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EX-23.1 - EX-23.1 - State National Companies, Inc.a14-16967_1ex23d1.htm

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As filed with the Securities and Exchange Commission on October 22, 2014

Registration No. 333-197441

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

AMENDMENT NO. 3

TO

 

FORM S-1

 

REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

 


 

STATE NATIONAL COMPANIES, INC.

(Exact name of registrant as specified in its charter)

 


 

Delaware

 

6331

 

26-0017421

(State or other jurisdiction of
incorporation or organization)

 

(Primary Standard Industrial
Classification Code Number)

 

(I.R.S. Employer
Identification Number)

 

1900 L. Don Dodson Drive
Bedford, Texas 76021

(817) 265-2000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 


 

David M. Cleff
Executive Vice President of Business Affairs,
General Counsel and Secretary
1900 L. Don Dodson Drive
Bedford, Texas 76021

(817) 265-2000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

Copies to:

 

J. Brett Pritchard

Locke Lord LLP

111 South Wacker Drive

Chicago, Illinois 60606

(312) 443-0700

 


 

Approximate date of commencement of proposed sale to the public:  From time to time after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box: x

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

Non-accelerated filer x

 

Smaller reporting company o

 


 

Calculation of Registration Fee

 

 

 

 

 

 

 

 

 

Common Stock, par value $0.001 per share

 

30,728,500

 

$

10.75(1)

 

$

322,686,750

 

$

41,541.74(1)

(1)   The amount of the registration fee consists of (i) $41,354.36, previously paid on July 15, 2014, in respect of 30,578,500 shares based on a proposed maximum offering price of $10.50 per share, which was the price per share of the most recent trade known to us on July 15, 2014, and (ii) $187.37, in respect of an additional 150,000 shares registered hereunder based on a proposed maximum offering price of $10.75 per share, which is the most recent trade known to us as of the date of this filing, which amount was also previously paid on July 15, 2014.

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until this registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 



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The information in this prospectus is not complete and may be changed.  These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective.  Neither we nor the selling shareholders are using this prospectus to offer to sell these securities or to solicit offers to buy these securities in any jurisdiction where the offer or sale of the securities is not permitted.

 

Subject to Completion, Dated October 22, 2014

 

GRAPHIC

 

30,728,500 Shares of Common Stock, $0.001 Par Value Per Share

 

This prospectus relates solely to the resale of up to an aggregate of 30,728,500 shares of our common stock by the selling shareholders identified in this prospectus.  The selling shareholders acquired the shares of common stock offered by this prospectus in a private placement in June 2014 in reliance on exemptions from registration under the Securities Act of 1933, as amended, and pursuant to our 2014 Stock Incentive Plan. We are registering the offer and sale of the shares of common stock to satisfy registration rights we have granted. See “Security Ownership of Certain Beneficial Owners, Management and Selling Shareholders” beginning on page 114 in this prospectus for a description of the selling shareholders.

 

The selling shareholders will receive all proceeds from their sale of shares of our common stock, and therefore we will not receive any of the proceeds from their sale of shares of our common stock. The shares which may be resold by the selling shareholders constituted approximately 69% of our issued and outstanding common stock on October 22, 2014.

 

Prior to the offering pursuant to this prospectus, there has been no public market for our common stock. Our common stock has been approved for listing on the NASDAQ Global Select Market under the symbol “SNC.”

 

Because all of the shares being offered under this prospectus are being offered by the selling shareholders, we cannot currently determine the price or prices at which our shares of common stock may be sold under this prospectus. We are aware that, prior to the date of this prospectus, certain qualified institutional buyers who purchased shares of our common stock in a private offering that closed in June 2014 have traded shares of our common stock through the FBR PlusTM System, which is operated by FBR Capital Markets & Co. (“FBR”), at prices per share ranging from $10.00 to $10.75 during the period from the closing of the private placement to October 1, 2014 (the date of the most recent trade known to us).  Until shares of our common stock are regularly traded or listed on a national securities exchange, we expect that the selling shareholders initially will sell their shares at prices per share between $10.00 and $10.75, if any shares are sold, and thereafter at prevailing market prices or privately negotiated prices. See “Plan of Distribution.”

 

We are an “emerging growth company” under applicable Securities and Exchange Commission rules and will be eligible for reduced public company reporting requirements.  See “Summary—We are an Emerging Growth Company.”

 


 

Investing in our common stock involves risks. You should read the section entitled “Risk Factors” beginning on page 14 for a discussion of certain risk factors that you should consider before investing in our common stock.

 



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Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 


 

The date of this prospectus is            , 2014

 


 


Table of Contents

 

TABLE OF CONTENTS

 

 

 

Page

 

 

 

CERTAIN IMPORTANT INFORMATION

 

ii

 

 

 

SUMMARY

 

1

 

 

 

RISK FACTORS

 

14

 

 

 

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

 

34

 

 

 

USE OF PROCEEDS

 

34

 

 

 

DIVIDEND POLICY

 

35

 

 

 

CAPITALIZATION

 

36

 

 

 

SELECTED FINANCIAL DATA

 

37

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

41

 

 

 

BUSINESS

 

72

 

 

 

REGULATION

 

95

 

 

 

MANAGEMENT

 

103

 

 

 

EXECUTIVE COMPENSATION

 

107

 

 

 

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND SELLING SHAREHOLDERS

 

114

 

 

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

120

 

 

 

DESCRIPTION OF CAPITAL STOCK

 

122

 

 

 

CERTAIN U.S. FEDERAL INCOME TAX CONSIDERATIONS FOR NON-U.S. HOLDERS

 

129

 

 

 

SHARES AVAILABLE FOR FUTURE SALE

 

133

 

 

 

PLAN OF DISTRIBUTION

 

136

 

 

 

LEGAL MATTERS

 

139

 

 

 

EXPERTS

 

139

 

 

 

ADDITIONAL INFORMATION

 

139

 

 

 

INDEX TO FINANCIAL STATEMENTS

 

F-1

 

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CERTAIN IMPORTANT INFORMATION

 

This Prospectus

 

You should rely only on the information contained in this prospectus.  We have not authorized any other person to provide you with information that is different from that contained in this prospectus.  If anyone provides you with different or inconsistent information, you should not rely on it.  The selling shareholders are offering to sell and seeking offers to buy our common stock only in jurisdictions where such offers and sales are permitted.  You should assume that the information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.  Our business, financial condition, results of operations and prospects may have changed since that date.  Information contained on our website, or any other website operated by us, is not part of this prospectus.

 

Frequently Used Terms

 

In this prospectus, unless the context suggests otherwise:

 

·                  references to “the Company,” “we,” “us” or “our” refer to State National Companies, Inc. and all of its consolidated subsidiaries;

 

·                  references to “State National” refer solely to State National Companies, Inc.;

 

·                  references to our “insurance company subsidiaries” refer to State National Insurance Company, Inc., a Texas-domiciled insurance company (“SNIC”), and its wholly-owned subsidiaries, National Specialty Insurance Company, a Texas-domiciled insurance company (“NSIC”) and United Specialty Insurance Company, a Delaware-domiciled insurance company (“USIC”). State National Intermediate Holdings, Inc. (“SNIH”) is an indirect subsidiary of State National and an intermediate holding company of SNIC and its wholly-owned subsidiaries, NSIC and USIC;

 

·                  all share amounts indicated herein have been adjusted to reflect a 736 for 1 stock split in the form of a stock dividend of shares of our common stock that was effected prior to the completion of the private placement;

 

·                  references to “Program Services” refer to the business segment through which we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for a ceding fee;

 

·                  references to “expansive licenses” refer to the broad licensing of our insurance subsidiaries to write insurance in the U.S.  SNIC and NSIC are admitted carriers licensed to write property and casualty business in all 50 states and the District of Columbia. USIC is an admitted carrier in Delaware and is eligible to write surplus lines in all 50 states and the District of Columbia.

 

·                  references to “issuing carrier” arrangements refer to our fronting business in our Program Services segment in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees;

 

·                  references to “capacity providers” refer to the foreign and domestic reinsurers, insurers and institutional risk investors that access U.S. property and casualty insurance market through our Program Services or issuing carrier business;

 

·                  references to “GAs” refer to general agents who sell, control and administer books of insurance business that are supported by third-party reinsurers;

 

·                  references to “ceding fees” refer to the fees we collect and earn in our Program Services segment from our GAs to compensate us for acting as the issuing carrier. These fees do not represent compensation for underwriting and policy acquisition expenses, because we do not incur those costs in our issuing carrier arrangements;

 

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·                  references to “Lender Services” refer to the business segment through which we provide CPI and certain ancillary insurance products to credit unions, banks and specialty finance companies;

 

·                  references to “CPI” refer to collateral protection insurance, which insures personal automobiles, light trucks, SUVs and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies;

 

·                  references to “reinsurer” refer to a company that assumes reinsurance risk;

 

·                  references to “quota share reinsurance” refer to reinsurance under which the insurer (the “ceding company”) transfers, or cedes, a fixed percentage of liabilities, premium and related losses for each policy covered on a pro rata basis in accordance with the terms and conditions of the relevant agreement; and

 

·                  “private placement” refers to our June 25, 2014 sale of 31,050,000 shares of our common stock in a private placement exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”).

 

All of the trade names and trademarks included in this prospectus are the property of their respective owners.

 

Market and Industry Data

 

Market and industry data used in this prospectus have been obtained from independent sources and publications as well as from research reports prepared for other purposes. Forward-looking information obtained from these sources is subject to the same qualifications and additional uncertainties regarding the other forward-looking statements in this prospectus.

 

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SUMMARY

 

This summary highlights information contained elsewhere in this prospectus, but it does not contain all of the information that you may consider important in making your investment decision. Therefore, you should read the entire prospectus carefully, including, in particular, the “Risk Factors” section beginning on page 14 of this prospectus and the financial statements and related notes included elsewhere in this prospectus before making an investment decision.

 

Overview

 

We are a leading specialty provider of property and casualty insurance operating in two niche markets across the United States.  In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for a ceding fee.  In our Lender Services segment, we specialize in providing collateral protection insurance, or CPI, which insures personal automobiles, light trucks, SUVs and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies. Our founding shareholders started our CPI business in 1973 and our Program Services business in 1979. Both of these businesses have a long track record of profitable operations.

 

Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier capacity to both specialty general agents or other producers (“GAs”), who sell, control, and administer books of insurance business that are supported by third parties that assume reinsurance risk, or reinsurers, domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business.  Issuing carrier arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. Our broad licensing authority, strong A.M. Best “A” (Excellent) rating, which is the third highest out of fifteen rating categories used by A.M. Best, and track record of over 25 years of profitable operations allow us to act as the policy-issuing carrier for business produced by GAs or insurers.  According to A.M. Best, “A” ratings are assigned to insurers that have an excellent ability to meet their ongoing financial obligations to policyholders.

 

We reinsure substantially all of the underwriting and operating risks in connection with our issuing carrier arrangements to our capacity providers. In many cases, we hold significant collateral to secure the associated reinsurance recoverables. We have ceded over $10 billion in premiums over 25 years with no unpaid reinsurance recoverables.  Because we generally only write in these lines on a fronting or issuing carrier basis, GAs and reinsurers can be confident that we will not compete with them with respect to the business they write through us. In exchange for providing our insurance capacity, licensing and rating to our GA and capacity provider clients, we receive ceding fees averaging in excess of 5% of gross written premiums. For the year ended December 31, 2013, our Program Services segment generated approximately $691 million in gross written premium, $32.9 million of earned ceding fees and $20.5 million in pre-tax income.

 

Our Lender Services segment generates premium from providing collateral protection insurance, or CPI, to our credit union, bank and specialty finance clients.  Our principal product in this segment is CPI. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.  We believe that we are the only vertically integrated CPI provider focused primarily on this product offering, and that the breadth and flexibility of our services enable us to provide our lender clients with responsive and customized policy terms, services and reporting to better serve their needs.  We service our CPI clients through InsurTrak, our proprietary technology platform that allows both us and our clients to track and manage a CPI program. We believe our InsurTrak system is highly scalable with the capacity to service a much larger volume of business without significant changes to the system. As of June 30, 2014, we had over 600 CPI clients and were servicing over 3.9 million CPI loans.

 

We have an exclusive relationship with CUNA Mutual to provide CPI.  CUNA Mutual is a leading insurance company focused on providing a range of insurance products to credit unions in the U.S. This alliance provides us access to approximately 95% of the nation’s credit unions through CUNA Mutual’s substantial sales force and has

 

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enabled us to achieve a leading market share of approximately 25% in our core credit union CPI market. We have recently amended our relationship with CUNA Mutual to increase our retention of the business subject to the alliance to 70% from 50% for policies written on or after July 1, 2014. In addition, our integrated CPI platform and InsurTrak have contributed to our ability to write business for credit unions, banks and specialty finance companies.  We believe that banks and specialty finance companies present significant growth opportunities for this business. For the year ended December 31, 2013, our Lender Services segment generated $118.9 million in gross written premium, $87.8 million in net written premium and pre-tax income of $15.8 million.

 

We write our insurance business through our three insurance company subsidiaries, which have expansive licenses to write insurance in the U.S. State National Insurance Company, Inc., or SNIC, and National Specialty Insurance Company, or NSIC, are admitted carriers licensed to write property and casualty business in all 50 states and the District of Columbia.  United Specialty Insurance Company, or USIC, is an admitted carrier in Delaware and is eligible to write surplus lines in all 50 states and the District of Columbia.  A surplus lines insurer is not directly regulated by the insurance departments in the states in which it writes and as a result has more latitude when insuring hard-to-place risks found in the surplus lines market. Having both admitted and surplus lines authority allows us to provide a broader and more flexible product offering in our issuing carrier business. These companies operate under an intercompany pooling agreement in order to take advantage of our strong “A” (Excellent) group rating from A.M. Best.

 

Our long history of profitable operations has enabled us to maintain our “A” (Excellent) A.M. Best rating while writing gross premiums in excess of $800 million in 2013 on approximately $145 million of shareholders’ equity, or over five times operating leverage at December 31, 2013. As of June 30, 2014, we had total assets of approximately $1.9 billion. The following table sets forth selected financial data for the periods presented:

 

 

 

Six Months Ended
June 30

 

Year Ended
December 31

 

($ in thousands)

 

2014

 

2013

 

2013

 

2012

 

2011

 

Program Services

 

 

 

 

 

 

 

 

 

 

 

Gross written premium

 

$

436,085

 

$

246,444

 

$

691,067

 

$

530,621

 

$

613,368

 

Net written premium

 

(16

)

(1,044

)

(1,018

)

1,141

 

2,431

 

Ceding fees

 

20,858

 

13,695

 

32,898

 

32,379

 

30,455

 

Pre-tax income

 

15,793

 

8,710

 

20,526

 

21,090

 

23,972

 

 

 

 

 

 

 

 

 

 

 

 

 

Lender Services

 

 

 

 

 

 

 

 

 

 

 

Gross written premium

 

$

55,290

 

$

50,733

 

$

118,898

 

$

104,200

 

$

99,466

 

Net written premium

 

40,690

 

37,854

 

87,791

 

78,024

 

77,872

 

Pre-tax income (loss)

 

(12,622

)

5,543

 

15,793

 

9,924

 

8,623

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

 

 

 

 

 

 

Gross written premium

 

$

491,375

 

$

297,176

 

$

809,965

 

$

634,821

 

$

712,834

 

Net written premium

 

40,674

 

36,810

 

86,773

 

79,165

 

80,303

 

Ceding fees

 

20,858

 

13,695

 

32,898

 

32,379

 

30,455

 

Pre-tax income (loss)

 

(21,342

)

3,843

 

25,498

 

20,537

 

32,877

 

Net income (loss)

 

(2,793

)

1,788

 

22,711

 

15,882

 

27,906

 

Adjusted net income (1)

 

13,395

 

8,688

 

22,084

 

19,651

 

21,570

 

 


(1)         Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual.  Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods.  For a reconciliation showing the

 

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effects of these adjustments to net income, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Results of Operations—Consolidated Results of Operations.”

 

Our Business Segments and Services

 

We have two primary business segments, Program Services and Lender Services.

 

·                  Program Services — Our Program Services segment is an issuing carrier business. We leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market to capacity providers in exchange for a ceding fee. Through our issuing carrier business, we write a wide variety of insurance products, principally including general liability insurance, commercial liability insurance, commercial multi-peril insurance, property insurance and workers compensation insurance.  We are able to reinsure substantially all of the underwriting and operating risks associated with our issuing carrier arrangements to our capacity providers. We mitigate the credit risk of our capacity providers generally by either selecting well capitalized, highly rated authorized reinsurers or requiring that the reinsurer post substantial collateral to secure the reinsured risks.

 

·                  Lender Services — Our Lender Services segment specializes in providing CPI, which insures personal automobiles and other vehicles held as collateral for loans made by credit unions, banks and specialty finance companies.  Our lender clients pay us directly for CPI and then add the cost of CPI to the loans of borrowers who do not uphold their obligation to the lender to insure the collateral underlying the loan. We also provide ancillary insurance products that currently are not actively marketed.

 

Our Competitive Strengths

 

We believe that our specialized business model provides us with the following competitive strengths:

 

·                  Successful and Focused U.S. Specialty Platform.  We have a track record of over 25 years of success in the CPI and issuing carrier markets in the U.S. with leading market positions in these two businesses.  We believe that our focus on these two niche markets provides us with the opportunity for achieving superior long-term growth and profitability. Our pre-tax income in our Program Services segment was $24.0 million, $21.1 million and $20.5 million for the years ending December 31, 2011, 2012 and 2013, respectively. Our pre-tax income in our Lender Services segment was $8.6 million, $9.9 million and $15.8 million for the years ending December 31, 2011, 2012 and 2013, respectively.

 

·                  Efficient, Fee-Based Issuing Carrier Business Model. We have a specialized issuing carrier model providing specialty GAs and capacity providers with access to our “A” (Excellent) rating from A.M. Best, expansive licensing and reputation in exchange for ceding fees averaging in excess of 5% of gross premiums written. For 2013, our Program Services segment generated approximately $691 million of gross written premium and approximately $39.7 million of ceding fees, of which approximately $32.9 million was earned during 2013. We have ceded over $10 billion in premiums over 25 years with no unpaid reinsurance recoverables. We reinsure substantially all liabilities associated with our issuing carrier arrangements and require our GAs (with capacity providers either providing some of these services directly or being responsible for the performance by the GAs) to handle all the services associated with policy administration, claims handling, cash handling, underwriting and other traditional insurance company services.  As a result, we generally retain little risk other than the credit risk of the capacity provider, and we incur minimal incremental expense on additional premium volume produced. Using our model, we are able to generate significant gross written premiums on a relatively small capital base compared to other insurance carriers. We believe that our long track record of success in this market and credibility with A.M. Best enables us to maintain our “A” rating with a relatively high operating leverage that we expect would be difficult for a competitor to obtain.

 

·                  Vertical Integration and Proprietary Technology in CPI Business.  We believe that we are the only fully vertically integrated CPI provider focused primarily on this product offering, in that our operations cover sales, policy issuance, policy administration, underwriting, claims handling and all other aspects of the CPI business cycle.  Our integration enables us to provide our lender clients with responsive and customized policy terms, services and reporting to better serve their needs.  We believe that other CPI market participants that contract out distribution, policy issuance or other functions of the business are not as well positioned to adapt to market

 

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and product changes and offer customized solutions as we are. In addition, our proprietary insurance tracking system, InsurTrak, delivers real-time visibility to us and our clients into current borrower insurance information. This versatile and scalable system can be easily customized for each client at little incremental cost to us. As of June 30, 2014, we were monitoring insurance status for approximately 3.9 million CPI loans for over 600 lender clients.

 

·                  Profitable, Low Risk Business Model.  Through our specialized Program Services and Lender Services businesses, we are able to generate profits with limited underwriting risk in our insurance subsidiaries.  We have operated our business profitably for over 25 years. We are able to do this in our Program Services business by generating significant ceding fees on gross premiums written and reinsuring substantially all of the risk inherent in the issuing carrier arrangement to our capacity providers, except for the credit risk of the capacity providers, which we mitigate by careful client selection, credit underwriting and, in many cases, significant collateral requirements.  Our Program Services business earned ceding fees of approximately $32.9 million, $32.4 million and $30.5 million for the years ended December 31, 2013, 2012 and 2011, respectively. Because we control all aspects of the CPI business operations, we can readily customize our product coverage and reporting to each client. We underwrite each of our lender client accounts and have the ability to move quickly to reprice the business in response to market or financial changes. Our fully vertically integrated CPI business historically has had high frequency but low severity losses and has produced attractive net combined ratios of 85.1%, 91.4% and 93.1% for the years ended December 31, 2013, 2012 and 2011, respectively.  The net combined ratio is the sum of the net loss ratio and the net expense ratio, as each is described below, and is a measure of the overall profitability of our Lender Services business, measuring its underwriting profitability and operational efficiency.

 

·                  Strong Competitive Position. We believe that our long track record with A.M. Best, insurance regulators and business partners, our specialized business model with significant operating leverage, our experience in assessing and monitoring credit risks and our willingness to refrain from writing primary business that competes with our capacity providers create meaningful market requirements for competitors that may desire to enter the Program Services business. We also believe that our fully vertically integrated CPI business, proprietary technology platform, access to approximately 95% of the credit union market through our exclusive relationship with CUNA Mutual and our 40-year track record of focusing on the CPI market give us a significant competitive advantage in our Lender Services business.

 

·                  Proven Leadership and Experienced Management Team.  We have a highly experienced and capable management team that is led by Terry Ledbetter, our co-founder and Chairman, President and Chief Executive Officer. Our senior executives have an average of over 22 years of experience with us. Our management team enjoys strong relationships, experience and reputation with rating agencies, insurance regulators and business partners. Utilizing our profitable, specialized business model, our management has positioned us for further growth in the future.

 

Our Growth Strategies

 

We intend to continue our profitable growth by focusing on the following strategies:

 

·                 Capitalize on Positive Market Opportunities. We believe that recently improved macroeconomic conditions, including rate hardening in property and casualty insurance lines and increasing automobile sales, should provide us with more growth opportunities in both of our business segments. Recent downgrades of certain insurance companies have, and we believe that future downgrades of other insurance companies will, create increased demand for our issuing carrier capacities.  We believe that the increased role of capital markets alternatives to reinsurance, the capitalization of recent hedge fund-backed reinsurers and the growth of the off-shore reinsurance market generally, including syndicates of Lloyd’s of London and Bermuda-based reinsurers, should drive demand for our services, as these firms typically do not have direct access to the U.S. market. In our CPI business, we believe that organic growth from our existing lender clients is, and potential new business from banks and specialty finance companies, will be, driven by overall growth in lenders’ portfolios as a result of rising automobile sales, higher average auto loan sizes and increasing credit availability.

 

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·                  Expand Direct Relationships with Capacity Providers and Specialty GAs.  Historically, our issuing carrier capacity has been constrained by the size of our capital base, and we have relied on our relationship-driven channels to generate new issuing carrier business with only a modest sales and marketing effort. In addition, we have historically relied on brokers to identify GAs in need of an issuing carrier.  With the additional capital from the private placement, we can address what we believe is increased demand from domestic and international carriers and institutional risk investors. We are seeking to further institutionalize the sales process by building more direct relationships with GAs and capacity providers and by hiring fully-dedicated sales staff.  Recent meetings by our senior executives with capacity providers in London and Bermuda and a direct marketing campaign with GAs have produced new business and viable leads.  We plan to continue such efforts to further expand our issuing carrier business.

 

·                  Expand Our CPI Business within the Banking and the Specialty Finance Company Market.  Because of our exclusive relationship with CUNA Mutual, we have focused our CPI business primarily on credit unions. As a result, our penetration in the CPI market for banks and specialty finance companies is low. However, we believe that the CPI market for banks, particularly regional and smaller banks, and specialty lenders is substantially larger than the credit union market and that the specialty finance company market is potentially more attractive to CPI providers due to higher incidences of borrowers’ failing to obtain or maintain the required insurance. We believe that the banking and specialty financing sector represents a significant growth opportunity for us. We recently have begun devoting additional sales and marketing efforts towards this market and are seeking to hire additional dedicated sales staff to address the bank and specialty lender markets. We expect these efforts to further increase the overall amount of CPI business we write.

 

Our History

 

The Ledbetter family founded a small general agency in 1973 selling CPI exclusively in Texas. By the late 1970s, the Company began to expand the CPI business beyond Texas.

 

We acquired the management contract for a Texas county mutual company (the “County Mutual”) in 1979 to accommodate the growth of its CPI business and to reduce operating costs.  The management contract enabled us to retain the profits generated from business we originated.  After acquiring the management contract for the County Mutual, we received inquiries from other carriers and GAs seeking to access the Texas non-standard automobile market, and recognized the opportunity to act as an issuing carrier.  The volume of business that the County Mutual wrote as an issuing carrier grew significantly.  Most of this business was non-standard automobile insurance in the state of Texas, and all of this business was 100% reinsured. No A.M. Best rating was required and the County Mutual was able to write at very high leverage ratios.  At one time, the County Mutual wrote approximately $400 million of premium on approximately $2 million of capital and surplus.  This high degree of leverage, the related reinsurer credit underwriting undertaken to support that leverage, and the significant collateral held against potential losses, were the foundation of our Program Services business model.  After legislative changes reduced the advantages of the county mutual model, we sold the management contract controlling the County Mutual in 2009.

 

In 1984, we formed SNIC to write our CPI business directly. SNIC received an “A” (Excellent) rating from A.M. Best in 1993, and has maintained the rating for over 20 years.  To utilize excess capital in SNIC, we expanded our issuing carrier operations outside of Texas.

 

In 1999, we acquired NSIC, an inactive insurance company licensed to write business in 21 states, and later expanded its licensing to all 50 states in order to write program business on an unrated basis. NSIC later became a subsidiary of SNIC in order to enjoy SNIC’s “A” (Excellent) A.M. Best rating.  We formed USIC in 2006 to write coverage on an excess and surplus basis.

 

In July of 2009, we formed an exclusive relationship with CUNA Mutual, a leading provider of insurance products to credit unions. This alliance provides us with access to their sales force of approximately 200 people and over 95% of the credit union market and has significantly increased our CPI business.  Additionally, over the last 15 years, we have expanded our CPI business through opportunistic acquisitions of multiple CPI agencies and books of business.

 

Our co-founders, Lonnie Ledbetter and Terry Ledbetter, have been instrumental in developing and growing our business.  Prior to the completion of the private placement, management responsibilities were shared equally

 

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between the co-founders, with Lonnie serving as Chairman and Chief Executive Officer and Terry serving as President.  On a day-to-day basis, Lonnie led the Lender Services segment while Terry led the Program Services segment.  In early 2013, Lonnie was diagnosed with cancer and has undergone treatment.  Since then, Terry has assumed most of the day to day responsibilities for both segments of the Company.  Upon completion of the private placement, Lonnie (age 71) retired and began a one-year consultancy with the Company, and Terry assumed the role of Chief Executive Officer and Chairman, in addition to his title of President.

 

Our Challenges and Risks

 

Our company and our business are subject to numerous risks.  As part of your evaluation of our business, you should consider the challenges and risks we face in implementing our business strategies, as described in the section of this prospectus entitled “Risk Factors.” Some of the principal risks related to our business include the following:

 

·                  Reinsurer credit risk.  In our Program Services segment, we write insurance on behalf of our capacity providers and reinsure substantially all of the risk under these policies in exchange for ceding fees. However, as the issuer of the policies, we remain directly liable to these policyholders. In 2013, we wrote insurance policies with approximately $691 million in gross written premiums through our issuing carrier business. If any of our reinsurers becomes insolvent, or otherwise refuses to pay policyholder claims in a timely manner, our liability for these claims could materially and adversely affect our financial condition and results of operations.

 

·                  A.M. Best rating.  We rely on our “A” rating from A.M. Best to operate our issuing carrier business and our Lender Services business.  There can be no assurances that our insurance subsidiaries will be able to maintain this rating.  Any downgrade in ratings would likely adversely affect our business through the loss of certain existing and potential policyholders and the loss of relationships with clients that might move to other companies with higher ratings. If we lost our “A” rating, our capacity providers likely would seek a higher rated issuing carrier to write their business.  Our Lender Services segment also would be adversely affected if a large number of our accounts were to require an insurer with an “A” rating.

 

·                  Regulatory risk.  In our Program Services segment, we enter into issuing carrier arrangements with capacity providers that wish to access insurance markets in states in which they are not licensed. The capacity provider administers the business and reinsures substantially all of the risks, and we receive a ceding fee. Some state insurance regulators may object to issuing carrier arrangements.  If regulators were to object to an issuing carrier arrangement, our Program Services business could be adversely affected.  In our Lender Services segment, we provide lender-placed automobile insurance to financial institutions.  A similar product, lender-placed residential hazard insurance, has come under increased regulatory scrutiny and has been subject to recent regulatory changes at both the federal and state levels.  If lender-placed automobile insurance becomes subject to similar regulatory scrutiny and is affected by regulatory changes, our CPI business could be adversely affected.  Either of these regulatory outcomes could have a material adverse effect on our business, financial condition and results of operations.

 

Subchapter S Corporation Status

 

Prior to the completion of the private placement, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and their intermediate holding company) to be pass-through entities for federal income tax purposes. As a result, prior to the completion of the private placement, the income for our parent company and pass-through subsidiaries was not subject to, and we did not pay, U.S. federal income taxes, and no provision or liability for federal or state income tax for our parent company has been included in our consolidated financial statements. Unless specifically noted otherwise, any amounts of our consolidated net income or our basic or diluted earnings per share presented in this prospectus, including in our consolidated financial statements and the accompanying notes appearing in this prospectus, do not reflect any provision for or accrual of any expense for federal income tax liability for our Company for any period presented. The tax provision, assets and liabilities that are reflected in our consolidated financial statements represent those for our insurance subsidiaries, SNIC, NSIC and USIC, and SNIH, as those entities are “C” corporations. Upon the completion of the private placement, our status as a Subchapter S corporation terminated and our income became subject to U.S. federal income taxes.

 

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Corporate Structure

 

Our corporate structure is as follows:

 

 

Private Placement

 

On June 25, 2014, we completed the sale of an aggregate of 31,050,000 shares of our common stock in a private placement exempt from registration under the Securities Act, which we refer to in this prospectus as the private placement, and received net proceeds of approximately $280.6 million.  In the private placement, FBR Capital Markets & Co., or FBR, acted as the initial purchaser for the shares sold to investors pursuant to Rule 144A and Regulation S under the Securities Act, and as placement agent for the shares sold to investors pursuant to Regulation D under the Securities Act.  The shares of common stock were sold to investors at an offering price of $10.00 per share, except for 575,000 shares that were sold to FBR and an affiliate of FBR at a price of $9.30 per share, representing the offering price per share sold to other investors less the amount of the initial purchaser discount or placement agent fee per share in the private placement.  We determined the offering price per share in the private placement in consultation with FBR.  In making such determination we considered many factors, including our business strategy and the amount of capital we needed to raise in the private placement to implement our business strategy, the market demand for our stock and our capital structure.

 

Of the net proceeds from the private placement, we used approximately (i) $190.6 million to purchase 21,030,294 shares of our common stock from certain of our shareholders pursuant to a stock redemption agreement we entered into with them prior to the private placement at a per share price equal to the net proceeds, after allocable expenses, per share that we received from the private placement, (ii) $17.8 million to make pre-tax payments to CUNA Mutual pursuant to the recent amendment to our Collateral Protection Alliance Agreement with CUNA Mutual, which we refer to as the alliance agreement, to increase our retention of the business subject to the alliance and (iii) $50 million to contribute to the capital of our insurance subsidiaries. We intend to use the remainder of the net proceeds for general corporate purposes.

 

In connection with the private placement, we entered into a registration rights agreement for the benefit of the holders of the shares sold in the private placement, which are being registered pursuant to the registration statement of which this prospectus is a part. See “Description of Capital Stock—Registration Rights—Purchasers in the Private Placement.”

 

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Determination of Offering Price for This Offering

 

Because all of the shares being offered under this prospectus are being offered by the selling shareholders, we cannot currently determine the price or prices at which our shares of common stock may be sold under this prospectus. We are aware that, prior to the date of this prospectus, certain qualified institutional buyers who purchased shares of our common stock in a private offering that closed in June 2014, have traded shares of our common stock through the FBR PlusTM System, which is operated by FBR Capital Markets & Co. (“FBR”), at prices per share ranging from $10.00 to $10.75 during the period from the closing of the private placement to October 1, 2014 (the date of the most recent trade known to us).  Until shares of our common stock are regularly traded or listed on a national securities exchange, we expect that the selling shareholders initially will sell their shares at prices per share between $10.00 and $10.75, if any shares are sold, and thereafter at prevailing market prices or privately negotiated prices. See “Plan of Distribution.”

 

We are an Emerging Growth Company

 

As a company with less than $1.0 billion in revenue during our last fiscal year, we qualify as an “emerging growth company” as defined in the Jumpstart our Business Startups Act of 2012, commonly known as the JOBS Act. As an emerging growth company, we may take advantage of specified reduced disclosure obligations and reductions in other requirements that are otherwise applicable generally to public companies for up to five years following the effectiveness of the registration statement of which this prospectus is a part. We intend to take advantage of certain of the reduced disclosure requirements applicable to emerging growth companies, including the reduced executive compensation disclosure requirements and the exemption from the requirements under Section 404(b) of the Sarbanes-Oxley Act for auditor attestation relating to internal control over financial reporting. We would cease to be an emerging growth company if we have more than $1.0 billion in annual revenues, have more than $700 million in market value of our capital stock held by non-affiliates, or issue more than $1.0 billion of non-convertible debt over a three-year period.  For the year ended December 31, 2013, we reported approximately $128.5 million in total revenue. As a result, for at least some period of years, our shareholders likely will not have the benefit of certain protective provisions and additional disclosures that would otherwise apply to most public companies.

 

Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. However, we are choosing to opt out of any extended transition period, and as a result we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for publicly reporting companies which are not emerging growth companies. Section 107 provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

Company Information

 

Our executive offices are located at 1900 L. Don Dodson Drive, Bedford, Texas 76021 and our telephone number is (817) 265-2000.  Our website address is www.statenational.com.  Information contained on our website is not incorporated by reference into this prospectus, and such information should not be considered to be part of this prospectus.

 

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The Offering

 

Common Stock Offered by the Selling Shareholders

 

A total of up to 30,728,500 shares of our common stock. The selling shareholders may from time to time sell some, all or none of the shares of common stock pursuant to the registration statement of which this prospectus is a part.

 

 

 

Shares of Common Stock Outstanding(1)

 

44,247,102

 

 

 

Use of Proceeds

 

The selling shareholders will receive all of the proceeds from the sale of shares of our common stock. We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders.

 

 

 

Dividend Policy

 

We intend to commence the payment of a $0.01 per share cash dividend on a quarterly basis to our shareholders of record beginning in the fourth quarter of 2014 based on third quarter earnings. Any declaration and payment of dividends that may be approved by our board of directors will depend on many factors, including general economic and business conditions, our strategic plans, our financial results and condition, legal and regulatory requirements and other factors that our board of directors deems relevant. Our board of directors may eliminate the payment of future dividends at its discretion, without notice to our shareholders.

 

Prior to the completion of the private placement, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and their intermediate holding company) to be pass-through entities for federal income tax purposes. We historically made periodic cash distributions to our shareholders that included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses that pass through to them. Upon the completion of the private placement, State National became taxable as a “C” corporation and has discontinued the manner in which it previously made periodic distributions to its shareholders, including distributions to provide shareholders with funds to pay their estimated personal U.S. federal income tax liabilities.

 

 

 

Stock Exchange Symbol

 

Shares of our common stock are not currently listed on any national securities exchange. Our common stock has been approved for listing on the NASDAQ Global Select Market under the symbol “SNC.”

 

 

 

Risk Factors

 

Investing in our common stock involves a high degree of risk. For a discussion of factors you should consider in making an investment, see “Risk Factors” beginning on page 14.

 


(1)    Throughout this prospectus, unless the context expressly states otherwise, the number of shares of common stock outstanding excludes: (i) 2,783,873 shares of common stock issuable upon the exercise of stock options outstanding as of the date of this prospectus with a weighted average exercise price of $10.00 per share; and (ii) 1,585,627 additional shares of common stock available for future issuance under our 2014 Stock Incentive Plan.

 

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In addition, throughout this prospectus, unless the context states otherwise, all share amounts give effect to a 736 for 1 stock split in the form of a stock dividend that was effected prior to the completion of the private placement.

 

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Summary Historical Financial Data

 

The following tables set forth our summary historical consolidated financial information for the periods ended and as of the dates indicated. These selected historical consolidated results are not necessarily indicative of results to be expected in any future period.

 

You should read the following selected consolidated financial information together with the other information contained in this prospectus, including the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this prospectus.

 

The income statement data for the years ended December 31, 2013, 2012 and 2011 are derived from our audited financial statements included elsewhere in this prospectus.  The income statement data for the years ended December 31, 2010 and 2009 and the balance sheet data as of December 31, 2011, 2010 and 2009 are derived from our audited financial statements that are not included in this prospectus. The income statement data for the six months ended June 30, 2014 and 2013 and the balance sheet data as of June 30, 2014 are each derived from our unaudited condensed financial statements included elsewhere in this prospectus.  Our unaudited consolidated condensed financial statements have been prepared on the same basis as our audited consolidated financial statements and, in our opinion, include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of such financial statements in all material respects.  The results of any interim period are not necessarily indicative of results that may be expected for a full year or any future period.

 

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($ in thousands, except

 

For the six months ended
June 30,

 

For the years ended
December 31,

 

for share information)

 

2014

 

2013

 

2013

 

2012

 

2011

 

2010

 

2009

 

OPERATING RESULTS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross written premium (1)

 

$

491,375

 

$

297,176

 

$

809,965

 

$

634,821

 

$

712,834

 

$

668,353

 

$

675,619

 

Net written premium (1)

 

40,674

 

36,810

 

86,773

 

79,165

 

80,303

 

88,598

 

92,209

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Premiums earned

 

43,986

 

39,482

 

84,378

 

78,096

 

81,974

 

90,244

 

93,062

 

Ceding fees (2)

 

20,858

 

13,695

 

32,898

 

32,379

 

30,455

 

31,010

 

33,179

 

Total revenues

 

70,930

 

58,723

 

128,503

 

122,123

 

124,749

 

132,589

 

137,840

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash from operating activities

 

(18,141

)

(6,447

)

33,856

 

27,060

 

30,296

 

34,464

 

21,521

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reconciliation of adjusted net income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(2,793

)

$

1,788

 

$

22,711

 

$

15,882

 

$

27,906

 

$

26,040

 

$

20,814

 

Plus (less): Provision for income taxes to reflect change to C corporation status (3)

 

3,957

 

589

 

(6,938

)

(2,980

)

(6,779

)

(5,762

)

(3,854

)

Less: Recognition of deferred tax asset upon conversion to C corporation (4)

 

14,460

 

 

 

 

 

 

 

Plus: Founder special compensation (5) (6)

 

11,160

 

6,311

 

6,311

 

6,749

 

443

 

4,929

 

2,815

 

Plus: Offering-related expenses (6)

 

4,441

 

 

 

 

 

 

 

Plus: Contract modification expense (6) (8)

 

11,090

 

 

 

 

 

 

 

Adjusted net income (7)

 

$

13,395

 

$

8,688

 

$

22,084

 

$

19,651

 

$

21,570

 

$

25,207

 

$

19,775

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SHARE INFORMATION

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

(0.08

)

$

0.05

 

$

0.66

 

$

0.46

 

$

0.82

 

$

0.76

 

$

0.61

 

Diluted earnings per share

 

(0.08

)

0.05

 

0.66

 

0.46

 

0.82

 

0.76

 

0.61

 

Basic weighted average shares outstanding

 

34,455,221

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

Diluted weighted average shares outstanding

 

34,455,221

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

 

 

 

As of
June 30,

 

($ in thousands)

 

2014

 

FINANCIAL CONDITION

 

 

 

Total investments and cash and cash equivalents

 

$

317,954

 

Deferred income taxes, net

 

25,042

 

Total assets

 

1,900,203

 

 

 

 

 

Total liabilities

 

1,674,824

 

 

 

 

 

Common stock

 

44

 

Additional paid in capital

 

218,605

 

Retained earnings

 

2,745

 

Accumulated other comprehensive income

 

3,985

 

Total shareholders’ equity

 

$

225,379

 

 


(1)         The CPI premiums written presented in this document reflect the effects of the allowance for policy cancellations, including any adjustments related to re-estimation of the allowance.  As such, the CPI premiums written are those that we expect to earn, which we refer to as “stick premiums,” while those that are expected to cancel are included in the allowance for policy cancellations.

 

(2)         Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross earned premium on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured.  Typically, the reinsured policies have a term of one year.  Ceding commissions earned on Lender Services business are not included as ceding fees.  CUNA Mutual’s ceding commission is included as a partial offset to commission expense.

 

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(3)         Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes.  This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2%, 35.7%, 35.5% and 34.1% for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

(4)         As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.5 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions. This excludes the tax effect related to contract modification expense as discussed in note (8) below.

 

(5)         During the periods presented, we made special compensation payments to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter in recognition of their service to our Company.  We refer to these payments as “Founder special compensation.”  Following the completion of the private placement, we no longer pay Founder special compensation, as Lonnie Ledbetter has retired, and the bonus compensation for the remainder of 2014 for Terry Ledbetter, who now serves as our Chairman, President and Chief Executive Officer, will be determined based on 2014 performance goals. See “Executive Compensation—Executive Incentive Plans.”

 

(6)         Founder special compensation, offering-related expenses, and contract modification expense are shown net of the estimated tax benefit for each period presented.  The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2%, 35.7%, 35.5% and 34.1% for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

(7)         Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual.  Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods.  Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.

 

(8)   In connection with the recent amendment to the alliance agreement with CUNA Mutual, we agreed to pay CUNA Mutual $17.8 million.  As a result, we recorded contract modification expense of $17.8 million, or $11.1 million net of tax benefit.

 

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RISK FACTORS

 

An investment in our common stock involves a high degree of risk. Before making an investment decision, you should carefully consider each of the following risk factors and all of the other information set forth in this prospectus. If any one or more of the risks discussed in this prospectus actually occurs, our business, financial condition, results of operations and prospects could be materially and adversely affected, the price of shares of our common stock could decline significantly, and you may lose all or a part of your investment. The risk factors described below are not the only ones that may affect us. Additional risks and uncertainties of which we are currently unaware or that we currently deem immaterial may also adversely affect our business, financial condition, results of operations and prospects. See “Cautionary Statement Concerning Forward-Looking Statements.”

 

Risks Relating to Our Program Services Segment

 

We may not be able to recover amounts due from our reinsurers, which would adversely affect our financial condition.

 

In our Program Services segment, we write insurance on behalf of our capacity providers and reinsure on a quota share basis 100% of the risk under these policies with these carriers in exchange for ceding fees.  Because we cede all of these risks to capacity providers, we generally hold no net reserves for losses or loss adjustment expenses that might arise as a result of claims made under these policies. However, as the issuer of the policies, we remain directly liable to these policyholders. In 2013, we wrote insurance policies with approximately $691 million in gross written premiums through our fronting, or issuing carrier, business.

 

We reinsure substantially all of the underwriting and operating risks in connection with our issuing carrier arrangements to our capacity providers.  We take the risk of insolvency or other failure to pay by a capacity provider. We generally select either well capitalized, highly rated authorized capacity providers or we require the capacity providers to post substantial collateral to secure the reinsured risks.  However, if any of our capacity providers becomes insolvent, or otherwise refuses to reimburse these policyholders for losses paid (or us, to the extent we reimburse these or pay policyholders or pay other claims directly) in a timely manner, our liability for these claims could materially and adversely affect our financial condition and results of operations. We often hold collateral to protect us against a capacity provider’s failure to pay claims. However, collateral may not be sufficient to cover our liability for these claims, and we may not be able to cause the capacity provider to deliver additional collateral.

 

As of June 30, 2014, we held approximately $1.6 billion in collateral securing approximately $1.1 billion in reinsurance recoverables.  In addition, we have approximately $366.2 million of unsecured reinsurance recoverables.  Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our capacity providers or any collateral securing the liabilities. This could occur because the loss experience based on the policy terms is higher than expected or due to litigation, regulatory or other extra-contractual liabilities.

 

If we fail to realize a reinsurance recoverable owed under these arrangements due to insolvency, dispute with reinsurers as to the meaning or enforceability of reinsurance arrangements or other unwillingness or inability of any of our reinsurers to meet their obligations to us, or due to our inability to access sufficient collateral to cover our liabilities, our business, financial condition, results of operations or prospects could be materially and adversely affected.  For additional information, see “Business—Reinsurance.”

 

If market conditions cause our reinsurance to be more costly or difficult to obtain, we may be required to bear increased risks or reduce the level of our underwriting commitments.

 

In our Program Services segment, we provide access to the U.S. property and casualty markets in exchange for a ceding fee through our issuing carrier business by providing access to our “A” (Excellent) A.M. Best rating, expansive licensing and reputation.  As part of our business strategy for our Program Services segment, we reinsure substantially all underwriting risk, credit risk and business risk related to our issuing carrier business.  We may be unable to maintain our current reinsurance arrangements or to obtain other reinsurance in adequate amounts and at favorable rates, particularly if reinsurers become unwilling or unable to support our specialized issuing carrier model in the future. In recent years, our Program Services segment has benefitted from favorable market conditions,

 

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including growth in the role of GAs and of offshore and other alternative sources of reinsurance.  A decline in the availability of reinsurance, increases in the cost of reinsurance or a decreased level of activity by GAs could limit the amount of issuing carrier business we could write and materially and adversely affect our business, financial condition, results of operations and prospects.

 

Regulators may challenge our use of fronting arrangements in states in which our capacity providers are not licensed.

 

We enter into fronting, or issuing carrier, arrangements with GAs and domestic and foreign insurers that want to access specific U.S. property and casualty insurance business in states in which such capacity provider is not licensed or is not authorized to write particular lines of insurance. The capacity provider or the GA administers the business, settles all claims and reinsures 100% of the risks. We receive a ceding fee, but generally do not share in the profits or losses of the business we write for the capacity provider. Some state insurance regulators may object to our issuing carrier arrangements.  In certain states, including Florida and Kentucky, the Insurance Commissioner has the authority to prohibit an authorized insurer from acting as an issuing carrier for an unauthorized insurer.  In addition, insurance departments in states in which there is no statutory or regulatory prohibition against an authorized insurer acting as an issuing carrier for an unauthorized insurer, such as New York, could deem the assuming insurer to be transacting insurance business without a license and the issuing carrier to be aiding and abetting the unauthorized sale of insurance.

 

If regulators in any of the states where we conduct our issuing carrier business were to prohibit or limit the arrangement, we would be prevented or limited from conducting that business for which a capacity provider is not authorized in those states, unless and until the capacity provider is able to obtain the necessary licenses. This could have a material and adverse effect on our business, financial condition results of operations and prospects.  In particular, we do significant business in Florida.  See “We write at least half of our Program Services business in several key states and adverse developments in these key states could have a material and adverse effect on our business, financial condition, results of operations and prospects.”

 

Notwithstanding these state law restrictions on ceding insurers, the Nonadmitted and Reinsurance Reform Act (“NRRA”) contained in The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) provides that all laws of a ceding insurer’s nondomestic state (except those with respect to taxes and assessments on insurers or insurance income) are preempted to the extent that they otherwise apply the laws of the state to reinsurance agreements of nondomestic ceding insurers. The NRRA places the power to regulate reinsurer financial solvency primarily with the reinsurer’s domiciliary state and requires credit for reinsurance to be recognized for a nondomestic ceding company if it is allowed by the ceding company’s domiciliary state.  A state insurance regulator might not view the NRRA as preempting a state regulator’s determination that an unauthorized reinsurer must obtain a license or that a statute prohibited our doing a fronting business. However, such a determination or a conflict between state law and the NRRA could cause regulatory uncertainty about our issuing carrier business, which could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Changes in state insurance regulation could materially and adversely affect our business.

 

Some states have adopted changes to their insurance laws and regulations that permit insurers to obtain credit for reinsurance from reinsurers who are able to post reduced collateral if they satisfy certain requirements, including specific rating criteria.  We require many of our capacity providers to post collateral to secure their reinsurance obligations.  If regulatory changes are adopted in the states in which our insurance subsidiaries are domiciled that permit non-admitted reinsurers to post reduced or no collateral in order for the insurer to obtain credit for that reinsurance, it may become more difficult for us to obtain collateral from our capacity providers who meet the applicable rating agency requirements or the capacity providers may no longer need to utilize our issuing carrier arrangements, which could materially and adversely affect the amount of business that we can write.

 

We depend on a limited number of capacity providers and GAs for a large portion of our gross written premium in our Program Services segment, and the loss of business provided by any one of them could materially and adversely affect us.

 

Our Program Services segment offers issuing carrier arrangements to both general agents, or GAs, who sell, control, and administer books of insurance business that are supported by third-party reinsurers seeking access to

 

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U.S. property and casualty insurance business, and domestic and foreign insurers, which we collectively refer to as “capacity providers,” that want to access specific U.S. property and casualty insurance business.

 

Other insurance companies may compete with us for the business of these capacity providers and GAs.  These capacity providers and GAs may choose to enter into issuing carrier arrangements with our competitors. For the six month period ended June 30, 2014 and the years ended December 31, 2013 and 2012, approximately 78%, 74% and 76% of our gross written premium in our Program Services segment was derived from our top ten issuing carrier arrangements.  Approximately 58%, 46% and 24% of our gross written premium in our Program Services segment was derived from our top two issuing carrier arrangements over the same periods.

 

A significant decrease in business from, or the entire loss of, our largest capacity provider or GA or several of our other large capacity providers or GAs would cause us to lose premium and require us to seek additional capacity providers or GAs or to replace the lost premium.  In the event that we are unable to do so, our business, financial condition, results of operations and prospects would be materially and adversely affected.

 

Failure of Capacity Providers or GAs to properly market, underwrite or administer policies could adversely affect us.

 

The marketing, underwriting, claims administration and other administration of policies in our Program Services segment are the responsibility of our capacity providers or our GAs.  Any failure by them to properly handle these functions could result in liability to us.  Even though they may be required to compensate us for any such liability, there are risks that any such failures could create regulatory or reputational issues for us and that they do not pay us because they become insolvent or otherwise, either of which could materially and adversely affect our business, financial condition, results of operations and prospects.

 

We write at least half of our Program Services business in several key states and adverse developments in these key states could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

For the six month period ended June 30, 2014 and the year ended December 31, 2013, we derived approximately 58% and 56%, respectively, of our gross written premium in our Program Services segment in the states of Texas, New York, California and Florida.  As a result, our financial results are subject to prevailing regulatory, legal, economic, demographic, competitive, and other conditions in these states.  Adverse developments relating to any of these conditions could have a material and adverse impact on our business, financial condition, results of operations and prospects. See “Business—Program Services Segment—Geographic Distribution.”

 

We may not be successful in building more direct relationships with GAs and capacity providers through a direct marketing campaign.

 

Historically, our issuing carrier capacity has been constrained by the size of our capital base, and we have relied on our relationship-driven channels to generate new issuing carrier business with only a modest sales and marketing effort. In addition, we have historically relied on brokers to identify GAs in need of an issuing carrier.  We believe that the additional capital from the private placement will enable us to expand our Program Services segment. We are seeking to further institutionalize our sales process by building more direct relationships with GAs and capacity providers and are seeking to hire fully-dedicated sales staff.  We may not be successful in our efforts to further expand our issuing carrier business.

 

We may face increased competition in our Program Services segment.

 

We believe there are relatively few active competitors in our Program Services segment.  Unlike us, some of our competitors may offer policy administration or other services or be willing take on significant underwriting risk. Any increase in competition in this segment, especially by one or more substantial companies, could materially and adversely affect our business, financial condition, results of operations and prospects.

 

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Some of our issuing carrier arrangements contain limits on the reinsurer’s obligations to us.

 

While we reinsure substantially all of the risks inherent in our issuing carrier programs, we have in certain cases entered into programs that contain limits on our reinsurers’ obligations to us, including loss ratio caps or aggregate reinsurance limits. For example, under our recent program with Nephila Capital Ltd., we bear no business or insurance risk except for annual aggregate agreement year losses in excess of a limit that we believe is highly unlikely to be exceeded. To the extent losses under these programs exceed the prescribed limits, we will be liable to pay the losses in excess of such limits, which could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Our losses resulting from the run-off of the retained business may exceed our reserves.

 

In the past, we have participated on a quota share basis to a limited extent in certain programs in the Program Services segment.  In early 2012, we reinsured to inception the retained business under most of the active contracts, but others continue to run-off. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors Affecting Our Operating Results—Run-off of the Retained Business.” As of June 30, 2014, we had reserves of $3.4 million related to this business. In the event our losses resulting from this business exceeds our reserves, the excess losses could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Risks Relating to Our Lender Services Segment

 

Lender-placed residential hazard insurance is under increased regulatory scrutiny and has been subject to recent regulatory changes at both the federal and state levels. If lender-placed automobile insurance becomes subject to similar regulatory scrutiny and is affected by regulatory changes, our business, financial condition, results of operations and prospects could be materially and adversely affected.

 

Through our Lender Services segment, we provide collateral protection insurance, or CPI, to financial institutions.  Other companies provide similar products to home lenders.  Under certain circumstances, when borrowers fail to provide hazard insurance on their residences, the owner or servicer of the loan may place such insurance to protect the collateral and passes on the premium to the borrower. This lender-placed residential hazard insurance has come under increased regulatory scrutiny and has been subject to recent regulatory changes.  For example, on December 18, 2013, Fannie Mae and Freddie Mac announced that effective June 1, 2014, mortgage servicers and their affiliates may not receive commissions or other forms of compensation with lender-placed insurance on GSE loans or ceding premiums to a reinsurer affiliated with the servicers.

 

State regulators have also taken action to restrict insurance practices relating to lender-placed residential hazard insurance. For example, in New York, on September 19, 2013, the State of New York’s Department of Financial Services, or NY DFS, released proposed regulations that, among other things, would prohibit insurers from: issuing force-placed insurance on mortgaged property serviced by a servicer affiliated with the insurer; paying commissions to a bank or servicer or other parties affiliated with a bank or servicer on force-placed insurance policies obtained by the servicer; paying contingent commissions based on underwriting profitability or loss ratios; making payments, including but not limited to the payment of expenses, to a servicer or other parties affiliated with a servicer in connection with securing force-placed insurance business; and providing free or below-cost, outsourced services to banks, servicers or their affiliates. The NY DFS and Florida Office of Insurance Regulation have also entered into settlements with certain large providers of lender-placed residential hazard insurance.  The NY DFS settlements, for example, included restitution for homeowners, multi-million dollar penalties, and major reforms for the companies’ lender-placed insurance programs.  The NY DFS is also encouraging other lender-placed residential hazard insurers and mortgage servicers operating in New York to adopt similar reforms.  The NY DFS has urged other states to implement these reforms, as evidenced by a letter to all state Insurance Commissioners in 2013.  There have also been multi-million dollar class action settlements that included not only payments by lender-placed residential hazard insurance carriers but contained restrictions on such lender-placed insurers as well.  If lender-placed automobile insurance becomes subject to similar regulatory scrutiny and is affected by regulatory changes, our business, financial condition, results of operations and prospects could be materially and adversely affected.

 

In the future, states may subject lender-placed automobile insurance to additional regulatory scrutiny or propose regulatory changes to related laws.  In particular, CPI’s higher expense ratios and lower loss ratios, as compared to other insurance products, presents a risk that regulatory requirements such as minimum loss ratios could be proposed

 

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in the future.  Any future proposed or adopted rules relating to automobile CPI could materially and adversely affect our business, financial condition, results of operation and prospects.

 

The CPI market is highly competitive, and we may not be able to compete effectively against larger companies.

 

The CPI market is highly competitive. We compete primarily on the basis of price, coverages offered, claims handling, customer service, geographic coverage, financial strength ratings, licenses, reputation, technology, relationships with business partners and experience. Some of our competitors have substantially more capital, comparable or higher ratings and greater resources than we have, and offer a broader range of products than we offer. Many of our competitors invest heavily in advertising and marketing efforts and/or expanding their online service offerings.  Some of these competitors may have better brand recognition than we have and have a larger market share than we do.  As a result, these larger competitors may be better able to offer lower rates to customers, to withstand larger losses, and to more effectively take advantage of new marketing opportunities. Our ability to compete against these larger competitors depends on our ability to deliver superior service and maintain our relationships with our clients.

 

We may undertake strategic marketing and operating initiatives to improve our competitive position and drive growth. If we are unable to successfully implement new strategic initiatives or if our marketing campaigns do not attract new customers, our competitive position may be harmed, which could materially and adversely affect our business, financial condition, results of operations and prospects.

 

The termination of our alliance with CUNA Mutual could materially and adversely affect our growth prospects for our CPI business and our liquidity.

 

Our alliance with CUNA Mutual has allowed us to significantly increase the amount of CPI business we write due to the business that is generated by CUNA Mutual’s sales and marketing efforts. For the six months ended June 30, 2014 and the year ended December 31, 2013, the CPI business generated through our alliance with CUNA Mutual represented approximately 54.7% and 53.8% of our total CPI business respectively. We recently amended the alliance agreement to increase our retention of the business subject to the alliance to 70% from 50% for business written on or after July 1, 2014, and in exchange have made payments to CUNA Mutual totaling approximately $17.8 million, which payments may be adjusted somewhat based on net premiums and loss ratio for the 12-month period ending June 30, 2015.  In addition, the term of the alliance has been extended at least through July 31, 2018.

 

If the alliance were to terminate and we no longer had access to those extensive sales and marketing efforts, our ability to continue to grow our CPI business would be materially and adversely affected.  CUNA Mutual has the right to terminate its alliance agreement with us upon a change in control of State National or certain of its subsidiaries, which is defined to include any substantial change in the senior management team involving the departure, within any 12-month period, of two or more of the following three executives: John Pearson, Trace Ledbetter and David Hale.  See “Business—Lender Services Segment—Business Overview—Relationship with CUNA Mutual.” In addition, if and when the alliance agreement terminates, depending upon the reason for the termination and subject to certain exceptions, we may be required to buy out CUNA Mutual’s right to participate in future program business at a price equal to the previous 12 months net premium times a percentage based on the loss ratio of the business during that period. Giving effect to the recent amendment of the alliance agreement, we estimate that the amount of this payment as of June 30, 2014 would be approximately $21.0 million. If we were required to make this payment, it could have a material and adverse effect on our liquidity.

 

We may not be successful in expanding our CPI business within the banking and specialty finance company markets.

 

Because of our exclusive relationship with CUNA Mutual, we have focused our CPI business on credit unions. As a result, our penetration in the CPI market for banks and specialty finance companies has been relatively low. We believe that the CPI market for banks is substantially larger than the credit union market and that the specialty finance company market is potentially more attractive to CPI providers due to higher incidences of borrowers’ failing to obtain or maintain the required insurance.  We recently have begun devoting additional sales and marketing efforts towards the bank and specialty finance markets and are seeking to hire additional dedicated sales staff to address those markets. Our efforts to further increase the overall amount of CPI business we write in the

 

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bank and specialty finance markets may not be successful, which could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Changes affecting the automobile loan business generally and the CPI business in particular could materially and adversely affect our business, financial condition, results of operations and prospects.

 

A number of economic and market conditions affect vehicle sales volume and product mix, the amount of automobile loans and the CPI market, including levels of unemployment, consumer confidence, average age of vehicles on the road, availability and cost of credit, cost of fuel, credit profiles of borrowers and amounts sought to be financed.  Our CPI business has benefitted in recent periods from a strong overall automobile loan environment, including increases in vehicle sales and average amounts financed.  Any negative changes in market conditions could materially and adversely affect demand for our CPI product offerings and, consequently, our business, financial condition, results of operations and prospects.

 

We write more of our Lender Services business in Texas than any other state, and adverse developments in Texas could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

For the six month period ended June 30, 2014 and the year ended December 31, 2013, we derived approximately 14% and 13%, respectively, of our gross written premium in our Lender Services segment from the State of Texas.  As a result, our financial results are subject to prevailing regulatory, legal, economic, demographic, competitive, and other conditions in Texas.  Adverse developments relating to any of these conditions could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

If we are unable to establish and maintain accurate allowance for policy cancellations, our business, financial condition, results of operations and prospects may be materially and adversely affected.

 

Our financial statements include an allowance for policy cancellations, which represent our best estimate of the amounts that our insurance subsidiaries will ultimately refund for CPI polices that cancel (net of applicable offsetting expenses) as of the date of the financial statements. There is inherent uncertainty in the process of establishing the allowance.

 

As a result of these uncertainties, the ultimate refunds paid may deviate, perhaps substantially, from the point-in-time estimates of such refunds and expenses, as reflected in the allowance for policy cancellations included in our financial statements.  To the extent that premium refunds exceed our estimates, we will be required to immediately recognize the unfavorable development and increase our allowance for policy cancellations, with a corresponding reduction in our net income in the period in which the allowance is increased.  Consequently, ultimate refunds paid could materially exceed the reported allowance for policy cancellations and have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Risks Relating to Our Business Generally

 

A downgrade in the A.M. Best rating of our insurance subsidiaries would reduce the amount of business we are able to write and could materially adversely impact the competitive positions of our insurance subsidiaries.

 

Rating agencies evaluate insurance companies based on their ability to pay claims. Our insurance subsidiaries have been assigned an “A” (Excellent) rating by A.M. Best Company, Inc. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time. Our competitive position relative to other companies is determined in part by the A.M. Best rating of our insurance subsidiaries. A.M. Best ratings are directed toward the concerns of policyholders and insurance agencies and are not intended for the protection of investors or as a recommendation to buy, hold or sell securities.

 

We rely on our “A” rating from A.M. Best to operate our issuing carrier business and our Lender Services business.  There can be no assurances that our insurance subsidiaries will be able to maintain this rating.  Any downgrade in ratings would likely adversely affect our business through the loss of certain existing and potential policyholders and the loss of relationships with clients that might move to other companies with higher ratings. If we lost our “A” rating, our capacity providers likely would seek a higher rated issuing carrier to write their business.

 

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Our Lender Services segment also would be adversely affected if a large number of our accounts were to require an insurer with an “A” rating.  In addition, pursuant to the arrangement with CUNA Mutual, if our A.M. Best rating falls below “A-” for more than 180 consecutive days, CUNA Mutual will be entitled to terminate the arrangement with us and thereafter CUNA Mutual will have the option to purchase our right to participate in the future business of the alliance.  We are not able to quantify the percentage of our business, in terms of premiums or otherwise, that would be affected by a downgrade in our A.M. Best ratings.

 

If we are unable to accurately underwrite risks and charge competitive yet profitable rates to our clients and policyholders, our business, financial condition, results of operations and prospects may be materially and adversely affected.

 

In general, the premiums for our insurance policies are established at the time a policy is issued and, therefore, before all of our underlying costs are known. Like other insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate premiums is necessary, together with investment income, to generate sufficient revenue to offset losses, loss adjustment expenses (“LAE”) and other underwriting costs and to earn a profit. If we do not accurately assess the risks that we assume, we may not charge adequate premiums to cover our losses and expenses, which would negatively affect our results of operations and our financial condition. Alternatively, we could set our premiums too high, which could reduce our competitiveness and lead to lower revenues. In addition, a variety of economic factors can affect losses in our CPI business. For example, difficult economic conditions could lead to increased losses as a result of increased premium deficiency and conversion/skip claims.

 

Pricing involves the acquisition and analysis of historical loss data, and the projection of future trends, loss costs and expenses, and inflation trends, among other factors, for each of our products in multiple risk tiers and many different markets. In order to accurately price our policies, we:

 

·                  collect and properly analyze a substantial volume of data from our insureds;

 

·                  develop, test and apply appropriate projections and rating formulas;

 

·                  closely monitor and timely recognize changes in trends; and

 

·                  project expected losses for our insureds with reasonable accuracy.

 

We seek to implement our pricing accurately in accordance with our assumptions. Our ability to undertake these efforts successfully and, as a result, accurately price our policies, is subject to a number of risks and uncertainties, including:

 

·                  insufficient or unreliable data;

 

·                  incorrect or incomplete analysis of available data;

 

·                  uncertainties generally inherent in estimates and assumptions;

 

·                  our failure to implement appropriate actuarial projections and rating formulas or other pricing methodologies;

 

·                  regulatory constraints on rate increases;

 

·                  our failure to accurately estimate investment yields and the duration of our liability for loss and LAE; and

 

·                  unanticipated court decisions, legislation or regulatory action.

 

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Our failure to accurately and timely pay claims could materially and adversely affect our business, financial condition, results of operations and prospects.

 

We must accurately and timely evaluate and pay claims that are made under our CPI and other policies. Many factors affect our ability to pay claims accurately and timely, including the training and experience of our claims representatives, our claims organization’s culture and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors. Our failure to pay claims accurately and timely could lead to regulatory and administrative actions, material litigation, undermine our reputation in the marketplace and materially and adversely affect our business, financial condition, results of operations and prospects.

 

In addition, if we do not train new claims employees effectively or lose a significant number of experienced claims employees, our claims department’s ability to handle an increasing workload could be adversely affected. In addition to potentially requiring that growth be slowed in the affected markets, our business could suffer from decreased quality of claims work which, in turn, could lower our operating margins.

 

Our insurance subsidiaries are subject to minimum capital and surplus requirements. Our failure to meet these requirements could subject us to regulatory action.

 

The laws of the states of domicile of our insurance subsidiaries impose risk-based capital standards and other minimum capital and surplus requirements. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do.

 

If we are unable to establish and maintain accurate loss reserves, our business, financial condition, results of operations and prospects may be materially and adversely affected.

 

Our financial statements include loss reserves, which represent our best estimate of the amounts that our insurance subsidiaries ultimately will pay on claims that have been incurred, and the related costs of adjusting those claims, as of the date of the financial statements. There is inherent uncertainty in the process of establishing insurance loss reserves.

 

As a result of these uncertainties, the ultimate paid loss and LAE may deviate, perhaps substantially, from the point-in-time estimates of such losses and expenses, as reflected in the loss reserves included in our financial statements.  To the extent that loss and LAE exceed our estimates, we will be required to immediately recognize the unfavorable development and increase loss reserves, with a corresponding reduction in our net income in the period in which the reserve levels are increased.  Consequently, ultimate losses paid could materially exceed reported loss reserves and have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Catastrophic losses or the frequency of smaller insured losses may exceed our expectations, which could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Our insurance business is subject to claims arising from catastrophes, such as hurricanes, tornadoes, windstorms, floods, earthquakes, hailstorms, severe winter weather, and fires, or other events, such as explosions, terrorist attacks, riots, and hazardous material releases. The incidence and severity of such events are inherently unpredictable, and our losses from catastrophes could be substantial.  In our Program Services business, although we reinsure substantially all of the underwriting risk through our issuing carrier arrangements, a catastrophe loss could impair the ability of one or more of our reinsurers to pay all of the reinsured claims, in which case we would be responsible for paying any claims not paid by our reinsurer(s). In our Lender Services business, it is possible that we may experience an unusual frequency of smaller losses in a particular period. In either case, the consequences could be substantial volatility in our financial condition or results of operations for any fiscal quarter or year, which could have a material and adverse effect on our business, financial condition, results of operations and prospects or our ability to write new business.

 

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Ongoing economic uncertainty could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Global economies and financial markets have experienced significant weakness and volatility since 2008, although the most extreme of these circumstances have abated since that time. Despite improved financial market performance since 2009, near-term U.S. economic prospects have only very gradually improved, with unemployment continuing at historically elevated levels. In addition, U.S. federal and state governments continue to experience significant structural fiscal deficits, creating uncertainty as to levels of taxation, inflation, regulation and other economic fundamentals that may impact future growth prospects. Significantly greater economic, fiscal and monetary uncertainty remains in Europe, due to the combination of poor economic growth, high unemployment and significant sovereign deficits. Continuation of these conditions may potentially affect (among other aspects of our business) the demand for and claims made under our products, the ability of clients, counterparties and others to establish or maintain their relationships with us, our ability to access and efficiently use internal and external capital resources and our investment performance. In the event that these conditions persist and result in a prolonged period of economic uncertainty, our business, financial condition, results of operations, our prospects and competitor landscape could be materially and adversely affected.

 

Our business is dependent on the efforts of our executive officers and other personnel.  If we are unsuccessful in our efforts to attract, train and retain qualified personnel, our business, financial condition, results of operations and prospects may be materially and adversely affected.

 

Our success is dependent on the efforts of our executive officers because of their industry expertise, knowledge of our markets, and relationships with our clients.  Our executive officers are Terry Ledbetter, Chairman, President and Chief Executive Officer, David Hale, Executive Vice President, Chief Operating Officer and Chief Financial Officer, John Pearson, Executive Vice President and National Sales Manager, Trace Ledbetter, Executive Vice President of Service, and David Cleff, Executive Vice President of Business Affairs, General Counsel and Secretary.  In connection with the private placement, we amended or entered into agreements with our executive officers that contain certain non-compete and non-solicit provisions.  Nonetheless, should any of our executive officers cease working for us, we may be unable to find acceptable replacements with comparable skills and experience in the niche markets that we target.  In addition, our business is also dependent on other skilled employees.  We cannot assure you that we will be able to attract, train and retain, on a timely basis and on anticipated economic and other terms, experienced and capable senior management, underwriters and support staff.  We intend to pay competitive salaries, bonuses and equity-based rewards in order to attract and retain such personnel, but there can be no assurance that we will be successful in such endeavors. The loss of key personnel, or the inability to recruit and retain qualified personnel in the future, could have a material adverse effect on our business, financial condition or operating results.  We do not currently maintain life insurance policies with respect to our executive officers or other employees.

 

If we are unable to maintain our technology platform or our technology platform fails to operate properly, or meet the technological demands of our clients with respect to the products and services we offer, our business, financial condition, results of operations and prospects could be materially and adversely affected.

 

If we are unable to properly maintain our InsurTrak system and the remainder of our technology systems or if our technology systems otherwise fail to perform in the manner we currently contemplate, our ability to effectively underwrite and issue policies, process claims and perform other business functions, and our CPI clients’ ability to track and manage their CPI programs, could be significantly impaired and our business, reputation and financial performance could be materially and adversely affected. In addition, the success of our business is dependent on our ability to resolve any issues identified with our technology arrangements during operations and make any necessary improvements in a timely manner. Further, we will need to match or exceed the technological capabilities of our competitors over time. We cannot predict with certainty the cost of such maintenance and improvements, but failure to make such improvements could have a material and adverse effect on our business, financial condition, results of operations and prospects. See “Business—Technology.”

 

Also, we use e-commerce and other technology to provide, expand and market our products and services. Accordingly, we believe that it will be essential to continue to invest resources in maintaining electronic connectivity with clients and, more generally, in e-commerce and technology. Our business may suffer if we do not maintain these arrangements or keep pace with the technological demands of our clients.

 

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If we experience security breaches or other disruptions involving our technology, our ability to conduct our business could be adversely affected, we could be liable to third parties and our reputation could suffer, which could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Our business is dependent upon the uninterrupted functioning of our information technology and telecommunication systems. We rely upon our systems, as well as the systems of our vendors, for all our business operations, including underwriting and issuing policies, processing claims, providing customer service, complying with insurance regulatory requirements and performing actuarial and other analytical functions necessary for underwriting, pricing and product development. Our operations are dependent upon our ability to timely and efficiently maintain and improve our information and telecommunications systems and protect them from physical loss, telecommunications failure or other similar catastrophic events, as well as from security breaches. A shut-down of, or inability to access, one or more of our facilities; a power outage; or a failure of one or more of our information technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis. In the event of a disaster such as a natural catastrophe, terrorist attack or industrial accident, or due to a computer virus, our systems could be inaccessible for an extended period of time. While we have implemented business contingency plans and other reasonable and appropriate internal controls to protect our systems from interruption, loss or security breaches, a sustained business interruption or system failure could adversely impact our ability to process our business, provide customer service, pay claims in a timely manner or perform other necessary business functions.

 

Our operations depend on the reliable and secure processing, storage and transmission of confidential and other information in our computer systems and networks. Computer viruses, hackers, employee misconduct and other external hazards could expose our data systems to security breaches, cyber-attacks or other disruptions. In addition, we routinely transmit and receive personal, confidential and proprietary information by electronic means. We have implemented security measures designed to protect against breaches of security and other interference with our systems and networks resulting from attacks by third parties, including hackers, and from employee or advisor error or malfeasance. We also assess and monitor the security measures of our third-party business partners, who in the provision of services to us are provided with or process information pertaining to our business or our clients. Despite these measures, we cannot assure that our systems and networks will not be subject to breaches or interference. Any such event may result in operational disruptions as well as unauthorized access to or the disclosure or loss of our proprietary information or our clients’ or insureds’ information, which in turn may result in legal claims, regulatory scrutiny and liability, reputational damage, the incurrence of costs to eliminate or mitigate further exposure, the loss of clients or affiliated advisors or other damage to our business. In addition, the trend toward broad consumer and general public notification of such incidents could exacerbate the harm to our business, financial condition and results of operations. Even if we successfully protect our technology infrastructure and the confidentiality of sensitive data, we could suffer harm to our business and reputation if attempted security breaches are publicized. We cannot be certain that advances in criminal capabilities, discovery of new vulnerabilities, attempts to exploit vulnerabilities in our systems, data thefts, physical system or network break-ins or inappropriate access, or other developments will not compromise or breach the technology or other security measures protecting the networks and systems used in connection with our business.

 

If we cannot sustain our business relationships, including our relationships with GAs, capacity providers and with clients in our Lender Service segment, we may be unable to compete effectively and operate profitably.

 

Our relationships with our clients are generally governed by agreements that may be terminated on short notice. As a result, our ability to compete and remain profitable depends, in part, on our maintaining business relationships with our clients, the marketing efforts of our sales professionals, the servicing efforts of our account managers and on our ability to offer insurance products and maintain financial strength ratings that meet the requirements and preferences of our clients. Any failure on our part to be effective in any of these areas may have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Performance of our investment portfolio is subject to a variety of investment risks that may materially and adversely affect our business, financial condition, results of operations and prospects.

 

Our results are affected, in part, by the performance of our investment portfolio. Our investment portfolio contains interest rate sensitive investments, such as fixed-income securities. As of June 30, 2014, our investment in fixed-income securities was approximately $190.0 million, or 98.7% of our total investment portfolio.  Increases in

 

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market interest rates may have an adverse impact on the value of our investment portfolio by decreasing the value of fixed-income securities. Conversely, declining market interest rates could have an adverse impact on our investment income as we invest positive cash flows from operations and as we reinvest proceeds from maturing and called investments in new investments that could yield lower rates than our investments have historically generated. Defaults in our investment portfolio may produce operating losses and materially and adversely impact our business, financial condition, results of operations and prospects.

 

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. Although we take measures to manage the risks of investing in a changing interest rate environment, we may not be able to mitigate interest rate sensitivity effectively. Our mitigation efforts include maintaining a high quality portfolio and managing the duration of the portfolio to reduce the effect of interest rate changes. Despite our mitigation efforts, a significant change in interest rates could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

In addition, the performance of our investment portfolio generally is subject to other risks, including the following:

 

·                  the risk of decrease in value due to a deterioration in the financial condition, operating performance or business prospects of one or more issuers of our fixed-income securities;

 

·                  the risk that our portfolio may be too heavily concentrated in the securities of one or more issuers, sectors or industries;

 

·                  the risk that we will not be able to convert investment securities into cash on favorable terms and on a timely basis; and

 

·                  general movements in the values of securities markets.

 

If our investment portfolio were to suffer a substantial decrease in value due to market, sector or issuer-specific conditions, our business, financial condition, results of operations and could be materially and adversely affected. A decrease in value of an insurance subsidiary’s investment portfolio could also put the subsidiary at risk of failing to satisfy regulatory minimum capital requirements and could limit the subsidiary’s ability to write new business.

 

The insurance industry is subject to extensive regulation, which may affect our ability to execute our business plan and grow our business.

 

We are subject to comprehensive regulation and supervision by government agencies in Texas and Delaware, states in which our insurance subsidiaries are domiciled, as well as all states in which they are licensed, sell insurance products, issue policies, or handle claims. Some states impose restrictions or require prior regulatory approval of specific corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policyholders and are not intended to protect the interests of shareholders. Our ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner is, and will continue to be, critical to our success. Some of these regulations include:

 

·                  Required Licensing. We operate under licenses issued by the insurance departments in the states in which we sell insurance. If a regulatory authority denies or delays granting a new license, our ability to enter that market quickly or offer new insurance products in that market may be substantially impaired. In addition, if the insurance department in any state in which we currently operate suspends, non-renews, or revokes an existing license, we would not be able to offer affected products in that state.

 

·                  Transactions Between Insurance Companies and Their Affiliates. Transactions between us or other of our affiliates and our insurance companies generally must be disclosed, and prior approval is required before any material or extraordinary transaction may be consummated. Approval may be refused or the time required to obtain approval may delay some transactions, which may adversely affect our ability to innovate or operate efficiently.  Our unregulated entities receive substantial payments for services rendered to our insurance

 

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company subsidiaries pursuant to arrangements approved by insurance regulators.  Changes in insurance regulation could materially and adversely affect the amount of cash flow we are able to generate outside of our insurance company subsidiaries.

 

·                  Regulation of Insurance Rates and Approval of Policy Forms. The insurance laws of most states in which we conduct business require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. If, as permitted in some states, we begin using new rates before they are approved, we may be required to issue refunds or credits to the policyholders if the new rates are ultimately deemed excessive or unfair and disapproved by the applicable insurance department. In other states, prior approval of rate changes is required and there may be long delays in the approval process or the rates may not be approved. Accordingly, our ability to respond to market developments or increased costs in that state could be adversely affected.

 

·                  Other Regulations. We must also comply with regulations involving, among other matters:

 

·                  the use of non-public consumer information and related privacy issues;

 

·                  the use of credit history in underwriting and rating policies;

 

·                  limitations on the ability to charge policy fees;

 

·                  limitations on types and amounts of investments;

 

·                  restrictions on the payment of dividends;

 

·                  the acquisition or disposition of an insurance company or of any company controlling an insurance company;

 

·                  involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;

 

·                  reporting with respect to financial condition; and

 

·                  periodic financial and market conduct examinations performed by state insurance department examiners.

 

The failure to comply with these laws and regulations may also result in regulatory actions, fines and penalties, and in extreme cases, revocation of our ability to do business in a particular jurisdiction. In the past we have been fined by state insurance departments for failing to comply with certain laws and regulations. In addition, we may face individual and class action lawsuits by insured and other parties for alleged violations of certain of these laws or regulations.

 

Regulation may become more extensive in the future, which may materially and adversely affect our business, financial condition, results of operations and prospects.

 

Compliance with applicable laws and regulations is time-consuming and personnel-intensive, and changes in these laws and regulations may materially increase our direct and indirect compliance and other expenses of doing business, thus materially and adversely affecting our business, financial condition, results of operations and prospects.

 

The National Association of Insurance Commissioners (“NAIC”) Creditor-Placed Insurance Model Act (“Model Act”) applies to insurance placed in connection with automobile loans and creates a legal framework within which creditor-placed insurance may be written and helps to maintain the separation between creditors and insurers.  It also serves to minimize the possibilities of unfair competitive practices in the sale of creditor-placed insurance. The Model Act has only been adopted by a few states, including Arkansas, Michigan, Mississippi and Tennessee, but other states have adopted regulations that cover creditor-placed insurance practices.  There could be an effort, especially from consumer groups, to expand the protections and breadth of the Model Act or similar regulations.  The NAIC Property and Casualty Insurance Committee is currently reviewing the Model Act and may make recommendations for changes later in 2014.  If changes are made to the Model Act or similar regulations that

 

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adversely affect our Lender Services business, our business, financial condition, results of operations and prospects could be materially and adversely affected.

 

In the future, states may make existing insurance laws and regulation more restrictive or enact new restrictive laws. In such event, we may seek to reduce our business in, or withdraw entirely from, these states. Additionally, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. Currently, the U.S. federal government does not directly regulate the property and casualty insurance business. However, Dodd-Frank Act established a Federal Insurance Office (“FIO”) within the Department of the Treasury. The FIO initially is charged with monitoring all aspects of the insurance industry (other than health insurance, certain long-term care insurance and crop insurance), gathering data, and conducting a study on methods to modernize and improve the insurance regulatory system in the United States. On December 12, 2013, the FIO issued a report (as required under the Dodd-Frank Act) entitled “How to Modernize and Improve the System of Insurance Regulation in the United States” (the “Report”), which stated that, given the “uneven” progress the states have made with several near-term state reforms, should the states fail to accomplish the necessary modernization reforms in the near term, “Congress should strongly consider direct federal involvement.” The FIO continues to support the current state-based regulatory regime, but will consider federal regulation should the states fail to take steps to greater uniformity (e.g., federal licensing of insurers). The Report also appears to signal greater activity by the federal government in dealing with non-U.S. regulators and regulatory regimes, using the authority expressly given by the Dodd-Frank Act to the U.S. Department of the Treasury and the United States Trade Representative to negotiate “covered agreements” with foreign authorities. We cannot predict what impact, if any, this guidance or any new legislation would have on our business, financial condition and results of operations. See “Regulation—Federal and State Legislative and Regulatory Changes.”

 

Our holding company structure and certain regulatory and other constraints, including adverse business performance, could affect our ability to satisfy our obligations.

 

We are a holding company and conduct our business operations through our various subsidiaries. Our principal sources of funds are dividends and other payments from our subsidiaries, income from our investment portfolio and funds that may be raised from time to time in the capital markets. We will be largely dependent on amounts from our subsidiaries to pay principal and interest on any indebtedness that we may incur, to pay holding company operating expenses, to make capital investments in our other subsidiaries and to pay dividends on our common stock.

 

Our insurance subsidiaries are subject to statutory requirements as to maintenance of policyholders’ surplus and payment of dividends, including in their states of domicile of Texas and Delaware.  In general, the maximum amount of dividends that the insurance subsidiaries may pay in any 12-month period without regulatory approval is the greater of adjusted statutory net income or 10% of statutory policyholders’ surplus as of the preceding calendar year end. Adjusted statutory net income is generally defined for this purpose to be statutory net income, net of realized capital gains, for the calendar year preceding the date of the dividend. In addition, other states may limit or restrict our insurance subsidiaries’ ability to pay shareholder dividends generally or as a condition to issuance of a certificate of authority. See “Regulation—State Insurance Regulation.”

 

We may require additional capital in the future and such additional capital may not be available to us, or only available to us on unfavorable terms.

 

Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. To the extent that the funds generated by our ongoing operations and initial capitalization are insufficient to fund future operating requirements, we may need to raise additional funds through financings or curtail our growth and reduce our assets. We cannot be sure that we will be able to raise equity or debt financing on terms favorable to us and our shareholders and in the amounts that we require, or at all. If we cannot obtain adequate capital, our business, financial condition, results of operations and prospects could be materially and adversely affected.

 

In addition, the terms of a capital raising transaction could require us to agree to stringent financial and operating covenants and to grant security interests on our assets to lenders or holders of our debt securities that could limit our flexibility in operating our business or our ability to pay dividends on our common stock and could make it more difficult for us to obtain capital in the future.

 

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The rates we charge under the policies we write in our Program Services segment and our Lender Services segment are subject to prior regulatory approval in most of the states in which we operate.

 

In most of the states in which we operate, we must obtain prior regulatory approval of insurance rates charged to our insureds and our clients’ insureds, including any increases in those rates. If we are unable to receive approval for the rate changes we request, or if such approval were delayed, our ability to operate our business in a profitable manner may be limited and our financial condition, results of operations, and liquidity may be adversely affected.

 

The effects of emerging claim and coverage issues on our business are uncertain and negative developments in this area could have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may materially and adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until after we have issued insurance policies that are affected by the changes. As a result, the full extent of our liability under an insurance policy may not be known until many years after the policy is issued. Changes of this nature may expose us to higher claims than we anticipated when we wrote the underlying policy. Unexpected increases in our claim costs many years after policies are issued may also result in our inability to recover from certain of our reinsurers the full amount that they would otherwise owe us for such claims costs because certain of the reinsurance agreements covering our business include commutation clauses that permit the reinsurers to terminate their obligations by making a final payment to us based on an estimate of their remaining liabilities. In addition, the potential passage of new legislation designed to expand the right to sue, to remove limitations on recovery, to deem by statute the existence of a covered occurrence, to extend the statutes of limitations or otherwise repeal or weaken tort reforms could have an adverse impact on our business. The effects of these and other unforeseen emerging claim and coverage issues are extremely hard to predict and could be harmful to our business and have a material adverse effect on our results of operations.

 

We rely on the use of credit scoring in pricing and underwriting certain of our insurance policies and any legal or regulatory requirements that restrict our ability to access credit score information could decrease the accuracy of our pricing and underwriting process and thus decrease our ability to be profitable.

 

We use credit scoring as a factor in pricing and underwriting decisions where allowed by state law. Consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against some groups of people and are calling for laws and regulations to prohibit or restrict the use of credit scoring in underwriting and pricing. Laws or regulations that significantly curtail or regulate the use of credit scoring, if enacted in a large number of states in which we operate, could impact the integrity of our pricing and underwriting process, which could, in turn, materially and adversely affect our business, financial condition, results of operations and prospects, and make it harder for us to be profitable over time.

 

Assessments and other surcharges for guaranty funds, second-injury funds, catastrophe funds, and other mandatory pooling arrangements for insurers may reduce our profitability.

 

Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insured parties as the result of impaired or insolvent insurance companies. In addition, as a condition to the ability to conduct business in various states, our insurance subsidiaries must participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various types of insurance coverage to individuals or entities that otherwise are unable to purchase that coverage from private insurers. The effect of these assessments and mandatory shared-market mechanisms or changes in them could reduce our profitability in any given period or limit our ability to grow our business.

 

The effects of litigation on our business are uncertain and could have a material and adverse effect on our business, financial condition, results of operation and prospects.

 

Although we are not currently involved in any material litigation with our clients or insureds, other members of the insurance industry are the target of class action lawsuits and other types of litigation, some of which involve claims for substantial or indeterminate amounts, and the outcomes of which are unpredictable. This litigation is

 

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based on a variety of issues, including insurance and claim settlement practices. We cannot predict with any certainty whether we will be involved in such litigation in the future or what impact such litigation would have on our business.

 

Risks Related to an Investment in Our Common Stock

 

There is currently no public market for our common stock, and an active public trading market for our common stock may not develop.

 

Currently, there is no established public trading market for our common stock.  FBR has informed us that once the registration statement of which this prospectus is a part is declared effective and our common stock is listed on the NASDAQ Global Select Market, our common stock will not continue to trade through the FBR PlusTM System.  Our common stock has been approved for listing on the NASDAQ Global Select Market under the symbol “SNC.”  However, we cannot assure you that an active public trading market for the shares will develop.  Accordingly, we cannot assure you as to:

 

·                  the likelihood that an active market will develop for our common stock;

 

·                  the liquidity of any such market;

 

·                  the ability of our shareholders to sell their shares of our common stock; or

 

·                  the price that our shareholders may obtain for their shares of our common stock.

 

If an active public trading market does not develop or is not maintained, holders of the shares may experience difficulty in reselling, or an inability to sell, the shares. Future trading prices for the shares may be adversely affected by many factors, including changes in our financial performance, changes in the overall market for similar shares and performance or prospects for companies in our industry.

 

The price of our common stock could be volatile

 

Upon the effective date of the registration statement of which this prospectus is a part, we expect our common stock to be listed on the NASDAQ Global Select Market.  However, the market price for shares of our common stock may be highly volatile and you may not be able to resell your shares of our common stock at or above the price you paid to purchase the shares or at all. Our performance, as well as government regulatory action, interest rates and general market conditions, could have a significant impact on the future market price of our common stock.  Some of the factors that could negatively affect our share price or result in fluctuations in the price of our common stock include:

 

·                  our operating results in any future quarter not meeting the expectations of market analysts or investors;

 

·                  reductions in our earnings estimates by us or market analysts;

 

·                  publication of negative research or other unfavorable publicity or speculation in the press or investment community about our company or the insurance industry in general;

 

·                  increases in interest rates causing investors to demand a higher yield or return on investment than an investment in our common stock may be projected to provide;

 

·                  changes in market valuations of similar companies;

 

·                  additions or departures of key personnel;

 

·                  changes in the economic or regulatory environment in the markets in which we operate;

 

·                  the occurrence of any of the other risk factors presented in this prospectus; and

 

·                  general market, economic and political conditions.

 

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Prior to the completion of the private placement, we were treated for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code, and claims of taxing authorities related to our prior status as an “S” corporation could harm us.

 

Upon completion of the private placement, our parent company’s “S” corporation status terminated, and State National became treated as a “C” corporation under “Subchapter C” of the income tax provisions of the Internal Revenue Code of 1986, as amended (the “Code”), which is applicable to most corporations and treats the corporation as an entity that is separate and distinct from its shareholders. If the open tax years in which State National was treated as an “S” corporation were audited by the Internal Revenue Service, and we are determined not to have qualified for, or to have violated, our “S” corporation status, we will be obligated to pay back taxes, interest and penalties, and we do not have the right to reclaim tax distributions that we have made to our shareholders during those periods. These amounts could include taxes on all of our taxable income while State National was treated as an “S” corporation. Any such claims could result in additional costs to us and could have a material adverse effect on our results of operations and financial condition.

 

We have entered into a tax indemnification agreement with our current shareholders and could become obligated to make payments to them for any additional federal, state or local income taxes assessed against them for fiscal periods prior to the completion of the private placement.

 

Prior to the completion of the private placement, our parent company and its pass-through subsidiaries were treated as an “S” corporation for U.S. federal income tax purposes. Upon the completion of the private placement, such “S” corporation status terminated, and State National became subject to federal and increased state income taxes. In the event of an adjustment to our reported taxable income for a period or periods prior to termination of our “S” corporation status, persons who held shares of our common stock during the time in which it was treated as an “S” corporation could be liable for additional income taxes for those prior periods. Therefore, prior to the completion of the private placement we entered into a tax indemnification agreement with our shareholders, who we refer to as our S Corporation Shareholders. Pursuant to the tax indemnification agreement, we will pay each such shareholder on an after-tax (or grossed-up) basis the amount of additional income taxes plus interest and penalties due as a result of adjustments (pursuant to a determination by, or a settlement with, a taxing authority or court, or pursuant to the filing of an amended tax return) to the taxable income of our parent company with respect to taxable periods during which it filed as an “S” corporation. The payments we could be required to make will be reduced by certain tax benefits that may be available to our S Corporation Shareholders as a result of such adjustments. Such payments will also include any reasonable out-of-pocket expenses incurred by the S Corporation Shareholders arising out of a claim for such tax liability.

 

In order to comply with the requirements of being a public company we will have to enhance certain of our corporate and financial processes, which will require significant company resources and management attention.

 

Following the effectiveness of the registration statement of which this prospectus is a part, we will be a public company. As a public company with listed equity securities, we will need to comply with new laws, regulations and requirements, certain corporate governance provisions of The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), periodic reporting requirements of the Exchange Act and other regulations of the SEC and the requirements of the NASDAQ Global Select Market, with which we are not required to comply as a private company.  In order to comply with these laws, rules and regulations, we will have to enhance certain of our corporate processes, which will require us to incur significant legal, accounting and other expenses.  These efforts will also require a significant amount of time from our board of directors and management, possibly diverting their attention from the implementation of our business plan and growth strategy.  We will need to, among other things:

 

·                  institute a more comprehensive compliance function;

 

·                  hire additional qualified personnel in our finance and accounting departments;

 

·                  design, establish, evaluate and maintain a system of internal controls over financial reporting in compliance with the requirements of Section 404 of Sarbanes-Oxley and the related rules and regulations of the SEC and the Public Company Accounting Oversight Board;

 

·                  comply with rules promulgated by the NASDAQ Global Select Market;

 

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·                  prepare and distribute annual, quarterly and other periodic public reports in compliance with our obligations under the federal securities laws;

 

·                  establish new internal policies, such as those relating to disclosure controls and procedures and insider trading;

 

·                  involve and retain to a greater degree outside counsel and accountants in the foregoing activities; and

 

·                  establish an investor relations function.

 

We have made, and will continue to make, changes to our corporate governance standards, disclosure controls, financial reporting and accounting systems to meet our obligations as a public company.  We cannot assure you that the changes we have made and will continue to make to satisfy our obligations as a public company will be successful.  During the audit of our financial statements for the year ended December 31, 2013, we identified a deficiency in internal controls that we considered to be a control deficiency and a material weakness.  A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. The material weakness identified related to our incorrectly classifying treasury bills purchased with a maturity date greater than three months, but less than one year, as cash and cash equivalents for 2012 and 2011. Under GAAP, these securities should have been reported as short-term investments.  This classification issue also impacted the statements of cash flows for 2013, 2012, and 2011 and a restatement was required to our previously issued consolidated financial statements for the years ended 2013, 2012 and 2011.  In response to this material weakness, we have established a more detailed accounting of our cash-equivalent and short-term securities in our financial reporting system and review the individual securities included in each category at the end of each reporting period.

 

Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our reputation and operating results could be harmed. It is possible that we or our independent auditors may identify additional control deficiencies or material weaknesses in our internal control over financial reporting in the future. Any failure or difficulties in implementing and maintaining these controls could cause us to fail to meet the periodic reporting obligations that we will become subject to if and when our common stock becomes listed on a national securities exchange, or result in material misstatement in our financial statements. The existence of a material weakness could result in errors to our financial statements requiring a restatement of our financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, which could lead to a decline in our stock price, delisting of our common stock, fines, sanctions and other regulatory action and potential litigation. We have not assessed the effectiveness of our disclosure controls and procedures or our internal controls over financial reporting, and because we are an “emerging growth company” as discussed below, we likely will not be required to conduct this assessment for some period of time.

 

We are an “emerging growth company” and are likely to remain one for some period of time.   As a result, our shareholders likely will not have the benefit of certain protective provisions that would otherwise apply to most public companies.

 

The JOBS Act became law in 2012.  The JOBS Act “IPO On-Ramp” provisions provide that companies with less than $1.0 billion of total annual gross revenues (“emerging growth companies”) will be exempted from certain disclosure requirements for up to five years following their initial public offerings.  An emerging growth company would be subject to reduced requirements during this period, including:

 

·                  fewer years of required financial statements in its registration statement (two years compared to three years by non-emerging growth companies);

 

·                  no requirement to present selected financial data for periods preceding the earliest audited period required to be presented in the registration statement for a company’s initial public offering;

 

·                  exemption from the requirements under Section 404(b) of the Sarbanes-Oxley Act for auditor attestation relating to internal control over financial reporting;

 

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·                  grandfather provisions allowing a company to forgo compliance with new or revised financial statement or auditing requirements; and

 

·                  reduced executive compensation disclosure, including reduction of the number of executive officers whose compensation is required to be described, fewer years of required disclosure, exemption from the requirement to include a compensation disclosure and analysis section and exemption from certain provisions of the Dodd-Frank Act relating to “say-on-pay,” “pay-for-performance,” comparative pay and golden parachutes.

 

As a result, for at least some period of years, our shareholders likely will not have the benefit of certain protective provisions and additional disclosures that would otherwise apply to most public companies.

 

If we become publicly traded, our senior executive officers and several of our directors may not be able to organize and effectively manage a publicly traded operating company, which could adversely affect our overall financial condition.

 

Our senior executive officers and a number of our directors have not served in those capacities with publicly traded operating companies and may not be successful in doing so. The demands of organizing and managing a publicly traded operating company are much greater than those relating to a private company, and some of our senior executive officers and directors may not be able to meet those increased demands. Failure to organize and effectively manage our business could materially and adversely affect our overall financial condition.

 

Future sales and issuances of shares of our capital stock may depress our share price.

 

We may in the future issue our previously authorized and unissued securities. We have an authorized capitalization of 150 million shares of our common stock and 10 million shares of preferred stock with such designations, preferences and rights as are contained in our charter or bylaws and as determined by our board of directors. Issuances of stock may result in dilution of our existing shareholders or a decrease in the per share price of our common stock. It is not possible to state the actual effect of the issuance of any shares of our preferred stock on the rights of holders of our common stock until our board of directors determines the specific rights attached to that class or series of preferred stock.

 

We cannot predict what effect, if any, future sales of our common stock, or the availability of shares for future sale, will have on the price prospective buyers are willing to pay for our common stock. Sales of a substantial number of shares of our common stock by us or our shareholders, or the perception that such sales could occur, may adversely affect the price prospective buyers are willing to pay for our common stock and may make it more difficult for you to sell your shares at a time and price that you determine appropriate. See “Shares Available for Future Sale” for further information regarding circumstances under which additional shares of our common stock may be sold.

 

Provisions contained in our organizational documents, as well as provisions of Delaware law, contractual agreements and compensation arrangements, could delay or prevent a change of control of us, which could adversely affect the price of shares of our common stock.

 

Our bylaws and Delaware law contain provisions that could have the effect of rendering more difficult or discouraging an acquisition deemed undesirable by our board of directors. Our corporate governance documents include provisions that:

 

·                  provide that special meetings of our shareholders generally can only be called by the chairman of the board of directors, the chief executive officer, the president or by a resolution approved by our board of directors;

 

·                  provide our board of directors the ability to issue undesignated preferred stock, the terms of which may be established and the shares of which may be issued without shareholder approval, and which may grant preferred holders super voting, special approval, dividend or other rights or preferences superior to the rights of the holder of common stock;

 

·                  eliminate the ability of shareholders to act by written consent in lieu of a meeting;

 

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·                  provide our board of directors the ability to issue common stock and warrants within the amount of authorized capital; and

 

·                  provide that shareholders seeking to bring business before our annual meeting of shareholders, or to nominate candidates for election as directors at our annual meeting of shareholders, generally must provide timely advance notice of their intent in writing and certain other information not less than 90 days nor more than 120 days prior to the one-year anniversary of the date of the preceding year’s annual meeting of shareholders.

 

In addition, some of our agreements, such as our alliance agreement with CUNA Mutual, and some of our incentive plans contain change of control provisions.  In addition, we have certain severance agreements with executives that provide for payments following a change of control.

 

The provisions discussed above, alone or together, could delay hostile takeovers and changes of control of our company or changes in our management, even if such transactions would be beneficial to our shareholders.

 

As a Delaware corporation, we will also be subject to anti-takeover provisions of Delaware law. The Delaware General Corporation Law (“DGCL”) provides that shareholders are not entitled to cumulative voting rights in the election of directors unless a corporation’s certificate of incorporation provides otherwise. Our certificate of incorporation does not provide for cumulative voting in the election of directors.

 

In addition, we are subject to Section 203 of the DGCL, which, subject to certain exceptions, prohibits a public Delaware corporation from engaging in a business combination (as defined in such section) with an “interested shareholder” (defined generally as any person who beneficially owns 15% or more of the outstanding voting stock of such corporation or any person affiliated with such person) for a period of three years following the time that such shareholder became an interested shareholder, unless: (1) prior to such time, the board of directors of such corporation approved either the business combination or the transaction that resulted in the shareholder becoming an interested shareholder; (2) upon consummation of the transaction that resulted in the shareholder becoming an interested shareholder, the interested shareholder owned at least 85% of the voting stock of such corporation at the time the transaction commenced (excluding for purposes of determining the voting stock outstanding (but not the outstanding voting stock owned by the interested shareholder) the voting stock owned by directors who are also officers or held in employee benefit plans in which the employees do not have a confidential right to tender or vote stock held by the plan); or (3) on or subsequent to such time the business combination is approved by the board of directors of such corporation and authorized at a meeting of shareholders by the affirmative vote of at least two-thirds of the outstanding voting stock of such corporation not owned by the interested shareholder.

 

Any provision of our certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our shareholders to receive a premium for their shares of common stock, and could also affect the price that some investors are willing to pay for shares of our common stock. See “Description of Capital Stock—Certain Anti-Takeover Effects of Provisions of Our Organizational Documents and Delaware Law.”

 

Applicable insurance laws may make it difficult to effect a change of control of our company.

 

State insurance holding company laws require prior approval by the respective state insurance departments of any change of control of an insurer. “Control” is generally defined as the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the Company, whether through the ownership of voting securities, by contract or otherwise. Control is generally presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or any entity that controls a domestic insurance company. Any person wishing to acquire control of us or of any substantial portion of our outstanding shares would first be required to obtain the approval of the domestic regulators (including those asserting “commercial domicile”) of our insurance subsidiaries or file appropriate disclaimers.

 

These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including through transactions, and in particular unsolicited transactions, that some or all of our shareholders might consider to be desirable.  See “Regulation—Holding Company Regulation—Change of Control.”

 

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Future issuance of debt or preferred stock, which would rank senior to our common stock upon our liquidation, and future offerings of equity securities, which would dilute our existing shareholders, may adversely affect the market value of our common stock.

 

In the future, we may attempt to increase our capital resources by issuing debt or making additional offerings of equity securities, including bank debt, commercial paper, medium-term notes, senior or subordinated notes and classes of shares of preferred stock. Upon liquidation, holders of our debt securities and preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of shares of our common stock. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market value of our common stock, or both. Our preferred stock, if issued, could have a preference on liquidating distributions or a preference on dividend payments that would limit amounts available for distribution to holders of shares of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, holders of shares of our common stock bear the risk of our future offerings reducing the market value of our common stock and diluting their stockholdings in us.

 

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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

 

Various statements contained in this prospectus, including those that express a belief, expectation or intention, as well as those that are not statements of historical fact, are forward-looking statements. These forward-looking statements may include projections and estimates concerning the timing and success of specific projects and our future production, revenues, income and capital spending. Our forward-looking statements are generally, but not always, accompanied by words such as “estimate,” “project,” “predict,” “believe,” “expect,” “anticipate,” “potential,” “should,” “would,” “may,” “plan,” “goal,” “target,” “can,” “could,” “continuing,” “ongoing,” “intend” or other words that convey the uncertainty of future events or outcomes. While our management considers these expectations and assumptions to be reasonable, they are inherently subject to significant business, economic, competitive, regulatory and other risks, contingencies and uncertainties, most of which are difficult to predict and many of which are beyond our control.

 

Examples of forward-looking statements include the plans and objectives of management for future operations, including those relating to future growth of our business, and are based on current expectations that involve assumptions that are difficult or impossible to predict accurately and 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, our ability to recover from our capacity providers, the cost and availability of reinsurance coverage, challenges to our use of issuing carrier or fronting arrangements by regulators or changes in state or federal insurance or other statutes or regulations, our dependence on a limited number of business partners, potential regulatory scrutiny of lender-placed automobile insurance, level of new car sales, availability of credit for vehicle purchases and other factors affecting automobile financing, our ability to compete effectively, a downgrade in the financial strength ratings of our insurance subsidiaries, our ability to accurately underwrite and price our products and to maintain and establish accurate loss reserves, changes in interest rates or other changes in the financial markets, the effects of emerging claim and coverage issues, changes in the demand for our products, the effect of general economic conditions, breaches in data security or other disruptions with our technology, and changes in pricing or other competitive environments.

 

The forward-looking statements in this prospectus speak only as of the date of this prospectus, 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.

 

These and other important factors, including those discussed under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements.

 

Any or all of our forward-looking statements in this prospectus may turn out to be inaccurate. The inclusion of this forward-looking information should not be regarded as a representation by us, FBR Capital Markets & Co. or any other person that the future plans, estimates or expectations contemplated by us will be achieved. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs.

 

All forward-looking statements are necessarily only estimates of future results, and there can be no assurance that actual results will not differ materially from expectations, and, therefore, you are cautioned not to place undue reliance on such statements. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this prospectus.

 

USE OF PROCEEDS

 

We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders pursuant to this prospectus.

 

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DIVIDEND POLICY

 

Prior to the completion of the private placement, it was our policy to pay dividends to our shareholders. Historically, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and their intermediate holding company) to be pass-through entities for federal income tax purposes. We historically made periodic cash distributions to our shareholders that included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses. Upon completion of the private placement, State National became taxable as a “C” corporation and has discontinued the manner in which it previously made periodic distributions to its shareholders, including distributions to provide shareholders with funds to pay their estimated personal U.S. federal income tax liabilities.

 

The following table shows recent quarterly dividends that have been paid on our common stock with respect to the periods indicated. The per share amounts set forth in the following table have been adjusted to give effect to the 736 for 1 stock split that we effected prior to the completion of the private placement. Accordingly, the per share amounts are presented to the nearest hundredth of a cent and are not representative of the amount of any future dividends we may pay.

 

($ in thousands, except for
share information)

 

Amount Per
Share

 

Total
Dividend

 

 

 

 

 

 

 

First Quarter 2012

 

$

0.30

 

$

10,244

 

Second Quarter 2012

 

0.04

 

1,211

 

Third Quarter 2012

 

0.02

 

565

 

Fourth Quarter 2012

 

0.06

 

2,156

 

First Quarter 2013

 

0.19

 

6,593

 

Second Quarter 2013

 

0.13

 

4,389

 

Third Quarter 2013

 

0.05

 

1,565

 

Fourth Quarter 2013

 

0.08

 

2,748

 

First Quarter 2014

 

0.34

 

11,519

 

Second Quarter 2014

 

0.14

 

4,721

 

 

We intend to commence the payment of a $0.01 per share cash dividend on a quarterly basis to our shareholders of record beginning in the fourth quarter of 2014 based on third quarter earnings. Any declaration and payment of dividends that may be approved by our board of directors will depend on many factors, including general economic and business conditions, our strategic plans, our financial results and condition, legal and regulatory requirements and other factors that our board of directors deems relevant.  Our board of directors may eliminate the payment of future dividends at its discretion, without notice to our shareholders.

 

State National Companies, Inc. is a holding company and has no direct operations.  Our ability to pay dividends in the future depends on the ability of our operating subsidiaries, including our insurance subsidiaries, to pay dividends to us. The laws of the jurisdictions in which our insurance subsidiaries are organized regulate and restrict, under certain circumstances, their ability to pay dividends to us. However, our agency, T.B.A. Insurance Group, Ltd. (“TBA”), is not statutorily restricted from paying dividends to us.  In addition, future debt agreements may contain certain prohibitions or limitations on the payment of dividends.  See “Risk Factors—Risks Relating to Our Business Generally—Our holding company structure and certain regulatory and other constraints, including adverse business performance, could affect our ability to satisfy our obligations.”

 

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CAPITALIZATION

 

The following table shows our capitalization as of June 30, 2014.  You should refer to “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the historical and pro forma financial information included elsewhere in this prospectus in evaluating the material presented below.

 

 

 

As of 
June 30,

 

($ in thousands)

 

2014

 

Debt outstanding:

 

 

 

Subordinated debentures

 

$

52,000

 

Shareholders’ equity:

 

 

 

Common stock: par value $0.001 per share; 150,000,000 shares authorized; 44,208,602 shares issued and outstanding

 

44

 

Preferred stock: par value $0.001 per share; 10,000,000 shares authorized; no shares issued and outstanding

 

 

Additional paid-in capital

 

218,605

 

Retained Earnings

 

2,745

 

Accumulated other comprehensive income

 

3,985

 

Total shareholders’ equity

 

225,379

 

Total capitalization

 

$

277,379

 

 

The table does not reflect:

 

·      2,783,873 shares of common stock issuable upon the exercise of stock options granted to our executive officers and other employees upon completion of the private placement, at an exercise price of $10.00;

 

·      1,585,627 additional shares of common stock available for future issuance under our 2014 Stock Incentive Plan; and

 

·      38,500 shares of common stock issued on July 9, 2014 to certain of our employees under our 2014 Stock Incentive Plan.

 

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SELECTED FINANCIAL DATA

 

The following tables set forth our selected historical consolidated financial information for the periods ended and as of the dates indicated. These selected historical consolidated results are not necessarily indicative of results to be expected in any future period. You should read the following selected consolidated financial information together with the other information contained in this prospectus, including the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this prospectus.

 

The income statement data for the years ended December 31, 2013, 2012 and 2011 and the balance sheet data as of December 31, 2013 and 2012 are derived from our audited financial statements included elsewhere in this prospectus.  The income statement data for the years ended December 31, 2010 and 2009 and the balance sheet data as of December 31, 2011, 2010 and 2009 are derived from our audited financial statements that are not included in this prospectus. The income statement data for the six months ended June 30, 2014 and 2013 and the balance sheet data as of June 30, 2014 and 2013 are each derived from our unaudited financial statements included elsewhere in this prospectus.  Our unaudited consolidated condensed financial statements have been prepared on the same basis as our audited consolidated financial statements and, in our opinion, include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of such financial statements in all material respects.  The results of any interim period are not necessarily indicative of results that may be expected for a full year or any future period.

 

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($ in thousands, except

 

For the six months ended
June 30,

 

For the years ended
December 31,

 

for share information)

 

2014

 

2013

 

2013

 

2012

 

2011

 

2010

 

2009

 

OPERATING RESULTS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross written premium (1)

 

$

491,375

 

$

297,176

 

$

809,965

 

$

634,821

 

$

712,834

 

$

668,353

 

$

675,619

 

Net written premium (1)

 

40,674

 

36,810

 

86,773

 

79,165

 

80,303

 

88,598

 

92,209

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Premiums earned

 

43,986

 

39,482

 

84,378

 

78,096

 

81,974

 

90,244

 

93,062

 

Ceding fees (2)

 

20,858

 

13,695

 

32,898

 

32,379

 

30,455

 

31,010

 

33,179

 

Total revenues

 

70,930

 

58,723

 

128,503

 

122,123

 

124,749

 

132,589

 

137,840

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash from operating activities

 

(18,141

)

(6,447

)

33,856

 

27,060

 

30,296

 

34,464

 

21,521

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reconciliation of adjusted net income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(2,793

)

$

1,788

 

$

22,711

 

$

15,882

 

$

27,906

 

$

26,040

 

$

20,814

 

Plus (less): Provision for income taxes to reflect change to C corporation status (3)

 

3,957

 

589

 

(6,938

)

(2,980

)

(6,779

)

(5,762

)

(3,854

)

Less: Recognition of deferred tax asset upon conversion to C corporation (4)

 

14,460

 

 

 

 

 

 

 

Plus: Founder special compensation (5) (6)

 

11,160

 

6,311

 

6,311

 

6,749

 

443

 

4,929

 

2,815

 

Plus: Offering-related expenses (6)

 

4,441

 

 

 

 

 

 

 

Plus: Contract modification expense (6) (8)

 

11,090

 

 

 

 

 

 

 

Adjusted net income (7)

 

$

13,395

 

$

8,688

 

$

22,084

 

$

19,651

 

$

21,570

 

$

25,207

 

$

19,775

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

FINANCIAL CONDITION

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments and cash and cash equivalents

 

$

317,954

 

$

218,038

 

$

252,686

 

$

241,008

 

$

228,933

 

$

214,686

 

$

195,369

 

Reinsurance recoverables (9)

 

1,491,994

 

1,267,910

 

1,372,225

 

1,201,053

 

1,074,404

 

934,564

 

809,116

 

Total assets

 

1,893,577

 

1,541,399

 

1,690,951

 

1,497,528

 

1,366,412

 

1,214,400

 

1,064,089

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unpaid losses and loss adjustment expenses

 

1,076,235

 

1,042,832

 

1,016,641

 

975,708

 

806,125

 

706,291

 

588,490

 

Unearned premiums

 

442,262

 

249,090

 

386,279

 

253,638

 

293,924

 

257,546

 

254,941

 

Allowance for policy cancellations (10)

 

35,054

 

29,203

 

39,623

 

32,775

 

27,511

 

27,646

 

24,296

 

Subordinated debentures

 

52,000

 

52,000

 

52,000

 

52,000

 

52,000

 

52,000

 

52,000

 

Total shareholders’ equity

 

225,379

 

129,373

 

145,354

 

142,223

 

140,087

 

128,516

 

108,549

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SHARE INFORMATION

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

(0.08

)

$

0.05

 

$

0.66

 

$

0.46

 

$

0.82

 

$

0.76

 

$

0.61

 

Diluted earnings per share

 

(0.08

)

0.05

 

0.66

 

0.46

 

0.82

 

0.76

 

0.61

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends paid

 

16,240

 

10,982

 

15,295

 

14,176

 

17,958

 

7,701

 

9,291

 

Basic weighted average shares outstanding

 

34,455,221

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

Diluted weighted average shares outstanding

 

34,455,221

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

34,176,896

 

 


(1)   The CPI premiums written presented in this document reflect the effects of the allowance for policy cancellations, including any adjustments related to re-estimation of the allowance.  As such, the CPI premiums written are those that we expect to earn, which we refer to as “stick premiums,” while those that are expected to cancel are included in the allowance for policy cancellations.

 

(2)   Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross earned premium on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured.  Typically, the reinsured policies have a term of one year.  Ceding commissions earned on Lender Services business are not included as ceding fees.  CUNA Mutual’s ceding commission is included as a partial offset to commission expense.

 

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(3)   Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes.  This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented.  The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2%, 35.7%, 35.5% and 34.1% for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

(4)   As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.5 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions. This excludes the tax effect related to contract modification expense as discussed in note (8) below.

 

(5)   During the periods presented, we made special compensation payments to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter, in recognition of their service to our Company.  We refer to these payments as “Founder special compensation.”  Following the completion of the private placement, we no longer pay Founder special compensation, as Lonnie Ledbetter has retired, and the bonus compensation for the remainder of 2014 for Terry Ledbetter, who now serves as our Chairman, President and Chief Executive Officer, will be determined based on 2014 performance goals.  See “Executive Compensation—Executive Incentive Plans.”

 

(6)   Founder special compensation, offering-related expenses, and contract modification expense are shown net of the estimated tax benefit for each period presented.  The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2%, 35.7%, 35.5% and 34.1% for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

(7)   Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual.  Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods.  Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.

 

(8)   In connection with the recent amendment to the alliance agreement with CUNA Mutual, we agreed to pay CUNA Mutual $17.8 million.  As a result, we recorded contract modification expense of $17.8 million, or $11.1 million net of tax benefit.

 

(9)   Our reinsurance recoverables are based on estimates, and our actual liabilities may exceed the amount that we are able to recover from our reinsurers or any collateral securing the liabilities. This could occur because the loss experience based on the policy terms is higher than expected or due to litigation, regulatory or other extra-contractual liabilities.  SNIC, NSIC, and USIC remain liable for unearned premiums and unpaid losses and loss adjustment expenses with respect to reinsurance ceded should the reinsurer be unable to meet its obligations. Management considers the possibility of a reinsurer becoming unable to meet its obligations as remote due to the reinsurers’ financial stability, A.M. Best Company rating, size, security funds available, and other factors as appropriate.

 

Following is a summary of these balances as of:

 

 

 

June 30,

 

December 31,

 

($ in thousands)

 

2014

 

2013

 

2013

 

2012

 

2011

 

2010

 

2009

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ceded unearned premiums

 

$

424,628

 

$

233,210

 

$

365,333

 

$

235,088

 

$

276,443

 

$

238,394

 

$

234,142

 

Ceded loss and loss adjustment expense reserves

 

1,067,366

 

1,034,700

 

1,006,892

 

965,965

 

797,961

 

696,170

 

574,974

 

Total reinsurance recoverables

 

1,491,994

 

1,267,910

 

1,372,225

 

1,201,053

 

1,074,404

 

934,564

 

809,116

 

Secured reinsurance recoverables

 

(1,125,792

)

(918,020

)

(1,014,947

)

(851,045

)

(590,609

)

(451,151

)

(520,903

)

Unsecured reinsurance recoverables

 

$

366,202

 

$

349,890

 

$

357,278

 

$

350,008

 

$

483,795

 

$

486,413

 

$

288,213

 

 

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(10) An allowance for policy cancellations is provided for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes that will be incurred on expected future policy cancellations associated with the Company’s CPI business. Premiums and cancellation data are accumulated by accounting month (month in which the premium was written/collected), lending institution and at the corporate level.  The estimation methodology utilizes actual cancellation rates (premium refunds divided by premiums written by accounting month) to determine expected future cancellations for that accounting month. The estimate for each accounting month decreases each subsequent month as actual refunds emerge.  While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are reviewed quarterly by Management, and any changes are reflected in current operations.

 

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Table of Contents

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-Looking and Other Statements

 

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this prospectus. This discussion includes forward-looking statements that are subject to risks, uncertainties and other factors described under the captions “Risk Factors” and “Cautionary Statement Concerning Forward-Looking Statements.” These factors could cause our actual results to differ materially from those expressed in, or implied by, those forward-looking statements.

 

Overview

 

We are a leading specialty provider of property and casualty insurance operating in two niche markets across the United States.  In our Program Services segment, we leverage our “A” (Excellent) A.M. Best rating, expansive licenses and reputation to provide access to the U.S. property and casualty insurance market in exchange for a ceding fee.  In our Lender Services segment, we specialize in providing collateral protection insurance, or CPI, which insures personal automobiles, light trucks, SUVs and other vehicles held as collateral for loans made by credit unions, banks, specialty lenders and other financial institutions.

 

Our Program Services segment generates significant fee income, in the form of ceding fees, by offering issuing carrier capacity to both specialty general agents, or GAs, who sell, control, and administer books of insurance business that are supported by third-party reinsurers, domestic and foreign insurers and institutional risk investors (“capacity providers”) that want to access specific lines of U.S. property and casualty insurance business.  Issuing carrier arrangements refer to our business in which we write insurance on behalf of a capacity provider and then reinsure the risk under these policies with the capacity provider in exchange for ceding fees. Our broad licensing authority, strong A.M. Best “A” rating and track record of over 25 years of profitable operations allow us to act as the policy-issuing carrier for business produced by GAs or insurers.  We reinsure substantially all of the underwriting and operating risks in connection with our issuing carrier arrangements to our capacity providers. In many cases, we hold significant collateral to secure the associated reinsurance recoverables. As such, this segment generates very large gross premium with little net premium (except for the run-off of the retained business as described below). We have ceded over $10 billion in premiums over 25 years with no unpaid reinsurance recoverables. Also, since the funds related to settling balances (premiums, commissions and losses) between the GAs and the reinsurers do not flow through the Company, no receivables or payables are reflected in the Company’s financial statements for these amounts. In exchange for providing our insurance capacity, licensing and rating to our GA and insurer clients, we receive ceding fees averaging in excess of 5% of gross written premiums.

 

Our Lender Services segment generates premium from providing collateral protection insurance, or CPI, to our credit union, bank and specialty finance clients.  Our principal product in this segment is CPI. Lenders purchase CPI to provide coverage for automobiles or other vehicles of borrowers who do not uphold their obligation to insure the collateral underlying the loan. Our lender clients pay us directly for CPI and then add the cost of CPI to the borrower’s loan. Our CPI business is fully vertically integrated: we manage all aspects of the CPI business cycle, including sales and marketing, policy issuance, policy administration, underwriting and claims handling.

 

The principal claims we pay in our Lender Services segment are for the following coverage options:  collision, which covers accidental loss or damage to the collateral caused by collision with another object; premium deficiency, which provides for reimbursement of earned premiums under a wide range of options based on physical damage status and loss ratio; and conversion/skip loss, which provides coverage for loss due to concealment, disposal, or misappropriation of the collateral by the borrower.  Although our CPI policies typically have a term of one year, the actual duration of such policies is usually much shorter, because many borrowers elect to cancel lender-placed policies and replace with borrower-obtained policies shortly after lender-placed polices become effective. We provide for an allowance for policy cancellations based on our historical experience.

 

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Factors Affecting Our Operating Results

 

Trending Market Opportunities. We believe that recently improved macroeconomic conditions, including rate hardening in property and casualty insurance lines, increasing availability of credit and increasing automobile sales, should provide us with more growth opportunities in both of our business segments.  We also believe that the increased role of capital markets alternatives to reinsurance, the capitalization of recent hedge fund-backed reinsurers and the growth of the off-shore reinsurance market generally should drive demand for our services, as these firms typically do not have direct access to the U.S. market.

 

In our Lender Services business, we believe that organic growth from our existing lender clients is, and potential new business from banks and specialty finance companies will be, driven by overall growth in lenders’ portfolios as a result of rising automobile sales, higher average auto loan sizes and increasing credit availability.  We expect that growth in lenders’ portfolios will result in increased premium writings for us. However, with the increasing availability of credit, we expect the credit quality of borrowers to deteriorate, resulting in increased losses and loss ratios in our Lender Services business compared to losses and loss ratios we experienced during prior periods when credit was not as available and the credit quality of borrowers would be expected to be higher.  Historically, we have targeted a loss ratio between 35% and 45%.  For the six months ended June 30, 2014 and the years ended December 31, 2013, 2012 and 2011, our net loss ratio was 42.0%, 37.3%, 33.9% and 36.4%, respectively. We believe the credit quality of borrowers has declined over the last few years with the increasing availability of credit, and our loss ratio has increased consistent with this trend and is returning to normal targeted levels.  Also consistent with this trend, our policy cancellation experience increased while credit availability was limited as we believe higher credit quality borrowers tend to be more diligent in providing evidence of insurance to their lending institution.  If credit availability continues to increase, we expect our cancellation experience to return to historical levels, which will further increase our premium writings.

 

We have experienced additional demand for our program services from an increase in hedge fund sponsored reinsurers and other institutional risk investors.  One recent example of a significant program with an institutional risk investor is Nephila Capital Ltd. Nephila is a hedge fund with approximately $10 billion in assets under management that participates in the reinsurance market for catastrophe exposed property business.  Nephila is currently accessing the U.S. market through our insurance subsidiaries and we estimate gross writings under this program for 2014 to be approximately $50 million, upon which we expect to earn ceding fees of approximately $1.2 million this year.  In addition, we have recently entered into a new arrangement with Nephila under which we have granted Nephila the exclusive right to produce U.S. property insurance, predominantly in areas potentially affected by catastrophes, for us during 2015 and 2016.  Under this arrangement, we have agreed to provide Nephila up to $400 million of premium capacity for 2015 and 2016, and Nephila has agreed to produce minimum premiums written of $300 million for 2015 and $400 million for 2016, with equivalent ceding fees paid to us on such amounts whether or not the minimum premium levels are produced, subject to our maintaining our “A” A.M. Best rating and potential reductions to the extent we do not have the authority to write the particular policies they desire to have written and they write such policies through other providers.

 

In addition, recent downgrades of certain insurance companies have, and we believe that future downgrades of other insurance companies will, create increased demand for our issuing carrier capacities.  For example, we currently have a large active program with certain subsidiaries of Meadowbrook Insurance Group, Inc. (MIG), including Century Surety Company, Star Insurance Company and Savers Property & Casualty Insurance Corporation.  This A.M. Best rating-sensitive book of business came to us in August of 2013 after A.M. Best downgraded the rating of the MIG insurance subsidiaries from “A-” to “B++”.  For 2013, we wrote gross premiums of $170 million under this program, for which we earned gross premiums of $64 million and ceding fees of $3.5 million.  For 2014, we expect to write approximately $300 million of gross premiums and to earn gross premiums of approximately $278 million, which includes the earnings of the 2013 unearned premiums.  We expect these estimated premium earnings to generate over $15 million of earned ceding fees in 2014, of which $6.9 million have been earned as of June 30, 2014.

 

Alliance with CUNA Mutual.  The Company’s alliance with CUNA Mutual that began in 2009 provides us access to a wider array of clients and added significant additional scale to our CPI business.  For the six months ended June 30, 2014 and the years ended December 31, 2013, 2012 and 2011, we have generated earned premiums of $16.7 million, $30.3 million, $25.2 million and $22.0 million, respectively, through the alliance with CUNA Mutual. Prior to July 1, 2014, this business was subject to a 50% quota share agreement with CUNA Mutual.  We

 

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recently amended the alliance agreement to increase our retention of the business subject to the alliance to 70% from 50% for business written on or after July 1, 2014, and in exchange have made payments to CUNA Mutual totaling approximately $17.8 million, which payments may be adjusted somewhat based on net premiums and loss ratio for the 12-month period ending June 30, 2015.  In addition, the term of the alliance has been extended at least through July 31, 2018. This arrangement also includes a ceding commission of 21%, which effectively offsets our general and administrative expenses since the commissions our insurance subsidiaries pay to the affiliated agent are eliminated in consolidation.  In addition, CUNA Mutual reimbursed 50% of direct commissions paid to the accounts that are subject to this agreement, which reimbursement will be reduced to 30% of direct commissions for business written on or after July 1, 2014. If the revised quota share percentage had been in effect in 2013 and the first six months of 2014, we would have earned additional premiums in our CPI business of approximately $11.8 million and $6.6 million respectively.

 

Run-off of the Retained Business.  In the past, the Company has participated on a quota share basis to a limited extent in certain programs in the Program Services segment.  Most recently, from 2007 until 2011, California had required USIC to retain 10% of the risks written.  After this requirement was lifted in early 2012, the Company reinsured to inception the retained business under most of the active contracts, but others continue to run-off.  As reflected in the “Business—Program Services Segment—Results of Operations,” we recorded negative premiums earned of $16,000, $550,000, and $501,000 for the six months ended June 30, 2014, June 30, 2013, and the year ended December 31, 2013, respectively.  In addition, we recorded negative losses and loss adjustment expenses on those premiums of $153,000, $390,000 for the six months ended June 30, 2014 and June 30, 2013, respectively, while we recorded a net positive expense for the year ended December 31, 2013 of $465,000.  The negative premiums and losses and loss adjustment expenses resulted primarily due to the novation of the three remaining active California programs (one in 2013 and two in 2012) in this run-off book of business, net policy refunds for a number of run-off accounts, and the run-off of claim reserves on retained accounts.

 

Most of the retained business was general liability business.  The Company has no active retained contracts and has no present intention of participating in future contracts.  We refer to this business as “the run-off of the retained business.”  For the years ended December 31, 2013 and 2012, we had paid losses relating to the run-off of the retained business of $1.6 million and $1.5 million, respectively.  As of June 30, 2014, we had net reserves of $3.4 million related to this business.

 

Subchapter S Corporation Status.  Prior to the completion of the private placement, we elected for our parent company to be taxed for federal income tax purposes as a “Subchapter S corporation” under the Internal Revenue Code and our subsidiaries (other than our insurance subsidiaries and intermediate holding company) to be pass-through entities for federal income tax purposes. As a result, prior to the completion of the private placement, the income for our parent company and pass-through subsidiaries was not subject to, and we did not pay, U.S. federal income taxes, and no provision or liability for federal or state income tax for our parent company pass-through subsidiaries has been included in our consolidated financial statements.  The tax provision, assets and liabilities that are reflected in our consolidated financial statements represent those for our insurance subsidiaries, SNIC, NSIC, and USIC, and their intermediate holding company, State National Intermediate Holdings, Inc. (“SNIH”), as those entities are “C” Corporations.  Despite the Subchapter S corporation status, the impact of taxes on our parent company are included in the financial statements in that our shareholders were provided with the cash to pay the taxes that passed through to the shareholders.  Prior to the completion of the private placement, we made periodic cash distributions to our shareholders that have included amounts necessary for them to pay their estimated personal U.S. federal income tax liabilities relating to the items of our income, gain, deductions and losses that pass through to them. See “Dividends.” Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes.  As a result, the Company’s deferred tax asset as of June 30, 2014 increased by approximately $19.5 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions and contract modification expense.

 

Founder Special Compensation.  During 2014, 2013, 2012 and 2011, we paid special compensation to our co-founders and principal executive officers, Lonnie Ledbetter and Terry Ledbetter, in recognition of their service to our Company.  We refer to these payments as “Founder special compensation.”  Founder special compensation payments were discretionary and determined by the Company’s owners in the first or second quarter of the year in which they were made, based on current period considerations including capital position, estimated capital needs and liquidity, and earnings for the prior year.  We paid founder special compensation in the aggregate amount of $17.9 million, $10.2 million, $10.7 million and $690,000 for the period ended June 30, 2014 and the years ended December 31, 2013, 2012 and 2011, respectively.  Following the

 

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completion of the private placement in June 2014, we will no longer pay founder special compensation, as Lonnie Ledbetter has retired, and the bonus compensation for the remainder of 2014 for Terry Ledbetter, who serves as our Chairman, President and Chief Executive Officer, will be determined based on 2014 performance goals.

 

Seasonality of Our Business.  Our Lender Services segment typically experiences seasonal fluctuations in written premium.  The fourth quarter tends to generate the greatest amount of written premium, whereas the first quarter of the year tends to generate the least.  We believe this trend follows loan delinquency patterns for the industry. We generally do not experience seasonality in our Program Services segment.

 

Principal Revenue and Expense Items

 

Premiums earned.  Premiums earned are the earned portion of our net premiums written, which are predominately CPI premiums. As the CPI product is not a traditional insurance product, the premium recognition is likewise different.  First, we do not record premiums until we collect them from our accounts since they have the right to waive the placement of insurance on any of their loans. Our premium notice cycles average approximately 45 to 65 days. Therefore, we earn premiums for such notice periods at the time they are written. Next, there is a high level of policy cancellations since borrowers often purchase insurance at the traditional rates that provides protection for them in addition to their lender.  Due to this high level of policy cancellations, we split the premium into two pieces:  (1) an allowance for future cancellations and (2) premiums that we expect to earn, which we refer to as “stick premiums.”  We earn stick premiums on a pro rata basis over the terms of the policies. The CPI premiums written as presented in this document reflect the effects of the allowance for policy cancellations including any adjustments related to re-estimation of the allowance.  As such, our recorded CPI premiums written are those that we expect to earn while those that are expected to cancel are included in the allowance for policy cancellations.  At the end of each reporting period, premium written that is not earned is classified as unearned premium, which is earned in subsequent periods over the remaining terms of the policies. Our policies typically have a term of one year, although the average duration of our CPI policies is typically less than six months due to policy cancellations.

 

Commission income.  Commission income is generated on business where we operate in an agency capacity on ancillary lines of business within our Lender Services segment.

 

Ceding fees.  Ceding fees are fees we receive in the Program Services segment in exchange for providing access to the U.S. property and casualty insurance market and are based on the gross premiums we write on behalf of our GA and capacity provider clients. We earn ceding fees in a manner consistent with the recognition of the gross earned premium on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured, which policies often have a one year term.

 

Net investment income.  We invest our statutory surplus and excess agency funds primarily in cash, cash equivalents, and fixed-maturity securities. Our net investment income includes interest income on our invested assets.

 

Realized net investment gains.  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 other comprehensive income.

 

Loss and loss adjustment expenses.  Loss and loss adjustment expenses (LAE) 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. We record loss and LAE related to estimates of future claim payments based on historical experience. We seek to establish all reserves at the most likely ultimate exposure based on our historical claims experience. We revise our estimates as we receive additional information about claims and the total costs of settlement.

 

Commissions.  Commission expenses are primarily related to the acquisition of our Lender Services business.  A significant portion of these amounts are paid to financial institutions as a means to reimburse the financial

 

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institution for costs associated with operating a CPI program. These commissions are partially offset by ceding commissions received under our quota reinsurance agreement with CUNA Mutual and the reimbursement we received from CUNA Mutual for 50% of the direct commission expense. The ceding commission compensates us for expenses, such as underwriting and policy acquisition expenses, that we incur in connection with the writing of the ceded business.

 

Taxes, licenses, and fees.  Taxes, licenses, and fees are primarily premium taxes and related licenses and fees that are charged by state jurisdictions as a result of writing certain lines of business as an insurance operation.

 

General and administrative expense.  General and administrative expense is composed of all other operating expenses, including various departmental salaries and benefits expenses for employees.  General and administrative expenses also include expenses related to our office space, postage, telephone and information technology charges, as well as legal and auditing fees and corporate travel.  In addition, general and administrative expense includes those charges that are related to the amortization of tangible and intangible assets.

 

Interest expense.  Interest expense represents amounts we incur on our outstanding indebtedness at the then-applicable interest rates.

 

Income tax expense.  We incur federal tax expenses on our “C” corporations and state and local income tax expenses in certain jurisdictions in which we operate.

 

Stock-based Compensation Expense.  Compensation expense for stock-based payments is recognized based on the measurement-date fair value for awards that will settle in shares. Compensation expense for awards that are settled in equity are recognized on a straight line pro rata basis over the vesting period. Stock-based compensation expense was approximately $43,000 for the quarter ended June 30, 2014, relating to stock options that we granted to our management in connection with the private placement, recognized on a pro rata basis over the vesting period.  Based on 2,783,873 options outstanding as of June 30, 2014, we estimate stock-based compensation costs will be approximately $1.2 million for the quarter ended September 30, 2014.  However, no assurance can be given regarding the future changes in estimates of stock-based compensation costs.

 

Other Measures and Ratios

 

Adjusted net income.  Adjusted net income is considered a non-GAAP financial measure because it reflects the following adjustments to net income, which is the most directly comparable measure calculated in accordance with GAAP: the pro forma provision for income taxes as if the Company had been treated as a C Corporation for each period presented, and the exclusion (net of tax benefit) of the increase in the Company’s deferred tax asset as a result of the conversion to C Corporation status, the amount of founder special compensation and the non-recurring offering-related expenses and contract modification expense related to the amendment to our alliance agreement with CUNA Mutual.  Management believes this measure is helpful to investors because it provides comparability in evaluating core financial performance between periods.  Management uses adjusted net income to evaluate core financial performance against historical results without the effect of these items.  For a reconciliation of this non-GAAP financial measure, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Results of Operations—Consolidated Results of Operations.”

 

Lender Services Insurance Ratios

 

Net loss ratio.  The net loss ratio is a measure of the underwriting profitability of our Lender Services business.  Expressed as a percentage, this is the ratio of net loss and LAE incurred to net premiums earned.

 

Net expense ratio.  The net expense ratio is a component of our operational efficiency in administering our Lender Services business. Expressed as a percentage, this is the ratio of net expenses (commissions, taxes, licenses, and fees and general and administrative) to net premiums earned.

 

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Net combined ratio.  The net combined ratio is a measure of the overall profitability of our Lender Services business.  This is the sum of the net loss ratio and the net expense ratio.

 

Program Services Expense Ratio

 

Program gross expense ratio.  The program gross expense ratio is a measure of our ability to earn increasing amounts of ceding fees with only minimal incremental expense in our Program Services business.  Expressed as a percentage, this is the ratio of general and administrative expense incurred to gross written premium.

 

Critical Accounting Estimates

 

Our consolidated financial statements include amounts that, either by their nature or due to the requirements of generally accepted accounting principles in the U.S. (GAAP), are determined using estimates and assumptions.  While we believe that the amounts included in our consolidated financial statements reflect our best judgment, actual amounts could ultimately materially differ from those currently presented.  We believe the items that require the most subjective and complex estimates are: unpaid losses and loss adjustment expense reserves, allowance for policy cancellations, unearned premium reserve, reinsurance recoverable, valuation of our investment portfolio and assessment of other-than-temporary impairments (OTTI).

 

We believe our accounting policies for these items are of critical importance to our consolidated financial statements. The following discussion provides more information regarding the estimates and assumptions required to arrive at these amounts.  For a complete summary of our significant accounting policies, see the notes to the consolidated financial statements.

 

Unpaid Losses and Loss Adjustment Expenses

 

The liability for unpaid losses and loss adjustment expenses includes an estimate for claims reported and an additional liability for claims incurred but not reported at the balance sheet date, as well as estimates of the expenses associated with processing and settling all reported and unreported claims, less estimates of anticipated salvage and subrogation recoveries.  Estimates are based upon past loss experience modified for current trends as well as economic, legal and social conditions.  Loss reserves are not discounted to present value, which would involve recognizing the time value of money and offsetting estimates of future payments by future expected investment income.

 

In establishing these estimates, we make various assumptions regarding a number of factors, including frequency and severity of claims, the length of time needed to achieve ultimate settlement of claims, inflation of medical costs, insurance policy coverage interpretations, jury determinations and legislative changes. Due to the inherent uncertainty associated with these estimates, and the cost of incurred but unreported claims, our actual liabilities may be different from our original estimates.  On a quarterly basis, we review our reserves for loss and loss adjustment expenses to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s results.  Additional information regarding the judgments and uncertainties surrounding our estimated reserves for loss and loss adjustment expenses can be found in “Business—Loss Reserves.”

 

Allowance for Policy Cancellations

 

An allowance for policy cancellations is provided for the estimated amount of return premiums and policy fees, net of commission expense and premium taxes that will be incurred on expected future policy cancellations associated with the Company’s business. Premiums and cancellation data are accumulated by accounting month (month in which the premium was written/collected), lending institution and at the corporate level.  The estimation methodology utilizes actual cancellation rates (premium refunds divided by premiums written by accounting month) to determine expected future cancellations for that accounting month. The balance for each accounting month decreases each subsequent month as actual refunds emerge.

 

On a quarterly basis, we review our estimates for allowance for policy cancellations to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s operating results. The allowance for policy cancellations for the six months ended June 30, 2014 and 2013 and for the years ended December 31, 2013, 2012, and 2011 included upward revisions to prior year estimates of $4.0 million, $2.2 million, $2.8 million, $1.7 million, and $1.0 million, respectively.  Because of the interplay between the allowance for policy cancellations and the related unearned premium reserve, changes in the allowance for policy

 

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cancellations are partially offset by related changes in the unearned premium reserve and amounts ceded to reinsurers.  After taking into account the associated changes in unearned premium and amounts ceded to reinsurers, the net negative impact to the balance sheet and the corresponding reduction in net income from the revised estimates for the six months ended June 30, 2014 and 2013 and for each of the years ending December 31, 2013, 2012, and 2011 was approximately $1.9 million, $1.2 million, $1.6 million, $1.3 million, and $1.0 million, respectively.

 

While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately refunded. The estimates are continually reviewed by management, and any changes are reflected in current operations.

 

Unearned Premium

 

Unearned premium reserves represent the portion of premiums written applicable to the unexpired terms of the policies.  The Lender Services segment calculates this reserve after adjusting for anticipated policy cancellations.

 

Reinsurance Recoverable

 

The recoverable for ceded unpaid losses and loss adjustment expenses includes an estimate for claims reported and an additional liability for claims incurred but not reported, based on the Company’s historical loss experience. While management believes the amounts included in the consolidated financial statements are adequate, such estimates may be more or less than the amount ultimately paid when the claims are settled. These estimates are reviewed and adjusted on a continuing basis, as necessary, as experience develops or as new information becomes known and such adjustments are included in current operations.  The recoverable for ceded premium reserves represent the portion of premiums written applicable to the unexpired terms of the policies.  The Lender Services segment calculates this reserve after adjusting for anticipated policy cancellations.

 

Investments

 

Investments are considered available-for-sale and are carried at fair value. The Company measures the fair value of the investments based upon quoted market prices from an independent pricing service and its third-party investment managers, using observable market information. The cost of securities sold is based on the specific identification method. Unrealized gains and losses associated with the available-for-sale portfolio, as a result of temporary changes in fair value during the period such investments are held, are reflected net of income taxes and reported in other comprehensive income as a separate component of shareholders’ equity. Unrealized losses associated with the available-for-sale portfolio that are deemed to be other-than-temporary are charged to income in the period in which the other-than-temporary impairment is determined. Debt security premiums and discounts are amortized into earnings using the effective-interest method.

 

The Company evaluates its investment portfolio for impairments of individual securities that are deemed to be other-than-temporary. Fixed maturity securities that are determined to have other-than-temporary impairment and it is more likely than not the Company will sell before recovery of their amortized cost, are written down to fair value and the entire amount of the write-down is included in net income, net of realized investment gains. For all other impaired fixed-maturity securities, the impairment loss is separated into the amount representing the credit loss and the amount representing all other factors. The amount of impairment loss that represents the credit loss is included in net income, net of realized investment gains. The amount of the impairment loss that relates to all other factors is included in other comprehensive income. Equity securities that are determined to have other-than-temporary impairment are recognized in net income, net of realized investment gains.

 

The process for identifying other-than-temporary declines in fair value involves the consideration of several factors, including, but not limited to, whether the issuer has been downgraded to below investment-grade, the length of time in which there has been a significant decline in value, the liquidity and overall financial condition of the issuer, the nature and performance of the collateral or other credit support backing the security, the significance of the decline in value, and whether the Company has the intent to sell the security or may be required to sell the security prior to its anticipated recovery. The Company reviews securities for other-than-temporary impairment internally and with its investment advisors.

 

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Outlook

 

Set forth below are some targets we have with respect to certain aspects of our financial performance after we have fully deployed the net proceeds of the private placement. We caution you that these targets may not materialize and may not be indicative of the actual results that we will achieve.  Many factors may cause our actual results to differ materially and significantly from the information set forth below. See “Cautionary Statement Concerning Forward-Looking Statements.”

 

One of the key financial measures that we use to evaluate our operating performance is return on average equity. We calculate return on average equity by dividing net income by the average GAAP equity. Our overall financial objective is to produce a return on equity of at least 15% over the long-term.

 

Program Services

 

Ceding Fees. In exchange for access to our rating, licensing and reputation, we typically charge a ceding fee of 5% to 6% of direct written premium. We are able to do this profitably because our specialized issuing carrier business model does not require the infrastructure associated with providing policy administration, claims handling, cash handling, underwriting, or other traditional insurance company services. Our customers, therefore, bear the cost of providing these services.

 

Gross Expense Ratio. Our GAs and capacity providers are responsible for providing all underwriting, policy administration, claims handling and other traditional insurance company services. As a result, we are able to produce significant premium volume with only minimal operating expenses. In addition, our fixed costs are a large component of the operating expenses while the incremental costs are small and are dependent upon the size and complexity of the programs being supported.  For the year ended December 31, 2013, our ratio of operating expenses to gross premiums written, or program gross expense ratio, was 1.6%.  For the three years ended December 31, 2013, this ratio has been in the range of 1.3% to 1.8%.  However, with the recent addition of two large programs, we expect the gross expense ratio to decrease to a range of 1.0% to 1.5%.

 

Gross Operating Leverage. A significant portion of our capital is used to support the gross premium produced in our Program Services segment. Generally, we do not retain any risk other than the credit risk of the capacity providers. We maintain strict credit underwriting standards, broad indemnification agreements and collateral requirements. Using this efficient model, we are able to generate significant gross written premiums on a relatively small amount of capital compared to our peers.  For the year ended December 31, 2013, our ratio of gross premiums written (including our Lender Services business) to shareholders’ equity, or gross premium written leverage ratio, was 5.57 to 1, and that ratio for the Program Services business alone was 4.75 to 1. With the increased capital from the net proceeds of the private placement, we plan to target a total company gross premium written leverage ratio of between 3 to 1 and 5 to 1 over time.

 

Lender Services

 

Insurance Ratios. Our primary underwriting goal is to achieve profitable results through an efficient net loss ratio and net expense ratio.  For the six months ended June 30, 2014 and the years ended December 31, 2013, 2012 and 2011, our net loss ratio was 42.0%, 37.3%, 33.9% and 36.4%, respectively, and our net expense ratio was 49.4%, 47.8%, 57.5% and 56.7%, respectively.  We target the pricing of our products to achieve a net loss ratio between approximately 35% to 45%. We target a net of expense ratio between 45% and 55%.  Our expense ratio is higher than most traditional insurance products due to the labor and systems intensive process involved in monitoring the insurance statuses for the loan portfolios of our Lender Services clients.

 

Corporate Segment

 

Investment Yield. We expect our portfolio will continue to include primarily fixed income securities and short-term investments. We plan to earn competitive relative returns while investing in a diversified portfolio of securities of high credit quality issuers and to limit the amount of credit exposure to any one issuer. As a result, we expect to earn an investment yield that approximates three- to five-year duration indices of comparable quality.  As of December 31, 2013, the yield on our investment portfolio was 2.6%.

 

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Financial Leverage. We target a financial leverage ratio, as measured by debt to GAAP equity of approximately 20% to 40%.

 

Income Tax Expense. Upon completion of the private placement, our parent company became a “C” Corporation for U.S. tax purposes and became subject to a combined federal and state corporate income tax rate between approximately 35% and 38%. We invest a portion of our investment portfolio in tax-exempt municipal securities, which investment may have the effect of lowering our effective tax rate.

 

Consolidated Results of Operations

 

 

 

Six Months Ended

 

Year Ended

 

 

 

June 30,

 

December 31,

 

($ in thousands)

 

2014

 

2013

 

2013

 

2012

 

2011

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

Premiums earned

 

$

43,986

 

$

39,482

 

$

84,378

 

$

78,096

 

$

81,974

 

Commission income

 

762

 

927

 

2,031

 

2,406

 

2,247

 

Ceding fees

 

20,858

 

13,695

 

32,898

 

32,379

 

30,455

 

Net investment income

 

2,218

 

2,419

 

4,901

 

5,525

 

6,217

 

Realized gain on sale of affiliate

 

 

 

 

 

663

 

Realized net investment gains

 

895

 

1,020

 

1,764

 

1,309

 

439

 

Other income

 

2,211

 

1,180

 

2,531

 

2,408

 

2,754

 

Total revenues

 

70,930

 

58,723

 

128,503

 

122,123

 

124,749

 

 

 

 

 

 

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

Losses and loss adjustment expenses

 

18,314

 

14,416

 

32,090

 

28,989

 

29,632

 

Commissions

 

1,229

 

1,620

 

2,378

 

2,922

 

4,352

 

Taxes, licenses, and fees

 

1,230

 

1,165

 

2,594

 

2,394

 

2,245

 

General and administrative

 

27,508

 

26,322

 

53,418

 

54,114

 

52,593

 

Founder special compensation

 

17,914

 

10,202

 

10,202

 

10,740

 

690

 

Offering-related expenses

 

7,129

 

 

 

 

 

Interest expense

 

1,148

 

1,155

 

2,323

 

2,427

 

2,360

 

Contract modification expense

 

17,800

 

 

 

 

 

Total expenses

 

92,272

 

54,880

 

103,005

 

101,586

 

91,872

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

(21,342

)

3,843

 

25,498

 

20,537

 

32,877

 

 

 

 

 

 

 

 

 

 

 

 

 

Income taxes:

 

 

 

 

 

 

 

 

 

 

 

Current tax expense

 

3,753

 

1,908

 

4,845

 

3,860

 

5,801

 

Deferred tax (benefit) expense

 

(22,302

)

147

 

(2,058

)

795

 

(830

)

 

 

(18,549

)

2,055

 

2,787

 

4,655

 

4,971

 

Net income (loss)

 

$

(2,793

)

$

1,788

 

$

22,711

 

$

15,882

 

$

27,906

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted net income

 

$

13,395

 

$

8,688

 

$

22,084

 

$

19,651

 

$

21,570

 

Reconciliation of adjusted net income:

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(2,793

)

$

1,788

 

$

22,711

 

$

15,882

 

$

27,906

 

Plus (less): Provision for income taxes to reflect change to C corporation status (1)

 

3,957

 

589

 

(6,938

)

(2,980

)

(6,779

)

Less: Recognition of deferred tax asset upon conversion to C corporation (2)

 

14,460

 

 

 

 

 

Plus: Founder special compensation (3)

 

11,160

 

6,311

 

6,311

 

6,749

 

443

 

Plus: Offering-related expenses (3)

 

 

4,441

 

 

 

 

 

 

 

 

 

Plus: Contract modification expense (3) (4)

 

 

11,090

 

 

 

 

 

 

 

 

 

Adjusted net income

 

$

13,395

 

$

8,688

 

$

22,084

 

$

19,651

 

$

21,570

 

 

49



Table of Contents

 


(1)   Upon the completion of the private placement, our parent company’s status as a Subchapter S corporation terminated and our consolidated income became fully subject to U.S. federal income taxes.  This adjustment represents estimated income taxes as if the Company had been treated as a C Corporation for each period presented. The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2% and 35.7% for the years ended December 31, 2013, 2012 and 2011, respectively.

 

(2)   As a result of the Company’s conversion to a C Corporation, the deferred tax asset increased by approximately $14.5 million primarily due to the effects of eliminating deferred tax balances on the insurance subsidiaries related to intercompany transactions. This excludes the tax effect related to contract modification expense as discussed in note (4) below.

 

(3)   Founder special compensation, offering-related expenses, and contract modification expense are shown net of the estimated tax benefit for each period presented.  The estimated tax was calculated assuming the Company’s blended statutory federal and state income tax rates of 37.7% and 38.1% for the periods ended June 30, 2014 and 2013, respectively, and 38.1%, 37.2% and 35.7% for the years ended December 31, 2013, 2012 and 2011, respectively.

 

(4)   In connection with the recent amendment to the alliance agreement with CUNA Mutual, we agreed to pay CUNA Mutual $17.8 million.  As a result, we recorded contract modification expense of $17.8 million, or $11.1 million net of tax benefit.

 

Consolidated Results of Operations for the Six Months Ended June 30, 2014 compared with the Six Months Ended June 30, 2013

 

Premiums earned.  Premiums earned increased by $4.5 million, or 11.4%, from $39.5 million for the six months ended June 30, 2013 to $44.0 million for the six months ended June 30, 2014, primarily due to a $4.0 million increase in Lender Services premiums earned.  Lender Services premium increases were driven primarily by rising automobile sales, higher average auto loan sizes and increasing credit availability.

 

Ceding fees.  Ceding fees increased by $7.2 million, or 52.3%, from $13.7 million for the six months ended June 30, 2013 to $20.9 million for the six months ended June 30, 2014, primarily due to the increase in gross earned premium from $248.2 million to $375.2 million related to the addition of two significant programs in late 2013. Gross written premium increased from $246.4 million for the six months ended June 30, 2013 to $436.1 million for the six months ended June 30, 2014.  We earn ceding fees in a manner consistent with the recognition of the gross earned premium on the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured.

 

Other income. Other income increased by $1.0 million from $1.2 million for the six months ended June 30, 2013 to $2.2 million for the six months ended June 30, 2014, primarily due to a $510,000 increase in rental income and a $427,000 increase in the gain on the sale of property and equipment.  The increase in rental income resulted from the early termination of a tenant’s lease.  The increase in the gain on the sale of property and equipment relates primarily to transferring ownership of a fully depreciated property prior to the completion of the private placement.  This was a non-cash transaction, the amount of which is also reflected in founder special compensation.

 

Losses and loss adjustment expenses.  Losses and LAE increased by $3.9 million, or 27.0%, from $14.4 million for the six months ended June 30, 2013 to $18.3 million for the six months ended June 30, 2014, which is partly the result of higher earned premiums. In addition, the net loss ratio on the Lender Services segment increased from 37.0% for the six months ended June 30, 2013 to 42.0% for the six months ended June 30, 2014.  The variance is partly attributable to an increase in claims volume as the number of loans insured rises as credit becomes more readily available.  The variance is also due to an increase in claims severity, especially for the