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AFSI > SEC Filings for AFSI > Form 10-Q on 11-Aug-2014All Recent SEC Filings

Show all filings for AMTRUST FINANCIAL SERVICES, INC.

Form 10-Q for AMTRUST FINANCIAL SERVICES, INC.


11-Aug-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q.

Note on Forward-Looking Statements

This Form 10-Q contains certain forward-looking statements that are intended to be covered by the safe harbors created by The Private Securities Litigation Reform Act of 1995. When we use words such as "anticipate," "intend," "plan," "believe," "estimate," "expect," or similar expressions, we do so to identify forward-looking statements. Examples of forward-looking statements include the plans and objectives of management for future operations, including those relating to future growth of our business activities and availability of funds, and are based on current expectations that involve assumptions that are difficult or impossible to predict accurately, many of which are beyond our control. There can be no assurance that actual developments will be those anticipated by us. Actual results may differ materially from those expressed or implied in these statements as a result of significant risks and uncertainties, including, but not limited to, non-receipt of expected payments from insureds or reinsurers, changes in interest rates, a downgrade in the financial strength ratings of our insurance subsidiaries, the effect of the performance of financial markets on our investment portfolio, our estimates of the fair value of our life settlement contracts, development of claims and the effect on loss reserves, accuracy in projecting loss reserves, the cost and availability of reinsurance coverage, the effects of emerging claim and coverage issues, changes in the demand for our products, our degree of success in integrating acquired businesses, the effect of general economic conditions, state and federal legislation, regulations and regulatory


investigations into industry practices, risks associated with conducting business outside the United States, developments relating to existing agreements, disruptions to our business relationships with Maiden Holdings, Ltd., National General Holding Corp., ACP Re, Ltd., or third party agencies and warranty administrators, difficulties with technology or breaches in data security, heightened competition, changes in pricing environments, and changes in asset valuations. Additional information about these risks and uncertainties, as well as others that may cause actual results to differ materially from those projected, is contained in our filings with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2013, and our quarterly reports on Form 10-Q. The projections and statements in this report speak only as of the date of this report and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.

Overview

We are a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. We provide insurance coverage for small businesses and products with high volumes of insureds and loss profiles that we believe are predictable. We target lines of insurance that we believe generally are underserved by the market. We have grown by hiring teams of underwriters with expertise in our specialty lines, through acquisitions of companies and assets that, in each case, provide access to distribution networks and renewal rights to established books of specialty insurance business. We have operations in three business segments:

         Small Commercial Business. We provide workers' compensation, commercial
          package and other commercial insurance lines produced by wholesale
          agents, retail agents and brokers in the United States.


         Specialty Risk and Extended Warranty. We provide coverage for consumer
          and commercial goods and custom designed coverages, such as accidental
          damage plans and payment protection plans offered in connection with
          the sale of consumer and commercial goods, in the United States and
          Europe, and certain niche property, casualty and specialty liability
          risks in the United States and Europe, including general liability,
          employers' liability and professional and medical liability.


         Specialty Program. We write commercial insurance for narrowly defined
          classes of insureds, requiring an in-depth knowledge of the insured's
          industry segment, through general and other wholesale agents.

Our Personal Lines Reinsurance business is currently in run-off. On August 1, 2013, we received notice that our participation in a quota share arrangement for this business was terminated. As we retained all assumed written premium through July 31, 2013 and the continuing cash flows associated with the business, we are not presenting the Personal Lines Reinsurance segment as a discontinued operation in accordance with ASC 205-20 Discontinued Operations.

We transact business primarily through our fourteen insurance subsidiaries domiciled in the United States and four insurance subsidiaries domiciled in Europe. We are authorized to write business in all 50 states in the United States and in the European Union. Our principal operating subsidiaries are rated "A"(Excellent) by A.M. Best Company ("A.M. Best").

For the six months ended June 30, 2014, our results of operations include activity for the following entities that were acquired subsequent to the six months ended June 30, 2013:

         Insco Insurance Services, Inc. and its subsidiaries, collectively known
          as "Insco Dico"


         AmTrust Lloyd's Holdings Limited and its wholly owned subsidiaries,
          including AmTrust at Lloyd's Limited, collectively known as "AmTrust
          Lloyd's", which was called Sagicor Europe Limited at acquisition


         Sequoia Insurance Company, Sequoia Indemnity Company and Personal
          Express Insurance Company, collectively known as "Sequoia"


         Mutual Insurance Holding Company and First Nonprofit Insurance Company
          and subsidiaries, collectively known as "FNIC"


         AMTCS Holdings, Inc. and subsidiaries, collectively known as "AMTCS",
          which was called CPPNA Holdings, Inc. at acquisition

In January 2014, we entered into a cut-through quota share reinsurance agreement (the "Cut Through Reinsurance Agreement")with Tower Group International, Ltd. ("Tower") to reinsure at least 60% of Tower's in force commercial lines policies and most new and renewal commercial lines business. At the inception of the Cut Through Reinsurance Agreement, we initially assumed $174 million of unearned premium. During the three and six months ended June 30, 2014, we assumed an additional $139 million and $233 million of premium, respectively. During the three months ended June 30, 2014, we had earned premium of approximately $104 million and incurred $50 million of loss and loss adjustment expense related to the Cut Through Reinsurance Agreement. Additionally, we incurred approximately $35 million of commission expense and $4 million of unallocated claims expense as part of the agreement during the three months ended June 30, 2014. During the six months ended June 30, 2014, we had earned premium


of approximately $196 million and incurred $109 million of loss and loss adjustment expense related to the Cut Through Reinsurance Agreement. Additionally, we incurred approximately $94 million of commission expense and $8 million of unallocated claims expense during the six months ended June 30, 2014.

Insurance, particularly workers' compensation, is generally affected by seasonality. The first quarter generally produces greater premiums than subsequent quarters. Nevertheless, the impact of seasonality on our Small Commercial Business and Specialty Program segments has not been significant. We believe that this is because we serve many small businesses in different geographic locations. In addition, we believe seasonality is muted by our acquisition activity.

We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our net income, return on average equity, and our loss, expense and combined ratios. The following summary provides further explanation of the key measures that we use to evaluate our results:

Gross Written Premium. Gross written premium represents estimated premiums from each insurance policy that we write, including as a servicing carrier for assigned risk plans, during a reporting period based on the effective date of the individual policy. Certain policies that we underwrite are subject to premium audit at that policy's cancellation or expiration. The final actual gross premiums written may vary from the original estimate based on changes to the final rating parameters or classifications of the policy.

Net Written Premium. Net written premium is gross written premium less that portion of premium that we ceded to third party reinsurers under reinsurance agreements. The amount ceded under these reinsurance agreements is based on the contractual formula contained in the individual reinsurance agreements.

Net Earned Premium. Net earned premium is the earned portion of our net written premiums. We earn insurance premiums on a pro-rata basis over the term of the policy. At the end of each reporting period, premiums written that are not earned are classified as unearned premiums, which are earned in subsequent periods over the remaining term of the policy. Our workers' compensation insurance and commercial package policies typically have a term of one year. Thus, for a one-year policy written on July 1, 2014 for an employer with a constant payroll during the term of the policy, we would earn half of the premiums in 2014 and the other half in 2015. We earn our specialty risk and extended warranty coverages over the estimated exposure time period. The terms vary depending on the risk and have an average duration of approximately 24 months, but range in duration from one month to 120 months.

Service and Fee Income. We currently generate service and fee income from the following sources:

         Product warranty registration and service - Our Specialty Risk and
          Extended Warranty business generates fee revenue for product warranty
          registration and claims handling services provided to unaffiliated
          third parties.


         Servicing carrier - We act as a servicing carrier for workers'
          compensation assigned risk plans in nine states. In addition, we also
          offer claims adjusting and loss control services for fees to
          unaffiliated third parties.


         Management services - We provide services to insurance consumers,
          traditional insurers and insurance producers by offering flexible and
          cost effective alternatives to traditional insurance tools in the form
          of various risk retention groups and captive management companies, as
          well as management of workers' compensation and commercial property
          programs. We also offer programs and alternative funding options for
          non-profit and public sector organizations for the management of their
          state unemployment insurance obligations.


         Installment, reinstatement and policy fees - We recognize fee income
          associated with the issuance of workers' compensation policies for
          installment fees, in jurisdictions where it is permitted and approved,
          and reinstatement fees, which are fees charged to reinstate a policy
          after it has been canceled for non-payment, in jurisdictions where it
          is permitted and approved. Additionally, we recognize policy fees
          associated with general liability policies placed by our subsidiary,
          Builders & Tradesmen's Insurance Services, Inc.


         Broker services - We provide brokerage services to Maiden in connection
          with our reinsurance agreement for which we receive a fee.


         Asset management services - We currently manage the investment
          portfolios of Maiden Holdings, Ltd. ("Maiden"), National General
          Holdings Corp ("NGHC") and ACP Re, Ltd. ("ACP Re") for which we receive
          a management fee.


         Information technology services - We provide information technology and
          printing and mailing services to NGHC and its affiliates for a fee.


Net Investment Income and Realized Gains and (Losses). We invest our statutory surplus funds and the funds supporting our insurance liabilities primarily in cash and cash equivalents, fixed maturity and equity securities. Our net investment income includes interest and dividends earned on our invested assets. We report net realized gains and losses on our investments separately from our net investment income. Net realized gains occur when we sell our investment securities for more than their costs or amortized costs, as applicable. Net realized losses occur when we sell our investment securities for less than their costs or amortized costs, as applicable, or we write down the investment securities as a result of other-than-temporary impairment. We classify equity securities and our fixed maturity securities as available-for-sale. We report net unrealized gains (losses) on those securities classified as available-for-sale separately within accumulated other comprehensive income on our balance sheet.

Loss and Loss Adjustment Expenses Incurred. Loss and loss adjustment expenses ("LAE") incurred represent our largest expense item and, for any given reporting period, include estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing claims. These expenses fluctuate based on the amount and types of risks we insure. We record loss and loss adjustment expenses related to estimates of future claim payments based on case-by-case valuations and statistical analysis. We seek to establish all reserves at the most likely ultimate exposure based on our historical claims experience. It is typical for our more serious bodily injury claims to take several years to settle and we revise our estimates as we receive additional information about the condition of injured employees and claimants and the costs of their medical treatment. Our ability to estimate loss and loss adjustment expenses accurately at the time of pricing our insurance policies is a critical factor in our profitability.

Acquisition Costs and Other Underwriting Expenses. Acquisition costs and other underwriting expenses consist of policy acquisition expenses, salaries and benefits and general and administrative expenses, net of ceding commissions. These items are described below:

         Policy acquisition expenses comprise commissions directly attributable
          to those agents, wholesalers or brokers that produce premiums written
          on our behalf. In most instances, we pay commissions based on collected
          premium, which reduces our credit risk exposure associated with
          producers in case a policyholder does not pay a premium. We pay state
          and local taxes, licenses and fees, assessments and contributions to
          various state guaranty funds based on our premiums or losses in each
          state. Surcharges that we may be required to charge and collect from
          insureds in certain jurisdictions are recorded as accrued liabilities,
          rather than expense. These expenses are offset by ceding commissions
          received.


         Salaries and benefits expenses are those salaries and benefits expenses
          for employees that are directly involved in the origination, issuance
          and maintenance of policies, claims adjustment and accounting for
          insurance transactions. We classify salaries and benefits associated
          with employees that are involved in fee generating activities as other
          expenses.


         General and administrative expenses are comprised of other costs
          associated with our insurance activities, such as federal excise tax,
          postage, telephones and internet access charges, as well as legal and
          auditing fees and board and bureau charges. They also include the
          amortization of intangible assets.


         Ceding commission on reinsurance transactions is a commission we
          receive from ceding gross written premium to third party reinsurers. In
          connection with the Maiden Quota Share, which is our primary source of
          ceding commissions, the amount we receive is a blended rate based on a
          contractual formula contained in the individual reinsurance agreements,
          and the rate may not correlate specifically to the cost structure of
          the individual segments. The ceding commissions the Company receives
          cover a portion of its capitalized direct acquisition costs and a
          portion of other underwriting expenses. Ceding commissions received
          from reinsurance transactions that represent recovery of capitalized
          direct acquisition costs are recorded as a reduction of capitalized
          unamortized deferred acquisition costs and the net amount is charged to
          expense in proportion to net premium revenue recognized. Ceding
          commissions received from reinsurance transactions that represent the
          recovery of other underwriting expenses are recognized in the income
          statement over the insurance contract period in proportion to the
          insurance protection provided and classified as a reduction of
          acquisition costs and other underwriting expenses. Ceding commissions
          received, but not yet earned, that represent the recovery of other
          underwriting expenses are classified as a component of accrued expenses
          and other current liabilities. We allocate earned ceding commissions to
          its segments based on each segment's proportionate share of total
          acquisition costs and other underwriting expenses recognized during the
          period. Ceding commission is netted against acquisition costs and other
          underwriting expenses.

Gain (loss) on Investment in Life Settlement Contracts. The gain (loss) on investment in life settlement contracts includes the gain on acquisition of life settlement contracts, the gain realized upon a mortality event and the change in fair value of the investments in life settlements as evaluated at the end of each reporting period. We determine fair value based upon our estimate of the discounted cash flow related to policies (net of reserves for improvements in mortality, the possibility that the high net worth


individuals represented in our portfolio may have access to better health care, the volatility inherent in determining the life expectancy of insureds with significant reported health impairments, the possibility that the issuer of the policy or a third party will contest the payment of the death benefit payable to us and the future expenses related to the administration of the portfolio), which incorporates current life expectancy assumptions, premium payments, credit exposure to the insurance companies that issued the life insurance policies and the rate of return that a buyer would require on the policies as no comparable market pricing is available. The gain (loss) realized upon a mortality event is the difference between the death benefit received and the recorded fair value of that particular policy. We allocate gain (loss) on investment in life settlement contracts to our segments based on gross written premium by segment.

Net Loss Ratio. The net loss ratio is a measure of the underwriting profitability of an insurance company's business. Expressed as a percentage, this is the ratio of net losses and LAE incurred to net premiums earned.

Net Expense Ratio. The net expense ratio is a measure of an insurance company's operational efficiency in administering its business. Expressed as a percentage, this is the ratio of the sum of acquisition costs and other underwriting expenses less ceding commission to net premiums earned. As we allocate certain acquisition costs and other underwriting expenses based on premium volume to our segments, net loss ratio on a segment basis may be impacted period over period by a shift in each segment's proportionate share of net written premium.

Net Combined Ratio. The net combined ratio is a measure of an insurance company's overall underwriting profit. This is the sum of the net loss and net expense ratios. If the net combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient.

Net Premiums Earned less Expenses Included in Combined Ratio (Underwriting Income). Underwriting income is a measure of an insurance company's overall operating profitability before items such as investment income, interest expense and income taxes.

Return on Equity. We calculate return on equity by dividing net income by the average of shareholders' equity.

One of the key financial measures that we use to evaluate our operating performance is return on average equity. Our return on annualized average equity was 27.8% and 23.9% for the three months ended June 30, 2014 and 2013, respectively, and 28.2% and 26.6% for the six months ended June 30, 2014 and 2013, respectively. In addition, we target a net combined ratio of 95% or lower over the long term, while seeking to maintain optimal operating leverage in our insurance subsidiaries commensurate with our A.M. Best rating objectives. Our net combined ratio was 90.9% and 92.1% for the three months ended June 30, 2014 and 2013, and 90.4% and 91.8% for the six months ended June 30, 2014 and 2013, respectively.

Critical Accounting Policies

Our discussion and analysis of our results of operations, financial condition and liquidity are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the amounts of assets and liabilities, revenues and expenses and disclosure of contingent assets and liabilities as of the date of the financial statements. As more information becomes known, these estimates and assumptions could change, which would have an impact on actual results that may differ materially from these estimates and judgments under different assumptions. Except as discussed below, we have not made any changes in estimates or judgments that have had a significant effect on the reported amounts as previously disclosed in our Annual Report on Form 10-K for the fiscal period ended December 31, 2013.

Ceding Commissions on Reinsurance Transactions - Ceding commissions on reinsurance transactions are commissions we receive from ceding gross written premiums to third party reinsurers. In connection with the Maiden Quota Share, which is our primary source of ceding commissions, the amount we receive is a blended rate based on a contractual formula contained in the individual reinsurance agreements, and the rate may not correlate specifically to the cost structure of the individual segments. The ceding commissions we receive cover a portion of its capitalized direct acquisition costs and a portion of other underwriting expenses. Ceding commissions received from reinsurance transactions that represent recovery of capitalized direct acquisition costs are recorded as a reduction of capitalized unamortized deferred acquisition costs and the net amount is charged to expense in proportion to net premium revenue recognized. Ceding commissions received from reinsurance transactions that represent the recovery of other underwriting expenses are recognized in the income statement over the insurance contract period in proportion to the insurance protection provided and classified as a reduction of acquisition costs and other underwriting expenses. Ceding commissions received, but not yet earned, that represent the recovery of other underwriting expenses are classified as a component of accrued expenses and other current liabilities. We allocate earned ceding commissions to its segments based on each segment's proportionate share of total acquisition costs and other underwriting expenses recognized during the period.


Results of Operations

Consolidated Results of Operations for the Three and Six Months Ended June 30,
2014 and 2013 (Unaudited)
                                        Three Months Ended June 30,         Six Months Ended June 30,
(Amounts in Thousands)                     2014              2013             2014             2013
Gross written premium                $    1,443,640      $ 1,040,614     $   3,109,836     $ 1,984,536

Net written premium                  $      923,670      $   639,997     $   2,053,951     $ 1,172,103
Change in unearned premium                  (48,733 )       (103,458 )        (349,963 )      (227,570 )
Net earned premium                          874,937          536,539         1,703,988         944,533
Service and fee income (related
parties - three months $15,118;
$14,414 and six months $27,318;
$24,921)                                     99,542           88,102           190,500         148,615
Net investment income                        32,594           22,634            61,121          40,729
Net realized gain on investments              3,906            2,067             9,345          19,351
Total revenues                            1,010,979          649,342         1,964,954       1,153,228
Loss and loss adjustment expense            587,233          364,110         1,145,803         636,366
Acquisition costs and other
underwriting expenses                       208,060          129,946           394,669         230,231
Other                                        87,588           80,985           175,179         133,137
Total expenses                              882,881          575,041         1,715,651         999,734
Income before other income
(expense), income taxes and equity
in earnings of unconsolidated
subsidiaries                                128,098           74,301           249,303         153,494
Other income (expense):
Interest expense                            (12,587 )         (7,608 )         (24,084 )       (14,969 )
Net gain (loss) on investment in
life settlement contracts net of
profit commission                            (5,070 )          1,080            (2,270 )             4
Foreign currency gain (loss)                  1,084              783              (768 )         2,055
Acquisition gain on purchase                      -           23,183                 -          48,715
Gain on sale                                  6,631                -             6,631               -
Total other income (expense)                 (9,942 )         17,438           (20,491 )        35,805
Income before income taxes and
equity in earnings (loss) of
unconsolidated subsidiaries                 118,156           91,739           228,812         189,299
Provision for income taxes                   17,966           27,402            45,410          43,511
Income before equity in earnings
. . .
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