refunds.
We also have not experienced a material impact in our reported claims or incurred losses in the first nine months of 2022 as a specific result of the COVID-19 pandemic.
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Investment Portfolio
With respect to our investment portfolio, we seek to hold a high-quality,
diversified portfolio of investments, which are primarily in fixed maturity and
available-for-sale investments and, as such, our investment portfolio has
limited exposure to equity market volatility. For the nine months ended
September 30, 2022 , we experienced a decrease of $58,333 in the fair value of
our fixed maturities investment portfolio. The decline in the fair value of our
fixed maturity investments is primarily attributable to the recent rise in
interest rates driven primarily by changing conditions in the financial markets
as compared to the comparatively lower rates that prevailed during the initial
part of the COVID-19 pandemic in 2020 and 2021, rather than underlying credit
risk within our investment portfolio. If there were to be continued equity and
debt financial market volatility, which in turn could create mark-to-market
investment valuation decreases, we expect there could be additional or increased
unrealized losses recorded or realized losses, if sold, in future reporting
periods. However, given the conservative nature of our investment portfolio, we
expect that any adverse impact on the value of our investment portfolio, as it
relates to COVID-19, will be temporary, and we do not expect a long-term
negative impact on our financial condition, results of operations or cash flows.
Other Concerns
Adverse events such as changes in the overall public health environment, changing infection patterns and new variants of COVID-19, health-related concerns about working in our offices, restrictions on travel, the potential impact on our business partners and customers, and other matters affecting our general work and business environment could harm our business and delay the implementation of our business strategy. We cannot anticipate all the ways in which the current global health crisis and financial market conditions could adversely impact our business in the future.
Significant Components of Results of Operations
Gross written premiums: Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for general and administrative expenses (including policy acquisition costs), reinsurance costs or other deductions. The volume of our gross written premiums in any given period is generally influenced by:
•addition and retention of
•new business submissions to our
•binding of new business submissions into policies;
•renewals of existing policies; and
•average size and premium rate of bound policies.
Gross earned premiums: Gross earned premiums are the earned portion of gross written premiums. We earn insurance premiums on a pro rata basis over the term of the policy. Our insurance policies generally have a term of one year. Ceded earned premiums: Ceded earned premiums are the amount of gross earned premiums ceded to reinsurers. We enter into reinsurance contracts to limit our maximum losses and diversify our exposure and provide statutory surplus relief. The volume of our ceded earned premiums is affected by the level of our gross earned premiums and any decision we make to increase or decrease limits, retention levels, and co-participations. Net earned premiums: Net earned premiums represent the earned portion of our gross written premiums, less that portion of our gross written premiums that is earned and ceded to third-party reinsurers, including ourProgram Partners and professional reinsurers, under our reinsurance agreements. Net investment income: We earn investment income on our portfolio of cash and invested assets. Our cash and invested assets are primarily comprised of fixed maturities, including other equity investments and short-term investments. Our net investment income includes interest income on our invested assets, income on funds held investments as well as unrealized gains and losses on our equity portfolio. 28 -------------------------------------------------------------------------------- Table of Contents Net realized gains/losses: Net realized gains/losses are a function of the difference between the amount received by us on the sale of a security and the security's recorded value as well as any "other-than-temporary impairments" relating to fixed maturity investments recognized in earnings. Other revenue: Other revenue includes brokerage, third-party administrative, management, consulting, and other fee-based revenues, which are commonly based on written premiums. Loss and loss adjustment expenses (LAE): Losses and LAE are net of reinsurance and include claims paid, estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending, and servicing claims. In general, our losses and LAE are affected by:
•frequency of claims associated with the particular types of insurance contracts that we write;
•trends in the average size of losses incurred on a particular type of business;
•mix of business written by us;
•changes in the legal or regulatory environment related to the business we write;
•trends in legal defense costs;
•wage inflation; and
•inflation in medical costs.
Losses and LAE are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Losses and LAE may be paid out over a period of years.
General and administrative expenses: General and administrative expenses include net commissions, insurance-related expenses, and general and administrative operating expenses. Net commissions consist of policy acquisition costs and other underwriting expenses, net of ceding commissions. Policy acquisition costs are principally comprised of the commissions we pay our brokers and program managers. Policy acquisition costs that are directly related to the successful acquisition or reinsurance of those policies are deferred. All policy acquisition costs are charged to expense in proportion to premium earned over the policy life. We receive ceding commissions on business ceded under our reinsurance contracts. Insurance-related expenses largely consist of state premium taxes. General and administrative operating expenses include employee salaries and benefits, corporate business insurance costs, technology costs, office rent, and professional services fees such as legal, accounting, audit, tax, and actuarial services. Intangible asset amortization: Intangible asset amortization consists of expenses incurred related to the amortization of intangible assets recorded as a result of business acquisitions and consists of trade names, customer lists and relationships, and non-compete agreements.
Noncash stock compensation: Noncash stock compensation includes expenses related to the fair value and issuance of restricted stock units (time, market and performance-based) and stock options.
Gains (losses) on embedded derivatives: Gains (losses) on embedded derivatives consist of the change in fair value of derivatives, the effect of net investment income on funds held investments, and the effect of realized gains and loss on funds held investments. Interest expense: Interest expense consists primarily of interest paid on our Secured Credit Facility and Surplus Notes (See "Financial Condition, Liquidity and capital resources - Debt and Credit Agreements"). Other income: Other income consists primarily of sublease revenue and other miscellaneous income items. Key Metrics
We discuss certain key financial and operating metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance.
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Underwriting income is a non-GAAP financial measure defined as income before
taxes excluding net investment income, investment revaluation gains, net
realized gains or losses, intangible asset amortization, noncash stock
compensation, noncash changes in fair value of embedded derivatives, interest
expense, other revenue, and other income and expenses. See "Reconciliation of
Non-GAAP Financial Measures" for a reconciliation of underwriting income to
income before taxes in accordance with GAAP.
Adjusted net income is a non-GAAP financial measure defined as net income
excluding the impact of certain items, including noncash intangible asset
amortization and stock compensation, noncash changes in fair value of embedded
derivatives, other expenses, and gains or losses that we believe do not reflect
our core operating performance, which items may have a disproportionate effect
in a given period, affecting comparability of our results across periods. See
"Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted
net income to net income in accordance with GAAP.
Loss ratio, expressed as a percentage, is the ratio of losses and LAE to net earned premiums.
Expense ratio, expressed as a percentage, is the ratio of general and administrative expenses to net earned premiums.
Combined ratio is the sum of the loss ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss.
Return on equity is net income expressed on an annualized basis as a percentage of average beginning and ending stockholders' equity during the period.
Adjusted return on equity is a non-GAAP financial measure defined as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders' equity during the period. See "Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted return on equity to return on equity in accordance with GAAP.
Tangible stockholders' equity is defined as stockholders' equity less goodwill and other intangible assets.
Return on tangible equity is a non-GAAP financial measure defined as net income
expressed on an annualized basis as a percentage of average beginning and ending
tangible stockholders' equity during the period. See "Reconciliation of Non-GAAP
Financial Measures" for a reconciliation of return on tangible equity to return
on equity in accordance with GAAP.
Adjusted return on tangible equity is a non-GAAP financial measure defined as
adjusted net income expressed on an annualized basis as a percentage of average
beginning and ending tangible stockholders' equity during the period. See
"Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted
return on tangible equity to return on equity in accordance with GAAP.
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Results of Operations
Consolidated Results of Operations for the Three Months Ended
The following table summarizes our results of operations for the three months
ended
Three Months Ended September 30,
(in thousands, except for percentages) 2022 2021 Change Percentage Change (1)
Revenues
Gross written premiums $ 162,183$ 177,624 $ (15,441) (8.7)% Increase in gross unearned premiums (1,061) (28,478) 27,417 (96.3)% Gross earned premiums 161,122 149,146 11,976 8.0% Ceded earned premiums (89,741) (97,191) 7,450 (7.7)% Net earned premiums 71,381 51,955 19,426 37.4% Net investment income 2,951 2,187 764 34.9% Net realized gains 9 49 (40) (81.6)% Other revenue 2,140 2,799 (659) (23.5)% Total revenue 76,481 56,990 19,491 34.2% Expenses Losses and loss adjustment expenses 45,647 32,129 13,518 42.1% General and administrative expenses 23,256 13,788 9,468 68.7% Intangible asset amortization 1,499 1,499 - -% Noncash stock compensation 460 468 (8) (1.7)% Interest expense 931 419 512 122.2% Total expenses 71,793 48,303 23,490 48.6% Gains (losses) on embedded derivatives 4,871 (121) 4,992 NM Other income 29 35 (6) (17.1)% Income before taxes 9,588 8,601 987 11.5% Income tax expense 2,014 2,083 (69) (3.3)% Net income $ 7,574$ 6,518 $ 1,056 16.2%
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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Three Months Ended September 30,
(in thousands, except for percentages) 2022 2021
Key metrics:
Underwriting income(1) $ 2,478 $ 6,038
Adjusted net income(1) $ 5,455 $ 7,678
Loss ratio 63.9 % 61.8 %
Expense ratio 32.6 % 26.5 %
Combined ratio 96.5 % 88.3 %
Return on equity 7.5 % 6.2 %
Adjusted return on equity(1) 5.4 % 7.3 %
Return on tangible equity(1) 15.5 % 12.7 %
Adjusted return on tangible equity(1) 11.2 % 15.0 %
(1) This metric represents a non-GAAP financial measure. See 'Reconciliation of Non-GAAP Financial Measures' for a reconciliation of this metric to the applicable GAAP metric.
The table below shows the total premiums earned on a gross and net basis for the respective three-month periods:
Three Months Ended September 30,
(in thousands, except for
percentages) 2022 2021 Change Percentage Change
Revenues
Gross written premiums $ 162,183 $ 177,624 $ (15,441) (8.7)%
Increase in gross unearned premiums (1,061) (28,478) 27,417 (96.3)%
Gross earned premiums 161,122 149,146 11,976 8.0%
Ceded earned premiums (89,741) (97,191) 7,450 (7.7)%
Net earned premiums $ 71,381 $ 51,955 $ 19,426 37.4%
Gross written premiums: Gross written premiums decreased $15,441 , or 8.7%, to
$162,183 for the three months ended September 30, 2022 , compared to $177,624 for
the three months ended September 30, 2021 . The decrease was primarily driven by
the Company's termination of an underwriting partner in a higher-risk segment at
the end of the third quarter of 2021 as the Company focuses on maintaining
underwriting discipline in a highly competitive environment.
Workers' compensation represented 54.9% of our gross written premiums for the
three months ended September 30, 2022 , compared to 54.3% for the three months
ended September 30, 2021 . For the three months ended September 30, 2022 , gross
written premiums for workers' compensation decreased by $7,389 , or 7.7%,
compared to the same period in 2021, reflecting the intentional decrease in
California business that resulted from the Company's measures undertaken to exit
certain unfavorable risks in 2021 in keeping with our overall strategy to
prioritize underwriting discipline, coupled with a recent highly competitive
market.
All other non-workers' compensation liability represented 45.1% of our gross
written premiums for the three months ended September 30, 2022 , compared to
45.7% for the three months ended September 30, 2021 . For the three months ended
September 30, 2022 , gross written premiums for all other non-workers'
compensation liability decreased $8,052 , or 9.9%, compared to the same period in
2021. The decrease is due primarily to a decline in our other liability line of
business, partially offset by growth in our accident & health, commercial and
commercial auto lines, a result of continued line of business diversification.
Gross earned premiums: Gross earned premiums increased $11,976 , or 8.0%, to
$161,122 for the three months ended September 30, 2022 , compared to $149,146 for
the three months ended September 30, 2021 . The increase in gross earned premiums
reflects the change in the increase in gross unearned premiums of $27,417 net of
a decrease in gross written
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premiums of
Ceded earned premiums: Ceded earned premiums decreased$7,450 , or 7.7%, to$89,741 for the three months endedSeptember 30, 2022 , compared to$97,191 for the three months endedSeptember 30, 2021 . The decrease in ceded earned premiums is primarily driven by an increase in our retention, partially offset by the growth in gross earned premiums as described above. Ceded earned premiums as a percentage of gross earned premiums decreased to 55.7% for the three months endedSeptember 30, 2022 , compared to 65.2% for the three months endedSeptember 30, 2021 , reflecting the Company's strategic decision to retain more gross written premiums. Net earned premiums: Net earned premiums increased$19,426 , or 37.4%, to$71,381 for the three months endedSeptember 30, 2022 , compared to$51,955 for the three months endedSeptember 30, 2021 . The increase is primarily due to the growth in gross earned premiums as described above and the Company's strategic decision to retain more gross written premiums. Net investment income (loss): Net investment income increased$764 , or 34.9%, to$2,951 for the three months endedSeptember 30, 2022 , compared to$2,187 for the three months endedSeptember 30, 2021 . The increase reflects the investment of the surplus notes proceeds and the reinvestment of funds from lower yielding maturities into higher yielding investments due to higher interest rates. The increase was partially offset by the unrealized losses on equity securities of$1,101 . During the first quarter of 2022, we purchased high-yield equity securities, which we believe will improve the yield on our portfolio.
Net realized gains: Net realized gains were
Other revenue: Other revenue decreased$659 , or 23.5%, to$2,140 for the three months endedSeptember 30, 2022 , compared to$2,799 for the three months endedSeptember 30, 2021 . The decrease is primarily driven by a decrease in brokerage revenue of$408 primarily due to lower placement fees reflecting the Company's increase in retention year over year. Losses and loss adjustment expenses: Losses and LAE increased$13,518 , or 42.1%, to$45,647 for the three months endedSeptember 30, 2022 , compared to$32,129 for the three months endedSeptember 30, 2021 . The increase is primarily attributable to the growth in earned premiums and increased retention during the three months endedSeptember 30, 2022 . This resulted in a loss ratio of 63.9% for the three months endedSeptember 30, 2022 compared to 61.8% for the three months endedSeptember 30, 2021 . General and administrative expenses: General and administrative expenses increased$9,468 , or 68.7%, to$23,256 for the three months endedSeptember 30, 2022 , compared to$13,788 for the three months endedSeptember 30, 2021 . The expense ratio was 32.6% for the three months endedSeptember 30, 2022 , compared to 26.5% for the three months endedSeptember 30, 2021 . 33 -------------------------------------------------------------------------------- Table of Contents The table below shows the components of general and administrative expenses for the respective three-month periods: Three Months Ended September 30, 2022 2021 Change Direct commissions$ 28,650 $ 27,594 $ 1,056 Ceding commissions (23,916) (31,655) 7,739 Net commissions 4,734 (4,061) 8,795 Insurance-related expenses 6,038 5,371 667 General and administrative operating expenses 12,484 12,478 6 Total general and administrative expenses$ 23,256
General and administrative expenses - % of gross written premiums 7.7 % 7.0 % Retention rate (1) 44.3 % 34.8 % Direct commission rate (2) 17.8 % 18.5 % Ceding commission rate (3) 26.7 % 32.6 %
(1) Net earned premium as a percentage of gross earned premiums. (2) Direct commissions as a percentage of gross earned premiums. (3) Ceding commissions as a percentage of ceded earned premiums.
Direct commissions increased$1,056 primarily due to an increase in gross earned premiums. Ceding commissions decreased$7,739 primarily due to an increase in retention. Insurance-related expenses increased$667 primarily as a result of an increase in gross earned premiums. General and administrative operating expenses increased$6 . Intangible asset amortization: Intangible asset amortization was$1,499 for the three months endedSeptember 30, 2022 , compared to$1,499 for the three months endedSeptember 30, 2021 . Noncash stock compensation: Noncash stock compensation was$460 for the three months endedSeptember 30, 2022 , compared with$468 for the three months endedSeptember 30, 2021 . Expenses incurred during both periods relate to the fair value of restricted stock units and stock options granted under the Company's 2020 Omnibus Plan recognized over the requisite service periods. Gains (losses) on embedded derivatives: The table below shows the components of gains (losses) on embedded derivatives for the respective three-month periods: Three Months Ended
2022 2021 Change
Change in fair value of embedded derivatives $ 5,812 $ 573 $ 5,239
Effect of net investment income on funds held
investments (953) (585) (368)
Effect of realized losses (gains) on funds
held investments 12 (109) 121
Total gains (losses) on embedded derivatives $ 4,871 $
(121)
Gains on embedded derivatives increased$4,992 to$4,871 for the three months endedSeptember 30, 2022 , compared to a loss of$121 for the three months endedSeptember 30, 2021 . The gain reflected an increase in the fair value of embedded derivatives of$5,239 , the effect of investment income on funds held investments of$368 and the effect of realized losses on funds held investments of$121 . The increase in fair value of the embedded derivatives resulted primarily from the increase in interest rates between periods, which has reduced the fair value of the underlying funds held under reinsurance agreements. 34 -------------------------------------------------------------------------------- Table of Contents Income tax expense: Income tax expense was$2,014 for the three months endedSeptember 30, 2022 , which resulted in an effective tax rate of 21.0%. The effective tax rate equaled the statutory rate of 21% since the impact of state taxes were offset by the impact of tax-exempt municipal income on the Company's investments. For the three months endedSeptember 30, 2021 , income tax expense was$2,083 , which resulted in an effective tax rate of 24.2%. The increase in the effective tax rate from the statutory rate of 21% is due primarily to the impact of recording our 2020 tax return accrual to return true-up in the third quarter of 2021.
Owned MGAs and Program Partner Premiums:
The following table shows the total premiums earned on a gross and net basis for
Three Months Ended September 30, 2022
Owned MGAs Program Partner Total
Gross written premiums $ 58,567 $ 103,616 $ 162,183
Increase in gross unearned premiums 2,627 (3,688) (1,061)
Gross earned premiums 61,194 99,928 161,122
Ceded earned premiums (20,454) (69,287) (89,741)
Net earned premiums $ 40,740 $ 30,641 $ 71,381
We utilize both quota share and catastrophe excess of loss ("XOL") contracts in
our reinsurance strategy for our Owned MGAs and Program Partners . For the three
months ended September 30, 2022 , the Company retained 66.6% of gross earned
premiums for Owned MGAs, compared to 30.7% for Program Partners .
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Consolidated Results of Operations for the Nine Months Ended September 30, 2022
Compared to September 30, 2021 The following table summarizes our results of operations for the nine months
ended
Nine Months Ended September 30, Percentage Change
(in thousands, except for percentages) 2022 2021 Change (1)
Revenues
Gross written premiums$ 477,775 $ 480,905 $ (3,130) (0.7) % Increase in gross unearned premiums (972) (64,836) 63,864 (98.5) % Gross earned premiums 476,803 416,069 60,734 14.6 % Ceded earned premiums (275,235) (275,037) (198) 0.1 % Net earned premiums 201,568 141,032 60,536 42.9 % Net investment income 5,136 6,562 (1,426) (21.7) % Net realized gains 311 72 239 NM Other revenue 7,145 8,683 (1,538) (17.7) % Total revenue 214,160 156,349 57,811 37.0 % Expenses Losses and loss adjustment expenses 125,727 86,735 38,992 45.0 % General and administrative expenses 63,235 40,946 22,289 54.4 % Other expenses 268 845 (577) (68.3) % Intangible asset amortization 4,498 4,326 172 4.0 % Noncash stock compensation 1,019 1,098 (79) (7.2) % Interest expense 1,806 1,271 535 42.1 % Total expenses 196,553 135,221 61,332 45.4 % Gains on embedded derivatives 14,463 1,869 12,594 NM Other income 76 191 (115) (60.2) % Income before taxes 32,146 23,188 8,958 38.6 % Income tax expense 6,741 5,102 1,639 32.1 % Net income $ 25,405$ 18,086 $ 7,319 40.5 %
(1) The Company defines increases or decreases greater than 200% as "NM" or not meaningful.
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Nine Months Ended September 30,
(in thousands, except for percentages) 2022 2021
Key metrics:
Underwriting income(1) $ 12,606 $ 13,351
Adjusted net income(1) $ 19,305 $ 20,103
Loss ratio 62.4 % 61.5 %
Expense ratio 31.4 % 29.0 %
Combined ratio 93.8 % 90.5 %
Return on equity 8.2 % 5.8 %
Adjusted return on equity(1) 6.2 % 6.4 %
Return on tangible equity(1) 17.0 % 12.1 %
Adjusted return on tangible equity(1) 12.9 % 13.4 %
(1) This metric represents a non-GAAP financial measure. See 'Reconciliation of Non-GAAP Financial Measures' for a reconciliation of this metric to the applicable GAAP metric.
The table below shows the total premiums earned on a gross and net basis for the respective nine-month periods:
Nine Months Ended September 30,
(in thousands, except for
percentages) 2022 2021 Change Percentage Change
Revenues
Gross written premiums $ 477,775 $ 480,905 $ (3,130) (0.7) %
Increase in gross unearned premiums (972) (64,836) 63,864 (98.5) %
Gross earned premiums 476,803 416,069 60,734 14.6 %
Ceded earned premiums (275,235) (275,037) (198) 0.1 %
Net earned premiums $ 201,568 $ 141,032 $ 60,536 42.9 %
Gross written premiums: Gross written premiums decreased $3,130 , or 0.7%, to
$477,775 for the nine months ended September 30, 2022 , compared to $480,905 for
the nine months ended September 30, 2021 . The decrease was primarily driven by
the Company's termination of an underwriting partner in a higher-risk segment at
the end of the third quarter of 2021 as the Company focuses on maintaining
underwriting discipline in a highly competitive environment.
Workers' compensation represented 58.3% of our gross written premiums for the
nine months ended September 30, 2022 , compared to 60.2% for the nine months
ended September 30, 2021 . For the nine months ended September 30, 2022 , gross
written premiums for workers' compensation decreased by $11,222 , or 3.9%,
compared to the same period in 2021, reflecting the intentional decrease in
California business that resulted from the Company's measures undertaken to
reduce certain unfavorable risks in 2021 in keeping with our overall strategy to
prioritize underwriting discipline, coupled with a recent highly competitive
market.
All other non-workers' compensation liability represented 41.7% of our gross
written premiums for the nine months ended September 30, 2022 , compared to 39.8%
for the nine months ended September 30, 2021 . For the nine months ended
September 30, 2022 , gross written premiums for all other non-workers'
compensation liability increased $8,092 , or 4.2%, compared to the same period in
2021. The increase is due primarily to growth in our accident & health,
commercial, and commercial auto lines, partially offset by decreases in our
other liability and homeowners lines, which is a result of continued line of
business diversification.
Gross earned premiums: Gross earned premiums increased $60,734 , or 14.6%, to
$476,803 for the nine months ended September 30, 2022 , compared to $416,069 for
the nine months ended September 30, 2021 . The increase in gross earned premiums
reflects the change in the increase in gross unearned premiums of $63,864 ,
slightly offset by a decrease in gross
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written premiums of
Ceded earned premiums: Ceded earned premiums increased$198 , or 0.1%, to$275,235 for the nine months endedSeptember 30, 2022 , compared to$275,037 for the nine months endedSeptember 30, 2021 . The slight increase in ceded earned premiums is primarily driven by the growth in gross earned premiums as described above, mostly offset by an increase in our retention. Ceded earned premiums as a percentage of gross earned premiums decreased to 57.7% for the nine months endedSeptember 30, 2022 , compared to 66.1% for the nine months endedSeptember 30, 2021 , reflecting the Company's strategic decision to retain more gross written premiums. Net earned premiums: Net earned premiums increased$60,536 , or 42.9%, to$201,568 for the nine months endedSeptember 30, 2022 , compared to$141,032 for the nine months endedSeptember 30, 2021 . The increase is primarily due to the growth in gross earned premiums as described above and the Company's strategic decision to retain more gross written premiums. Net investment income: Net investment income decreased$1,426 , or 21.7%, to$5,136 for the nine months endedSeptember 30, 2022 , compared to$6,562 for the nine months endedSeptember 30, 2021 . The decrease reflects unrealized losses of$4,542 on equity securities, partially offset by higher interest and dividend income. During the first quarter of 2022, we purchased high-yield securities, which we believe will improve the yield on our portfolio. Net realized gains: Net realized gains were$311 for the nine months endedSeptember 30, 2022 , compared to net realized gains of$72 for the nine months endedSeptember 30, 2021 . Net realized gains for the nine months endedSeptember 30, 2022 includes earn-out proceeds received of$1,400 related to the Company's sale of TRI in 2021. The net realized gain was offset by our repositioning strategy to sell our lower-yielding assets and purchase higher-yielding investments, prior to anticipated interest rate increases. This turnover in our portfolio resulted in realized losses of$1,022 during the first quarter of 2022. Other revenue: Other revenue decreased$1,538 , or 17.7%, to$7,145 for the nine months endedSeptember 30, 2022 , compared to$8,683 for the nine months endedSeptember 30, 2021 . The decrease is primarily driven by a reduction in brokerage revenue of$818 due to lower placement fees reflecting the Company's increase in retention year over year. In addition, managing general agent fees, third-party administrator fees, consulting and other fee-based revenue were all lower during the period. Losses and loss adjustment expenses: Losses and LAE increased$38,992 , or 45.0%, to$125,727 for the nine months endedSeptember 30, 2022 , compared to$86,735 for the nine months endedSeptember 30, 2021 . The increase is primarily attributable to the growth in earned premiums and increased retention during the nine months endedSeptember 30, 2022 . This resulted in a loss ratio of 62.4% for the nine months endedSeptember 30, 2022 , compared to 61.5% for the nine months endedSeptember 30, 2021 . General and administrative expenses: General and administrative expenses increased$22,289 , or 54.4%, to$63,235 for the nine months endedSeptember 30, 2022 , compared to$40,946 for the nine months endedSeptember 30, 2021 . The expense ratio was 31.4% for the nine months endedSeptember 30, 2022 , compared to 29.0% for the nine months endedSeptember 30, 2021 . 38 -------------------------------------------------------------------------------- Table of Contents The table below shows the components of general and administrative expenses for the respective nine-month periods: Nine Months Ended September 30, 2022 2021 Change Direct commissions$ 85,691 $ 78,304 $ 7,387 Ceding commissions (77,541) (89,547) 12,006 Net commissions 8,150 (11,243) 19,393 Insurance-related expenses 17,698 14,796 2,902 General and administrative operating expenses 37,387 37,393 (6) Total general and administrative expenses$ 63,235
General and administrative expenses - % of gross written premiums 7.8 % 7.8 % Retention rate (1) 42.3 % 33.9 % Direct commission rate (2) 18.0 % 18.8 % Ceding commission rate (3) 28.2 % 32.6 %
(1) Net earned premium as a percentage of gross earned premiums. (2) Direct commissions as a percentage of gross earned premiums. (3) Ceding commissions as a percentage of ceded earned premiums.
Direct commissions increased$7,387 primarily due to an increase in gross earned premiums. Ceding commissions decreased$12,006 primarily due to an increase in retention. Insurance-related expenses increased$2,902 primarily as a result of an increase in gross earned premiums. General and administrative operating expenses decreased$6 . The decrease in general and administrative operating expense reflects an increase in salaries and benefits of$1,295 , which related primarily to a general increase in workforce, and a decrease in professional fees of$806 and depreciation expense of$183 . Other expenses: Other expenses were$268 for the nine months endedSeptember 30, 2022 and primarily relates to management and office transition costs. Other expenses were$845 for the nine months endedSeptember 30, 2021 and primarily relates to secondary offering costs of$555 and executive transition costs totaling$290 . Intangible asset amortization: Intangible asset amortization increased$172 to$4,498 for the nine months endedSeptember 30, 2022 , compared to$4,326 for the nine months endedSeptember 30, 2021 . The increase is primarily driven by the addition of intangible assets acquired in the acquisition of WIC in the third quarter of 2021. Noncash stock compensation: Noncash stock compensation was$1,019 for the nine months endedSeptember 30, 2022 , compared with$1,098 for the nine months endedSeptember 30, 2021 . Expenses incurred during both periods relate to the fair value of restricted stock units and stock options granted under the Company's 2020 Omnibus Plan recognized over the requisite service periods. Gains on embedded derivatives: The table below shows the components of gains (losses) on embedded derivatives for the respective nine-month periods: Nine Months
Ended
2022 2021 Change
Change in fair value of embedded derivatives $ 16,848 $ 3,761 $ 13,087
Effect of net investment income on funds held
investments (2,395) (1,783) (612)
Effect of realized losses (gains) on funds
held investments 10 (109) 119
Total gains on embedded derivatives $ 14,463 $ 1,869 $ 12,594
39-------------------------------------------------------------------------------- Table of Contents Gains on embedded derivatives increased$12,594 to$14,463 for the nine months endedSeptember 30, 2022 , compared to$1,869 for the nine months endedSeptember 30, 2021 . The gain reflected an increase in the fair value of embedded derivatives of$13,087 , the effect of investment income on funds held investments of$612 and the effect of realized losses (gains) on funds held investments of$119 . The increase in fair value of the embedded derivatives resulted primarily from an increase in interest rates between periods, which has reduced the value of the underlying funds held under reinsurance agreements. Income tax expense: Income tax expense was$6,741 for the nine months endedSeptember 30, 2022 , which resulted in an effective tax rate of 21.0%. The effective tax rate equaled the statutory rate of 21% since the impact of state taxes were offset by the impact of tax-exempt municipal income on the Company's investments. For the nine months endedSeptember 30, 2021 , income tax expense was$5,102 , which resulted in an effective tax rate of 22.0%. The increase in the effective tax rate from the statutory rate of 21% is due primarily to the impact of recording our 2020 tax return accrual to return true-up in the third quarter of 2021.
Owned MGAs and Program Partner Premiums:
The following table shows the total premiums earned on a gross and net basis for
Nine Months Ended September 30, 2022
Owned MGAs Program Partner Total
Gross written premiums $ 187,050 $ 290,725 $ 477,775
Increase in gross unearned premiums (1,732) 760 (972)
Gross earned premiums 185,318 291,485 476,803
Ceded earned premiums (67,781) (207,454) (275,235)
Net earned premiums $ 117,537 $ 84,031 $ 201,568
We utilize both quota share and XOL contracts in our reinsurance strategy for
our Owned MGAs and Program Partners . Direct commissions for Program Partners
include third-party agent commissions and MGA service fees, while Owned MGA
direct commissions include only third-party agent commissions. For the nine
months ended September 30, 2022 , the Company retained 63.4% of gross earned
premiums for Owned MGAs compared to 28.8% for Program Partners .
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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 gains or losses, intangible
asset amortization, noncash stock compensation, noncash changes in fair value of
embedded derivatives, interest expense, other revenue, and other 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, other revenue, and other income and
expenses. We use this metric because we believe it gives our management and
other users of our financial information useful insight into our underwriting
business 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 September 30,
(in thousands, except percentages) 2022 2021
Net income $ 7,574 $ 6,518
Income tax expense 2,014 2,083
Income before taxes 9,588 8,601
Other revenue (2,140) (2,799)
(Gains) losses on embedded derivatives (4,871) 121
Net investment income (2,951) (2,187)
Net realized gains (9) (49)
Interest expense 931 419
Intangible asset amortization 1,499 1,499
Noncash stock compensation 460 468
Other income (29) (35)
Underwriting income $ 2,478 $ 6,038
Nine Months Ended September 30,
(in thousands, except percentages) 2022 2021
Net income $ 25,405 $ 18,086
Income tax expense 6,741 5,102
Income before taxes 32,146 23,188
Other revenue (7,145) (8,683)
Gains on embedded derivatives (14,463) (1,869)
Net investment income (5,136) (6,562)
Net realized gains (311) (72)
Other expenses 268 845
Interest expense 1,806 1,271
Intangible asset amortization 4,498 4,326
Noncash stock compensation 1,019 1,098
Other income (76) (191)
Underwriting income $ 12,606 $ 13,351
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Adjusted net income
We define adjusted net income as net income excluding the impact of certain
items, including noncash intangible asset amortization and stock compensation,
noncash changes in fair value of embedded derivatives, other expenses and gains
or losses that we believe do not reflect our core operating performance, which
items may have a disproportionate effect in a given period, affecting
comparability of our results across periods. We calculate the tax impact only on
adjustments that would be included in calculating our income tax expense using
an expected effective tax rate for the 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 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 September 30, Nine Months Ended September 30,
(in thousands, except percentages) 2022 2021 2022 2021
Net income $ 7,574 $ 6,518 $ 25,405 $ 18,086
Intangible asset amortization 1,499 1,499 4,498 4,326
Noncash stock compensation 460 468 1,019 1,098
Change in fair value of embedded derivative (5,812) (573) (16,848) (3,761)
Unrealized losses on equity securities 1,101 - 4,542 -
Realized loss (gain) on sale of investment - 112 (1,400) 112
Other expenses - - 268 845
Total adjustments (2,752) 1,506 (7,921) 2,620
Tax impact of adjustments 633 (346) 1,821 (603)
Adjusted net income $ 5,455 $ 7,678 $ 19,305 $ 20,103
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 stockholders'
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 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 September 30, Nine Months Ended September 30,
(in thousands, except
percentages) 2022 2021 2022 2021
Adjusted return on equity
calculation:
Numerator: adjusted net income $ 5,455 $ 7,678 $ 19,305 $ 20,103
Denominator: average equity 406,587 419,818 412,483 416,200
Adjusted return on equity 5.4 % 7.3 % 6.2 % 6.4 %
Return on equity 7.5 % 6.2 % 8.2 % 5.8 %
Return on tangible equity and adjusted return on tangible equity
We define tangible stockholders' equity as 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 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 stockholders' equity during
the period. We regularly evaluate acquisition opportunities and have
historically made acquisitions that affect stockholders' equity. We use return
on tangible equity and adjusted return on tangible equity as internal
performance measures in the management of our
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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 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 September 30, Nine Months Ended September 30,
(in thousands, except percentages) 2022 2021 2022 2021
Return on tangible equity calculation:
Numerator: net income $ 7,574 $ 6,518 $ 25,405 $ 18,086 Denominator:
Average stockholders' equity 406,587 419,818 412,483 416,200
Less: average goodwill and other intangible
assets 211,713 214,942 213,212 216,356
Average tangible stockholders' equity 194,874 204,876 199,271 199,844
Return on tangible equity 15.5 % 12.7 % 17.0 % 12.1 %
Return on equity 7.5 % 6.2 % 8.2 % 5.8 %
Three Months Ended September 30, Nine Months Ended September 30,
(in thousands, except percentages) 2022 2021 2022 2021
Adjusted return on tangible equity
calculation:
Numerator: adjusted net income $ 5,455 $ 7,678 $ 19,305 $ 20,103
Denominator: average tangible equity 194,874 204,876 199,271 199,844
Adjusted return on tangible equity 11.2 % 15.0 % 12.9 % 13.4 %
Return on equity 7.5 % 6.2 % 8.2 % 5.8 %
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: Benchmark, which is domiciled inKansas and commercially domiciled inCalifornia ; ALIC, which is domiciled inUtah ; 7710, which is domiciled inSouth Carolina ; and BSIC, which is domiciled inArkansas . Accordingly, the holding company may receive cash through: (i) loans from banks; (ii) draws on a revolving loan agreement; (iii) issuance of equity and debt securities; (iv) corporate service fees from our operating subsidiaries; (v) payments from our subsidiaries pursuant to our consolidated tax allocation agreement and other transactions; 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, 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.
UnderKansas andCalifornia law, dividends payable from Benchmark without the prior approval of the applicable insurance commissioner must not exceed the greater of (i) 10% of Benchmark's surplus as shown on the last statutory financial statement on file with theKansas Insurance Department and theCalifornia Department of Insurance , respectively; 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 Benchmark's own securities. 43 -------------------------------------------------------------------------------- Table of Contents UnderUtah law, dividends payable from ALIC without the prior approval of the applicable insurance commissioner must not exceed the lesser of: (i) 10% of ALIC's surplus as shown on the last statutory financial statement on file with theUtah 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 ALIC's own securities. UnderSouth 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: (i) when paid from other than earned surplus must not exceed the lesser of: (a) 10% of 7710's surplus as regards policyholders as shown in 7710's most recent annual statement; or (b) the net income, not including net realized gains or losses as shown in 7710's most recent annual statement; or (ii) when paid from earned surplus must not exceed the greater of: (a) 10% of 7710's surplus as regards policyholders as shown in 7710Insurance Company's most recent annual statement; or (b) 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. UnderArkansas 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 theArkansas 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 2022 without regulatory approval is approximately$17,000 based on our wholly-owned insurance subsidiaries' latest filed annual statements. 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 by state law to maintain a minimum level of policyholders' surplus.Kansas ,Utah ,Arkansas , andSouth Carolina utilize a risk-based capital requirement as promulgated by theNational 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 ofSeptember 30, 2022 andDecember 31, 2021 , the total adjusted capital of our insurance subsidiaries was in excess of their respective prescribed risk-based capital requirements.
As of
Management believes that we have sufficient liquidity available to meet our operating cash needs and obligations and committed capital expenditures for the next twelve 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.
Nine Months
Ended
2022 2021
Cash, cash equivalents and restricted cash provided by
(used in):
Operating activities $ 76,547 $ 53,410
Investing activities (154,742) (71,131)
Financing activities 46,020 (1,125)
Net increase (decrease) in cash, cash equivalents and
restricted cash $ (32,175) $ (18,846)
44-------------------------------------------------------------------------------- Table of Contents Operating Activities: Net cash provided by operating activities for the nine months endedSeptember 30, 2022 was$76,547 , compared to$53,410 for the same period in 2021. Net cash provided by operating activities includes 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 nine months endedSeptember 30, 2022 primarily reflects increased unpaid loss and loss adjustment expenses of$34,431 ; increased funds held under reinsurance agreements of$25,016 ; an increase in accounts payable, accrued expenses and other liabilities of$10,518 ; decreased prepaid reinsurance premiums of$10,022 ; partially offset by increases in premiums and other receivables of$11,520 ; an increase in other assets of$9,040 ; and an increase in reinsurance recoverables of$6,963 . Unpaid loss and loss adjustment expenses increased primarily due to growth in gross earned premiums and an increase in our retention. The decrease in prepaid reinsurance premiums was the result of increased retention. Funds held under reinsurance agreements increased due to a reduction in the derivatives. The increases in premiums and other receivables and reinsurance recoverables were primarily a result of steady gross written premiums during the period and the timing of payments. The increase in accounts payable, accrued expenses and other liabilities is primarily due to an increase in funds held by our reinsurance brokerage services division for insurance contracts not yet executed. Other assets increased primarily as a result of increases in our deferred policy acquisition costs, prepaid software, and brokerage contract asset balances. Net cash provided by operating activities for the nine months endedSeptember 30, 2021 reflects increases in unpaid loss and loss adjustment expenses of$52,975 ; unearned premiums of$64,879 ; and funds held under reinsurance agreements of$19,585 ; partially offset by increases in premiums and other receivables of$25,167 ; reinsurance recoverables of$18,460 ; prepaid reinsurance premiums of$30,252 ; other assets of$10,863 and decreases in reinsurance premiums payable of$7,829 ; and accounts payable, accrued expenses and other liabilities of$11,430 . 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. Investing Activities: Net cash used in investing activities for the nine months endedSeptember 30, 2022 was$154,742 , compared to net cash used in investing activities of$71,131 for the same period in 2021. Net cash used in investing activities for the nine months endedSeptember 30, 2022 includes$154,403 net cash used in the purchase and sale of investments and$339 in capital expenditures. Net cash used in investing activities for the nine months endedSeptember 30, 2021 includes$67,476 net cash used in the purchase and sale of investments,$3,795 in cash used in the acquisition of a subsidiary, net of cash received,$232 in cash received for the sale of equity method investments and$92 in capital expenditures. Financing Activities: Net cash provided by financing activities for the nine months endedSeptember 30, 2022 was$46,020 , compared to net cash used in financing activities of$1,125 for the same period in 2021. Net cash provided by financing activities for the nine months endedSeptember 30, 2022 primarily includes$48,455 of net cash proceeds received from the issuance of surplus notes, partially offset by principal payment made on the Company's debt of$1,238 , an earn-out payment of$750 related to our 2021 acquisition of WIC, payments for deferred financing costs of$251 and a payment for our interest rate cap of$173 . Net cash used in financing activities for the nine months endedSeptember 30, 2021 primarily includes the principal payments made on the Company's debt. Debt and Credit Agreements Secured Credit Facility OnJuly 16, 2020 , we entered into the Credit Agreement withFirst Horizon Bank , which, among other things, extended our credit facility for a period of five years throughMay 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 . OnMay 6, 2022 , we entered into a First Amendment to the Credit Agreement to, among other things, facilitate the approval of certain internal distributions among the Company and certain of its subsidiaries as part of the Company's overall capital management strategy. 45 -------------------------------------------------------------------------------- Table of Contents OnSeptember 28, 2022 , we entered into a Second Amendment to the Second Amended and Restated Credit Agreement that, among other things, replaces LIBOR as the benchmark rate with Term SOFR (as defined in the Credit Agreement), reduces the applicable margin under the Credit Agreement on Eurodollar loans from 4.50% to 3.50% and on ABR loans from 3.50% to 2.50%, and convert all extant Eurodollar loans under the Credit Agreement to Term SOFR loans. The variable interest rate plus applicable margin was 6.76% and 4.64% as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The outstanding principal balance of the loan is to be repaid in quarterly installments that escalate from approximately$206 to$825 untilMarch 2025 . All equity securities of the subsidiaries of the Company (other thanBenchmark Holding Company and its subsidiaries) have been pledged as collateral. Hedging Arrangement InSeptember 2022 , we entered into the Interest Rate Cap Agreement that became effectiveSeptember 30, 2022 , to hedge cash flows associated with interest rate fluctuations on our secured credit facility, with a termination date ofMay 31, 2024 . The Interest Rate Cap Agreement has a notional amount of$29,700 that effectively converted the outstanding balance of the secured credit facility from variable rate debt to capped variable rate debt, resulting in a change in the applicable interest rate from an interest rate of one-month SOFR plus the applicable margin (as provided by the secured credit facility) to one-month SOFR interest rate, capped at 5.00%, plus the applicable margin. The notional amount of the Interest Rate Cap Agreement decreases quarterly in proportion to the quarterly principal payments on the secured credit facility. The Interest Rate Cap Agreement is designated as a cash flow hedge and the change in fair value is recorded in accumulated other comprehensive income and is subsequently reclassified to interest expense in the period when the hedged forecasted interest payments affect earnings. The Company paid a fixed amount of$173 for the Interest Rate Cap Agreement.
Surplus Notes
OnAugust 24, 2022 , Benchmark issued Surplus Notes which consisted of$50,000 in aggregate principal amount of 6.75% surplus notes due 2042 in a private placement exempt from registration under the Securities Act. In connection with the issuance of the Surplus Notes, Benchmark entered into theFiscal Agency Agreement with The Bank of New York Mellon, as fiscal agent, paying agent, registrar and transfer agent, providing for the terms of the Surplus Notes. The Surplus Notes are unsecured, subordinated debt obligations of the Company and are reflected as debt on our condensed consolidated balance sheets. All payments of principal and interest, which accrues at the rate of 6.75% per year and is payable quarterly, on the Surplus Notes are subject to prior approval by the Commissioner of theKansas Insurance Department .
We recorded
Reinsurance
We cede a portion of the risk we accept on our balance sheet to third-party reinsurers through a variety of reinsurance arrangements. We manage these arrangements to align risks with ourProgram Partners , optimize our net retention relative to our financial objectives, balance sheet size and 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 XOL reinsurance as tools in our overall risk management strategy to achieve these goals, usually in conjunction with each other. Quota share reinsurance involves the proportional sharing of premiums and losses of each defined program. We utilize quota share reinsurance for several purposes, including (i) to cede risk toProgram Partners , which allows us to share economics and align incentives, and (ii) to cede risk to third-party reinsurers in order to manage our net written premiums appropriately based on our financial objectives, capital base,A.M. Best financial strength rating, and risk appetite. It is a core pillar of our underwriting philosophy thatProgram Partners retain a portion of the underwriting risk of their program. We believe this best aligns interests, attracts higher quality programs, and leads to better underwriting results. Under XOL reinsurance, losses in excess of a retention level are paid by the reinsurer, subject to a limit, and are customized per program or across multiple programs. We utilize XOL reinsurance to protect against catastrophic or other unforeseen extreme loss activity that could otherwise negatively impact our profitability and capital base. The majority of our exposure to catastrophe risk stems from the workers' compensation premium we 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. We believe we mitigate this risk by our focus on small- to mid-sized accounts, which means that we generally do not have concentrated employee counts at single locations that could be exposed to a catastrophic loss. The costs and limits of the reinsurance coverage we purchase vary from year to year based on the availability of quality reinsurance at an acceptable price and our desired level of retention. 46
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Ratings
We have a financial strength rating of "A" (Excellent) fromA.M. Best .A.M. Best assigns 16 ratings to insurance companies, which currently range from "A++" (Superior) to "S" (Rating Suspended). "A" (Excellent) is the third highest rating issued byA.M. Best . The "A" (Excellent) rating is assigned to insurers that have, inA.M. Best'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 - Risks related to our business and industry - A downgrade in theA.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 byA.M. Best have an impact on the ability of insurance companies to attract and retain agents and brokers and on the risk profiles of the submissions for insurance that insurance companies receive. The "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
There have been no material changes in the Company's contractual obligations as
of
Financial condition
Stockholders' Equity
As of
We had
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$530,118 atSeptember 30, 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 insurance regulatory requirements with respect to investments under the applicable insurance laws;
•maintain an appropriate level of liquidity to satisfy the cash requirements of current operations and long-term obligations;
•adjust investment risk to offset or complement insurance risk based on our total corporate risk tolerance; and
•realize the highest possible levels of investment income and after-tax total rates of return.
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The composition of our investment portfolio is shown in the following table as
of September 30, 2022 and December 31, 2021 .
September 30, 2022
Cost or
Amortized Cost Fair Value
Fixed maturities:
U.S. government and government securities $ 59,974 $ 56,899
Foreign governments 400 392
States, territories and possessions 16,088 14,380
Political subdivisions of states, territories and
possessions 38,614 33,863
Special revenue and special assessment obligations 116,311 103,318
Industrial and public utilities 125,572 118,252
Commercial mortgage-backed securities 141,552 123,478
Residential mortgage-backed securities 25,769 24,171
Other loan-backed securities 51,857 50,339
Hybrid securities 5,798 5,026
Total fixed maturities 581,935 530,118
Equity securities 39,838 35,296
Total investments $ 621,773 $ 565,414
December 31, 2021
Cost or
Amortized Cost Fair Value
Fixed maturities:
U.S. government and government securities $ 41,490 $ 41,434
Foreign governments 2,500 2,490
States, territories and possessions 10,593 10,766
Political subdivisions of states, territories and
possessions 39,170 40,002
Special revenue and special assessment obligations 93,664 95,991
Industrial and public utilities 100,774 103,257
Commercial mortgage-backed securities 119,378 118,218
Residential mortgage-backed securities 16,549 17,368
Other loan-backed securities 41,236 41,425
Hybrid securities 105 110
Total fixed maturities 465,459 471,061
Equity securities 984 969
Total investments $ 466,443 $ 472,030
The following table shows the percentage of the total estimated fair value of
our fixed maturity securities as of September 30, 2022 and December 31, 2021 by
credit rating category, using the lower of ratings assigned by Moody's Investor
Service or S&P.
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September 30, 2022
(in thousands, except percentages) Fair Value % of Total
AAA $ 104,952 19.8 %
AA 298,615 56.3 %
A 93,376 17.6 %
BBB 29,651 5.6 %
BB 3,501 0.7 %
Below investment grade 23 0.0 %
Total fixed maturities $ 530,118 100.0 %
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 %
Critical Accounting Policies and Estimates
The unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q include amounts based on the use of estimates and judgments of management. We identified the accounting estimates that 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 consolidated 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 consolidated 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 consolidated financial statements include: (i) reserves for unpaid loss and LAE; (ii) reinsurance recoveries; (iii) investment fair value measurements; (iv) goodwill and intangible assets; and (v) business combinations. For a detailed discussion of our accounting policies, see the "Notes to the Consolidated and Combined Financial Statements" included in our 2021 Form 10-K. We test for goodwill impairment at the reporting unit level during the fourth quarter of each year and between annual tests if a triggering event indicates the possibility of an impairment. We monitor changing business conditions as well as industry and economic factors, among others, for events which could trigger the need for an interim impairment analysis. The declining share price our stock has caused the market capitalization to fall below the book value as ofSeptember 30, 2022 . As a result of the decrease in share price, we performed an interim impairment analysis atSeptember 30, 2022 and concluded that no impairment relating to goodwill existed as ofSeptember 30, 2022 . 49
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