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FRF > SEC Filings for FRF > Form 10-Q on 14-Nov-2012All Recent SEC Filings

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Form 10-Q for FORTEGRA FINANCIAL CORP


14-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") represents an overview of our results of operations and financial condition and should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in Part I, Item 1 of this Form 10-Q. Except for the historical information contained herein, the discussions in MD&A contain forward-looking statements that involve risks and uncertainties. Our future results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Item 1A. Risk Factors" of this Form 10-Q.

Executive Summary
Our net income for the three months ended September 30, 2012 and 2011 was $4.1 million, respectively, with the 2012 results including $1.0 million attributable to the change is accounting estimate and three months of results from our October 2011 acquisition of PBG, while 2011 included the loss on CIRG and a higher level of realized gains on the sale of investments. Earnings per diluted share increased 5.3% to $0.20 for the three months ended September 30, 2012 from $0.19 for the same period in 2011, and included a $0.05 per diluted share increase from the change in accounting estimate.

For the three months ended September 30, 2012, our overall revenues increased $7.8 million, or 13.8%, to $64.3 million from $56.5 million for the same period in 2011, and included a $4.0 million increase in revenues attributable to the change in accounting estimate. This increase was also due to higher net earned premiums, ceding commissions, and service and administrative fees, which was partially offset by lower realized investments (losses) gains and brokerage commission.

Total expenses increased $7.5 million, or 15.1%, to $57.7 million for the three months ended September 30, 2012 from $50.1 million for the same period in 2011, and include a $2.5 million increase in expenses attributable to the change in accounting estimate. The majority of the increase, which includes the results of the PBG acquisition, was due to increases in commissions of $3.6 million, of which $2.7 million was from the change in accounting estimate, personnel costs of $1.8 million and net losses and loss adjustment expenses of $1.7 million. As a result of our entry into the new $125.0 million credit facility with Wells Fargo Bank, N.A. in August 2012, we wrote off $0.7 million of previously capitalized transaction costs, which are included in interest expense, associated with the termination of the SunTrust Bank, N.A. revolving credit facility during the three months ended September 30, 2012. This new credit facility will give us additional liquidity to further expand our existing businesses and explore future avenues of growth.

Our net income for the nine months ended September 30, 2012 increased $2.6 million, or 28.3%, to $11.6 million from $9.0 million for the same period in 2011, with the 2012 results including $1.0 million attributable to the change is accounting estimate, and nine months of results from our October 2011 acquisition of PBG, while 2011 includes six months of results from our July 1, 2011 divestiture of CIRG and the related loss on the sale of that subsidiary as well as a higher level of realized gains on the sale of investments. Earnings per diluted share increased 33.3% to $0.56 for the nine months ended September 30, 2012 from $0.42 for the same period in 2011 and included a $0.05 per diluted share increase from the change in accounting estimate.


For the nine months ended September 30, 2012, our overall revenues increased $16.6 million, or 10.1%, to $181.6 million from $165.0 million for the same period in 2011, and include a $4.0 million increase in revenues attributable to the change in accounting estimate. This increase was also due to increased net earned premiums, ceding commissions and brokerage commissions, which was partially offset by lower net realized investment (losses) gains and net investment income.

Total expenses increased $12.2 million, or 8.1%, to $163.5 million for the nine months ended September 30, 2012 from $151.3 million for the same period in 2011. The majority of the increase was due to increases in commissions of $7.7 million, of which $2.7 million was from the change in accounting estimate, net losses and loss adjustment expenses of $3.9 million, and personnel costs of $3.1 million. Partially offsetting this increase was a reduction of $2.1 million in other operating expenses due to higher acquisition related charges and the loss on the sale of CIRG impacting 2011. Additionally, interest expense decreased $0.6 million due to lower borrowing costs and the effect of the swap, which was partially offset by the $0.7 million charge for previously capitalized transaction costs on the SunTrust Bank, N.A. revolving credit facility.

Critical Accounting Policies
Fortegra's critical accounting policies involving significant judgments and assumptions used in the preparation of the Consolidated Financial Statements as of September 30, 2012 are unchanged from the disclosures presented in the MD&A of Fortegra's 2011 Annual Report except as discussed below:

Change in Accounting Estimate - Unearned Premium Reserves for the Payment Protection Segment
During the period ended September 30, 2012, we reviewed our unearned premium reserves in relation to the loss patterns and the related recognition of income and based on our analysis determined that a change to the Rule of 78s method results in a more accurate estimate of net earned premium reserves. The change is being accounted for as a change in accounting estimate and was applied prospectively. See the Note, "Summary of Significant Accounting Policies" of the Notes to the Consolidated Financial Statements of this Form 10-Q for the effect of this change in accounting estimate.

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts On January 1, 2012, we adopted the new guidance for Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This guidance was adopted on a retrospective basis and has been applied to all prior period financial information contained in our Consolidated Financial Statements. See the Note, "Recent Accounting Standards" of the Notes to the Consolidated Financial Statements of this Form 10-Q for the effect of the retrospective application.

Recently Issued Accounting Standards
For a discussion of recently issued accounting standards see the Note "Recent Accounting Standards" of the Notes to the Consolidated Financial Statements of this Form 10-Q.

COMPONENTS OF REVENUES AND EXPENSES

REVENUES
Service and Administrative Fees. We earn service and administrative fees from our Payment Protection and BPO business segments. Such fees are typically positively correlated with transaction volume and are recognized as revenue as they become both realized and earned. We earn service and administrative fees from a variety of activities, including the administration of credit insurance, the administration of debt cancellation programs, the administration of motor club programs, the administration of warranty programs and the administration of collateral tracking and asset recovery programs.

Payment Protection. Our Payment Protection products are sold as complementary products to consumer retail and credit transactions and are thus subject to the volatility of volume of consumer purchase and credit activities. We receive service and administrative fees for administering Payment Protection products that are sold by our clients, such as credit insurance, debt protection, motor club and warranty solutions. We earn administrative fees for administering debt cancellation plans, facilitating the distribution and administration of warranty or extended service contracts, providing motor club membership benefits and providing related services for our clients. For credit insurance products, our clients typically retain the risk associated with credit insurance products that they sell to their customers through economic arrangements with us. Our Payment Protection revenue includes revenue earned from reinsurance arrangements with producer owned reinsurance companies owned by our clients. Our clients own producer owned reinsurance companies ("PORCs") that assume the credit insurance premiums and associated risk that they originate in exchange for fees paid to us for ceding the premiums. In addition, our Payment Protection revenue includes administrative fees charged by us under retrospective commission arrangements with producers, where the commissions paid are adjusted based on actual losses incurred compared to premium earned after a specified net allowance retained by us. Under these arrangements, our insurance companies receive the insurance premiums and administer the policies that are distributed by our clients. The producer of the credit insurance policies receives a retrospective commission if the premium generated by that producer in the accounting period exceeds the costs associated


with those polices, which includes our administrative fees, incurred claims, reserves and premium taxes. If the net result is negative, we either offset that negative amount against future retrospective commission payments, reduce the producer's up-front commission on a prospective basis to increase the likelihood that it will return to a positive position or request payment of the negative amount from the producer. Revenues in our Payment Protection business may fluctuate seasonally based on consumer spending trends, where consumer spending has historically been higher in September and December, corresponding to back-to-school and the holiday season. Accordingly, our Payment Protection revenues may reflect higher third and fourth quarters than in the first half of the year.

BPO. Our BPO revenues consist primarily of service and administrative fees for providing a broad set of administrative services tailored to insurance and other financial services companies including ongoing sales and marketing support, premium billing and collections, policy administration, claims adjudication, call center management services and the development of web-hosted applications for the reinsurance market. In addition, our BPO segment markets and sells health, accident, critical illness and life insurance policies to customers in the U.S. Our BPO revenues are based on the volume of business that we manage on behalf of our clients. Our BPO segment typically charges fees on a per-unit of service basis as a percentage of our client's insurance premiums.

Brokerage Commissions and Fees. Brokerage commissions and fees consist of commissions paid to us by insurance companies, net of the portion of the commissions we share with retail insurance brokers and agents. The commissions we receive from insurance carriers are typically calculated as a percentage of the premiums paid for the specialized and complex insurance products (commonly known as "surplus lines") we distribute. We typically earn our commissions on the later of the effective date of the policy or the date coverage is bound. We pay our retail insurance agent and broker clients a portion of the gross commissions we receive from insurance carriers for placing insurance. In certain cases, our Brokerage segment also charges fees for policy issuance, inspections and other types of transactions. Our Brokerage segment also derives fees from master license agreements to use the eReinsure system together with fees for the transactions completed through its platform.

Brokerage commissions and fees are generally affected by fluctuations in the amount of premium charged by insurance carriers. The premiums charged fluctuate based on, among other factors, the amount of capital available in the insurance marketplace, the type of risk being insured, the nature of the insured party and the terms of the insurance purchased. If premiums increase or decrease, our revenues are typically affected in a corresponding fashion. In a declining premium rate environment, the resulting decline in our revenue may be offset, in whole or in part, by an increase in commission rates from insurance carriers and by an increased likelihood that insured parties may use the savings generated by the reduction in premium rates to purchase greater coverage. In an increasing pricing environment, the resulting increase in our revenue may be offset, in whole or in part, by a decrease in commission rates by insurance carriers and by an increased likelihood that insured parties may determine to reduce the amount of coverage they purchase. The market for Property and Casualty ("P&C") insurance products is cyclical from a capacity and pricing perspective. We refer to a period of reduced capacity and rising premium rates as a "hard" market and a period of increased capacity and declining premium rates as a "soft" market.

Gross commission rates for the products that we distribute in our Brokerage segment, whether acting as a wholesale broker or as a Managing General Agent ("MGA"), generally range from 15% to 25% of the annual premium for the policy. Brokerage commissions and fees net of commissions paid to our retail insurance agent and broker clients typically approximate 10%.

Demand for surplus lines insurance products also affects our premium volume and net commissions. State regulations generally require a buyer of insurance to have been turned down by three or more traditional carriers before being eligible to purchase the surplus lines distributed by us. As standard insurance carriers eliminate non-core lines of business and implement more conservative risk selection techniques, demand for excess and surplus lines insurance improves.

We also receive profit commissions for certain arrangements with certain insurance carriers on binding authority business. These profit commissions are based on the profitability of the business that we underwrite or broker on the insurance carrier's behalf. Profit commissions typically range from 0.6% to 1.7% of the annual premium and are paid periodically based on the terms of the individual carrier contract.

Our surplus lines brokerage commission and fee revenues fluctuate seasonally based on policy renewal dates and timing of profit commissions, and have historically been higher in the first two calendar quarters compared to the last two calendar quarters. In addition, our fee revenues at eReinsure are subject to seasonal fluctuations and are generally higher in the second and fourth quarters.

Ceding Commissions. Ceding commission earned under coinsurance agreements are based on contractual formulas that take into account, in part, underwriting performance and investment returns experienced by assuming companies. As experience changes, adjustments to the ceding commissions are reflected in the period incurred. Ceding commissions are only generated by our Payment


Protection segment on credit insurance products.

We elect to cede to reinsurers under coinsurance arrangements a significant portion of the credit insurance that we distribute on behalf of our clients. We continue to provide all policy administration for credit insurance that we cede to reinsurers. Ceding commissions consist of commissions paid to us by our reinsurers to reimburse us for costs related to the acquisition, administration and servicing of policies and premium that we cede to reinsurers. In addition, a portion of the ceding commission is determined based on the underwriting profits of the ceded credit insurance. The credit insurance that we distribute has historically generated attractive underwriting profits. Furthermore, some reinsurers pay to us a portion or all of the investment income earned on reserves that are maintained in trust accounts.

Ceding commissions are generally positively correlated with our credit insurance transaction and premium volumes. The portion of our ceding commissions that is related to the underwriting profits of the ceded credit insurance also fluctuates based on the claims made on such policies. The portion of our ceding commissions that is related to investment income can be impacted by the amount of reserves that are maintained in trust accounts and changes in interest rates. Ceding commissions are earned over the life of the policy.

Net Earned Premium. Net earned premium consists of revenue generated from the direct sale of Payment Protection insurance policies by our distributors or premiums written for Payment Protection insurance policies by another carrier and assumed by us. Whether direct or assumed, the premium is earned over the term of the respective policy. Premiums earned are offset by earned premiums ceded to our reinsurers, including PORCs. The amount ceded is proportional to the amount of risk assumed by the reinsurer.

The principal factors affecting net earned premiums are: (i) the proportion of the risk assumed by our reinsurers as defined in the applicable reinsurance treaty; (ii) increases and decreases in written premium; (iii) increases and decreases in policy cancellation rates; (iv) the average duration of the policies written; and (v) changes in regulation that would modify the earning patterns for the policies underwritten and administered.

We limit the underwriting risk we take in our Payment Protection insurance policies. When we do assume risk in our Payment Protection insurance policies, we utilize both reinsurance (e.g., quota share and excess of loss) and retrospective commission agreements to manage and mitigate our risk.

Net Realized Gains (Losses) on the Sale of Investments. We realize gains when invested assets are sold for an amount greater than the amortized cost in the case of fixed maturity securities and cost basis for equity securities. We recognize realized losses for invested assets sold for an amount less than their carrying cost or when fixed maturity securities or equity securities are written down as a result of an other-than-temporary impairment ("OTTI").

Net Investment Income. We earn net investment income from interest payments and dividends received from our investment portfolio, and interest earned on our cash accounts and notes receivable, less portfolio management expenses. Our investment portfolio is invested primarily in fixed maturity securities which tend to produce consistent levels of investment income. The fair value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair value generally increases or decreases in an inverse relationship with fluctuations in interest rates. Investment income can be significantly impacted by changes in interest rates. Interest rate volatility can increase or reduce unrealized gains or unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the fair value of, fixed maturity and short-term investments.

We also have investments that carry prepayment risk, such as mortgage-backed and asset-backed securities. Actual net investment income and/or cash flows from investments that carry prepayment risk may differ from estimates at the time of investment as a result of interest rate fluctuations. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, commercial mortgage obligations and bonds are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates. Therefore, we may be required to reinvest those funds in lower interest-bearing investments. Conversely, in times of rising interest rates, prepayments slow as borrowers tend to be less likely to refinance borrowings at higher interest rates, which tends to increase the duration of our investment holdings. With the increase in investment duration, we will have less cash flows from prepayments to invest at higher prevailing market rates.

Other Income. Other income consists primarily of miscellaneous fees generated by our Brokerage and Payment Protection segments.

EXPENSES


Net Losses and Loss Adjustment Expenses. Net losses and loss adjustment expenses include actual paid claims and the change in unpaid claim reserves and consist of direct and assumed losses less ceded losses. Our profitability depends in part on accurately predicting net loss and loss adjustment expenses. Incurred claims are impacted by loss frequency, which is the measure of the number of claims per unit of insured exposure, and loss severity, which is based on the average size of claims. Factors affecting loss frequency and loss severity include changes in claims reporting patterns, claims settlement patterns, judicial decisions, legislation, economic conditions, morbidity patterns and the attitudes of claimants towards settlements.

Actual claims paid are claims payments made to the policyholder or beneficiary during the accounting period. The change in unpaid claim reserve is an increase or reduction to the unpaid claim reserve in the accounting period to maintain the unpaid claim reserve at the levels evaluated by our actuaries.

Unpaid claims are reserve estimates that are established in accordance with U.S. GAAP using generally accepted actuarial methods. Credit life and AD&D unpaid claims reserves include claims in the course of settlement and incurred but not reported ("IBNR"). Credit disability unpaid claims reserves also include continuing claim reserves for open disability claims. For all other product lines, unpaid claims reserves are bulk reserves and are entirely IBNR. We use a number of algorithms in establishing our unpaid claims reserves. These algorithms are used to calculate unpaid claims as a function of paid losses, earned premium, target loss ratios, in-force amounts, unearned premium reserves, industry recognized morbidity tables or a combination of these factors.

In arriving at our unpaid claims reserves, we conduct an actuarial analysis on a basis gross of reinsurance. The same estimates used as a basis in calculating the gross unpaid claims reserves are then used as the basis for calculating the net unpaid claims reserves, which take into account the impact of reinsurance. Anticipated future loss development patterns form a key assumption underlying these analyses. Our claims are generally reported and settled quickly, resulting in a consistent historical loss development pattern. From the anticipated loss development patterns, a variety of actuarial loss projection techniques are employed, such as the chain ladder method, the Bornhuetter-Ferguson method and expected loss ratio method.

Our unpaid claims reserves do not represent an exact calculation of exposure, but instead represent our best estimates, generally involving actuarial projections at a given time. The process used in determining our unpaid claims reserves cannot be exact since actual claim costs are dependent upon a number of complex factors such as changes in doctrines of legal liabilities and damage awards. These factors are not directly quantifiable, particularly on a prospective basis. We periodically review and update our methods of making such unpaid claims reserve estimates and establishing the related liabilities based on our actual experience. We have not made any changes to our methodologies for determining unpaid claims reserves in the periods presented.

Commissions. Commissions include the commissions paid to distributors selling credit insurance policies offered by our Payment Protection segment. Commission rates, in many instances, are set by state regulators and are also impacted by market conditions. In certain instances, our commissions are subject to retrospective adjustment based on the profitability of the related policies. These retrospective commission adjustments are payments made or adjustments to future commission expense based on claims experience. Under these retrospective commission arrangements, the producer of the credit insurance policies, which is typically our client, receives a retrospective commission if the premium generated by that producer in the accounting period exceeds the costs associated with those policies, which includes our administrative fees, claims, reserves and premium taxes. If the net result is negative, we either offset that negative amount against future retrospective commission payments, reduce the producer's up-front commission on a prospective basis to increase the likelihood that it will return to a positive position or request payment of the negative amount from the producer.

Personnel Costs. Personnel costs represent the amounts attributable to wages, salaries, bonuses and benefits for our full and part-time employees, as well as expense related to our stock-based compensation. In addition to our general personnel costs, some of the employees in our Brokerage and Payment Protections segments are paid a percentage of revenues they generate. Accordingly, compensation for brokers in our Brokerage segment is predominantly variable. Bonuses for the remaining employees are discretionary and are based on an evaluation of their individual performance and the performance of their particular business segment, as well as our entire company.

Other Operating Expenses. Other operating expenses consist primarily of rent, insurance, investigation fees, transaction expenses, professional fees, technology costs, travel and entertainment and advertising, and may include variable costs based on the volume of business we process. Other operating expenses are a significant portion of our expenses.

Depreciation. Depreciation expense is the allocation of the capitalized cost of property and equipment over the periods benefited by the use of the asset.

Amortization of Intangibles. Amortization of intangibles is an expense recorded to allocate the cost of intangible assets, such as purchased customer accounts and non-compete agreements acquired as part of our business acquisitions, over their estimated


useful lives.

Interest Expense. Interest expense includes interest payable on our credit facilities, mainly our notes payable and preferred trust securities and is directly correlated to the balances outstanding and the prevailing interest rates on these debt instruments.

Income Taxes. Income taxes are comprised of federal and state taxes based on income in multiple jurisdictions and changes in uncertain tax positions, if any.

RESULTS OF OPERATIONS
The following tables set forth our Consolidated Statements of Income:
(in thousands, except shares, per share
amounts and percentages)                                           For the Three Months Ended
                                                                                                          % Change from
                                          September 30, 2012    September 30, 2011     Change from 2011       2011
Revenues:
Service and administrative fees          $           10,056   $             10,125   $           (69 )        (0.7 )%
Brokerage commissions and fees                        8,411                  8,611              (200 )        (2.3 )
Ceding commission                                    11,122                  7,027             4,095          58.3
Net investment income                                   744                    801               (57 )        (7.1 )
Net realized (losses) gains on the sale
of investments                                          (16 )                1,196            (1,212 )      (101.3 )
. . .
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