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SKYWARD SPECIALTY INSURANCE GROUP, INC. – 10-K – Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a growing specialty insurance company delivering commercial P&C products and solutions on a non-admitted (or E&S) and admitted basis, predominantly inthe United States . We focus our business on markets that are underserved, dislocated and/or for which standard insurance coverages are insufficient or inadequate to meet the needs of businesses, including our customers and prospective customers operating in these markets. Our customers typically require highly specialized, customized underwriting solutions and claims capabilities. As such, we develop and deliver tailored insurance products and services to address each of the niche markets we serve. Our portfolio of insured risks is highly diversified - we insure customers operating in a wide variety of industries; we distribute through multiple channels; we write multiple lines of business, including general liability, excess liability, professional liability, commercial auto, group accident and health, property, surety and workers' compensation; we insure both short and medium duration liabilities; and our business mix is balanced between E&S and admitted markets. All of these factors enable us to respond to market opportunities and dislocations by deploying capital with attractive risk-adjusted returns. We believe this diversification, combined with our underwriting and claims expertise, will produce strong growth and consistent profitability across P&C insurance pricing cycles. We seek to lead in our chosen market niches and establish sustainable competitive positions in these markets. We refer to this strategy as "Rule Our Niche" and it forms the basis of our approach to building a strong defensible market position, creating a competitive moat, and winning our chosen markets. We believe that the principles underlying our strategy are key to achieving and sustaining best-in-class underwriting results through P&C insurance pricing cycles. We consistently strive for excellence in risk selection, pricing, and claims outcomes, and to amplify these critical functions with the use of advanced technology and analytics. 34 -------------------------------------------------------------------------------- Table of Conte nt s Results of Operations The following table summarizes our results for the years endedDecember 31, 2022 and 2021: ($ in thousands) 2022 2021 Gross written premiums$ 1,143,952 $ 939,859 Ceded written premiums (468,409) (410,716) Net written premiums 675,543 529,143 Net earned premiums 615,994 499,823 Commission and fee income 5,199 3,973 Losses and LAE 402,512 354,411 Underwriting, acquisition and insurance expenses 182,171 138,498 Underwriting income(1)$ 36,510 $ 10,887 Net investment income$ 36,931 $ 24,646 Net investment (losses) gains$ (15,705) $ 17,107 Income before federal income tax$ 49,783 $ 48,309 Net income$ 39,396 $ 38,317 Adjusted operating income(1)$ 58,574 $ 36,062 Loss and LAE ratio 65.3 % 70.9 % Expense ratio 28.7 % 26.9 % Combined ratio 94.0 % 97.8 % Adjusted loss and LAE ratio(1) 63.9 % 67.7 % Expense ratio 28.7 % 26.9 % Adjusted combined ratio(1) 92.6 % 94.6 % Return on equity 9.3 % 9.4 % Return on tangible equity(1) 11.8 % 11.9 % Adjusted return on equity(1) 13.8 % 8.8 % Adjusted return on tangible equity(1) 17.6 % 11.2 % (1) See "Reconciliation of Non-GAAP Financial Measures" in this Item 7
Reconciliation of Non-GAAP Financial Measures
Adjusted Operating Income (Loss)
The following table provides a reconciliation of adjusted operating income to
net income for the years ended
2022 2021
Before After Before After
income income income income
($ in thousands) taxes taxes taxes taxes
Income as reported $ 49,783 $ 39,396 $ 48,309 $ 38,317
Less:
Net impact of LPT (8,572) (6,772) (16,063) (12,690)
Net investment (losses) gains (15,705) (12,407)
17,107 13,515
Net realized gain on sale of business - -
5,077 4,011
Impairment charges - - (2,821) (2,229)
Other income (loss) 1 1 (445) (352)
Adjusted operating income$ 74,059 $ 58,574
35 -------------------------------------------------------------------------------- Table of Conte nt s Underwriting income (loss) The following table provides a reconciliation of underwriting income (loss) to income (loss) before federal income tax for the years endedDecember 31, 2022 and 2021: ($ in thousands) 2022 2021 Income before federal income tax$ 49,783 $ 48,309 Add: Interest expense 6,407 4,622 Amortization expense 1,547 1,520 Impairment charges - 2,821 Less: Net investment income 36,931 24,646 Net investment (losses) gains (15,705) 17,107 Net realized gain on sale of business - 5,077 Other income (loss) 1 (445) Underwriting income$ 36,510 $ 10,887
Adjusted Loss Ratio / Adjusted Combined Ratio
The following table provides a reconciliation of the adjusted loss and LAE ratio and adjusted combined ratio to the loss and LAE ratio and combined ratio for the years endedDecember 31, 2022 and 2021: ($ in thousands) 2022 2021 Net earned premiums$ 615,994 $ 499,823 Losses and LAE 402,512 354,411 Less: Pre-tax net impact of LPT 8,572 16,063 Adjusted losses and LAE$ 393,940 $ 338,348 Loss and LAE ratio 65.3 % 70.9 % Less: Net impact of LPT 1.4 % 3.2 % Adjusted loss and LAE ratio 63.9 % 67.7 % Combined ratio 94.0 % 97.8 % Less: Net impact of LPT 1.4 % 3.2 % Adjusted combined ratio 92.6 % 94.6 %
Tangible Stockholders' Equity
The following table provides a reconciliation of tangible stockholders' equity
to stockholders' equity for the years ended
($ in thousands) 2022
2021
Stockholders' equity $ 421,662 $
426,080
Less: goodwill and intangible assets 89,870
91,336
Tangible stockholders' equity $ 331,792 $ 334,744
$ 331,792 $ 334,744
Adjusted Return on Equity
The following table provides a reconciliation of adjusted return on equity to
return on equity for the years ended
($ in thousands) 2022 2021 Numerator: adjusted operating income$ 58,574 $ 36,062 Denominator: average stockholders' equity$ 423,871 $ 409,803 Adjusted return on equity 13.8 % 8.8 % 36
-------------------------------------------------------------------------------- Table of Conte nt s Return on Tangible Equity
Return on tangible equity for the years ended
reconciles to return on equity as follows:
($ in thousands) 2022
2021
Numerator: net income$ 39,396 $
38,317
Denominator: average tangible stockholders' equity
Return on tangible equity
11.8 % 11.9 %
Adjusted Return on Tangible Equity
Adjusted return on tangible equity for the years ended
2021 reconciles to return on equity as follows:
($ in thousands) 2022
2021
Numerator: adjusted operating income$ 58,574 $
36,062
Denominator: average tangible stockholders' equity
Adjusted return on tangible equity
17.6 % 11.2 % Underwriting Results Premiums
The following table presents gross written premiums by underwriting division for
the years ended
%
($ in thousands) 2022 2021 Change Change
Industry Solutions $ 267,628 $ 219,973 $ 47,655 21.7 %
Global Property 205,081 167,887 37,194 22.2 %
Programs 163,653 140,283 23,370 16.7 %
Accident & Health 130,808 112,146 18,662 16.6 %
Captives 124,286 87,836 36,450 41.5 %
Professional Lines 93,011 59,992 33,019 55.0 %
Surety 79,062 51,792 27,270 52.7 %
Transactional E&S 75,098 27,997 47,101 168.2 %
Total continuing business $ 1,138,627 $ 867,906 $ 270,721 31.2 %
Exited business 5,325 71,953 (66,628) (92.6) %
Total gross written premiums $ 1,143,952 $ 939,859 $ 204,093 21.7 %
The year over year increase in gross written premiums, when compared to 2021,
was driven by double-digit premium growth in each of our eight underwriting
divisions. The gross written premium increases were primarily driven by (i)
retention, (ii) rate increases, and (iii) new business. Growth was also impacted
by the addition of new products and expanded coverage offerings, new
underwriting teams and new tech-enabled partnerships. Partially offsetting the
increase in gross written premiums was the continued impact of the run-off of
exited business.
Net earned premiums were $616.0 million for the year ended December 31, 2022 ,
compared to $499.8 million for the same 2021 period, an increase of $116.2
million or 23.2%. The increase in net earned premiums was primarily driven by
the same reasons that drove the increase in gross written premiums discussed
above. For additional information regarding out reinsurance programs, see the
discussion included in "Item 1 Business - Reinsurance".
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Table of Conte nt s
Losses and LAE
The following table sets forth the components of the loss and LAE ratio and
adjusted loss and LAE ratio for the years ended
2022 2021
% of % of
Losses Net Earned Losses Net Earned
($ in thousands) and LAE Premiums and LAE Premiums
Losses and LAE:
Non-cat loss and LAE(1) $ 387,440 62.8 % $ 326,520 65.3 %
Cat loss and LAE(1) 6,500 1.1 % 11,828 2.4 %
Prior accident year development - non-LPT - - % - -%
Prior accident year development - LPT 8,572 1.4 % 16,063 3.2%
Total losses and LAE $ 402,512 65.3 % $ 354,411 70.9 %
Adjusted losses and LAE(2):
Non-cat loss and LAE(1) $ 387,440 62.8 % $ 326,520 65.3 %
Cat loss and LAE(1) 6,500 1.1 % 11,828 2.4 %
Prior accident year development - non-LPT - - % - - %
Total adjusted losses and LAE(2) $ 393,940 63.9 % $ 338,348 67.7 %
(1) Current accident year
(2) See "Reconciliation of Non-GAAP Financial Measures" included in this Item 7
The loss and LAE ratio improved 5.6 points when compared to the same 2021 period. The loss and LAE ratio for the year ended 2022 was impacted by 1.4 points of LPT prior accident year development compared to 3.2 points for the same 2021 period. Additional information regarding the LPT can be found in the "Loss Portfolio Transfer" discussion included in this Item 7. The adjusted loss and LAE ratio improved 3.8 points when compared to the same 2021 period. The improvement was primarily driven by (i) a shift in the mix of business, (ii) continued run-off of exited business, and (iii) lower catastrophe losses. Catastrophe losses from Hurricane Ian and Winter Storm Elliott added 1.1 points to the loss and LAE ratio compared to the same 2021 period, which was impacted by 2.4 points of catastrophe losses from tornadoes in the Midwest, Hurricane Ida and the first quarter winter storms.
Losses and
The following table sets forth the presentation of the development of the ultimate liability by accident year for the years endedDecember 31, 2022 and 2021: ($ in thousands) Development (Favorable) Adverse Accident Year 2022 2021 Prior$ 7,701 $ 27,980 2019 22,440 (1,280) 2020 (6,756) 1,300 2021 (9,000) - Total$ 14,385 $ 28,000 Reserve development on losses subject to LPT $
14,385
Reserve development on losses excluding losses subject to
LPT
$
- $ -
During the year ended
accident years 2021 and prior developed unfavorably by
related to losses subject to the LPT.
Within exited lines, adverse development of
accident year primarily driven by increased frequency and severity in general
and professional liability. The remaining
development was from various other accident years.
38 -------------------------------------------------------------------------------- Table of Conte nt s Within multi-line solutions, favorable development of$10.8 million was from the 2020 through 2021 accident years and was primarily driven by a reduction in frequency of claims in commercial auto and general liability. The remaining$2.3 million of net adverse development was from various other accident years.
There was no net development in short tail/monoline specialty lines.
During the year endedDecember 31, 2021 , our net incurred losses and LAE for accident years 2020 and prior developed adversely by$28.0 million driven by$28.8 million of adverse development in exited lines and$4.8 million of adverse development in multi-line solutions, partially offset by$5.6 million of favorable development in short tail lines. Within exited lines, the$28.8 million of adverse development was primarily related to the 2013, 2015, and 2018 accident years and was predominantly driven by increases in both frequency and severity of losses in general liability. Within multi-line solutions, adverse development of$4.8 million was primarily related to the 2016 and 2017 accident years and was driven by increased frequency and severity of claims in commercial auto. Partially offsetting the adverse development was favorable development of$5.6 million within short tail lines, primarily related to the 2019 and 2020 accident years, driven by favorable loss emergence relative to actuarial expectations in property and accident & health.
Loss Portfolio Transfer
OnApril 1, 2020 , with a valuation date ofJune 30, 2019 , we entered into a LPT retroactive reinsurance agreement withR&Q Bermuda (SAC) Limited , a third party reinsurer domiciled inBermuda that specializes in assuming legacy blocks of insurance business and running them off. The LPT covers liabilities (including claim payments, allocated LAE and certain extra-contractual obligations) related to certain policies issued or assumed for policy years 2017 and prior. The LPT agreement covers the majority of our exited business. We believe purchasing this coverage reduces the volatility associated with the covered business produced in 2017 and prior, and has allowed our management team to focus on the continuing business which we believe provide the best path for continued profitable growth. As of the Valuation Date, we agreed to cede$153.1 million of Net LPT Reserves for certain lines of business, primarily related to 2017 and prior policy years, subject to an aggregate cash deductible of$105 million which was withheld from the reinsurer. Subsequent to the Valuation Date but prior to the Inception Date, we strengthened the Net LPT Reserves by$5.5 million . This development resulted in an increase in the Net LPT Reserves of$5.5 million to$158.6 million . Consequently, at the Inception Date, the cash remitted to the third party reinsurer for the cession of the Net LPT reserves was$53.6 million (reflecting the$158.6 million of Net LPT Reserves less the$105 million cash deductible). As of the Inception Date, the LPT provided reinsurance protection of approximately$127.4 million above the Net LPT Reserves, subject to co-participations at specified amounts, detailed below. We paid$43.5 million in premium to the reinsurer for this reinsurance protection. This premium payment of$43.5 million combined with the$53.6 million remitted to the reinsurer resulted in a total cash transfer of$97.1 million on the Inception Date. The LPT is structured into two distinct sections with separate and independent reinsurance structures. Section A (representing$22.2 million of ceded net reserves at inception of the LPT) is the smaller section of the LPT covering claims from exited workers' compensation and general liability lines of business primarily related to business written in policy years 2011 and prior. Section B (representing$130.9 million of ceded net reserves at inception of the LPT) is a substantially larger section, covering claims from other exited business and certain continuing business related to policies written in years 2017 and prior, principally comprised of general liability and commercial auto lines. As ofDecember 31, 2022 , our net loss reserves subject to the LPT were$68.6 million . We materially strengthened our reserves subject to the LPT in line with the in depth actuarial and claims analyses performed specific to our business subject to the LPT. At the same time, we reduced the number of open claims by 70.1% since the inception of the LPT.
Section A
Based on the reserves on the Valuation Date, we ceded$22.2 million of net reserves related to Section A, subject to the aggregate cash deductible. The LPT provides 100% reinsurance coverage on the first$2.8 million of incurred losses and LAE above the ceded net reserves for Section A. Above the$2.8 million coverage layer is a further$5.0 million of reinsurance coverage for which we retain 50% of the incurred losses and LAE. InApril 2021 , we reviewed every open claim for the business covered by Section A, with the help of a leading independent actuarial firm, to ensure that our reserves were set to our expected ultimate loss. Based on the review, we strengthened our reserves subject to Section A. As ofDecember 31, 2022 , total incurred losses and LAE (including claims paid, case reserves and IBNR) were$34.7 million , which is$4.7 million in excess of our reinsurance coverage under Section A of the LPT. As a result, should new claims arise or existing claims develop adversely such that we need to increase our incurred losses and LAE on business covered by Section A, there would be no further reinsurance coverage on these policies subject to the LPT. As ofDecember 31, 2022 , paid losses and LAE on policies subject to Section A of the LPT were$22.0 million , which is$8.0 million below our total reinsurance coverage under Section A. We believe the ratio of paid losses and LAE to total incurred losses and LAE of 63.5% as ofDecember 31, 2022 , on policies covered under Section A of the LPT, in combination with the age of the policies (primarily policy years 2011 and prior) and the declining number of open claims (Section A open claims have been reduced by 51.8% since the Valuation Date), underscores the strength of our reserve position on Section A. The following chart sets forth the Section A reinsurance structure, the paid and incurred losses and LAE positions within the structure as ofDecember 31, 2022 , and the reduction in open claims from the Valuation Date throughDecember 31, 2022 .
[[Image Removed: skwd-20221231_g6.jpg]]
[[Image Removed: skwd-20221231_g7.jpg]]
Section B
Based on the reserves on the Valuation Date, we ceded$130.9 million of net reserves related to Section B, subject to the aggregate cash deductible. The LPT provides 100% reinsurance coverage on the first$19.1 million of incurred losses and LAE above the ceded net reserves for Section B. Above the$19.1 million layer, a further$70.0 million of reinsurance coverage is provided, for which we have a 50% co-participation on the incurred losses and LAE in the layer. There is a further$36.0 million of reinsurance that provides 100% coverage above the$70.0 million layer. InSeptember 2021 , we reviewed open claims for the business covered by Section B. Based on the review, we strengthened our reserves subject to Section B. As ofDecember 31, 2022 , total incurred losses and LAE (including claims paid, case reserves and IBNR) were$220.0 million with the entire$36.0 million of 100% coverage layer are available should new claims arise or existing claims develop adversely. As ofDecember 31, 2022 , paid losses and LAE on policies subject to Section B were$164.0 million , which is$92.0 million below our total reinsurance coverage under Section B, which includes the co-participation amounts. As with Section A, we believe that the Section B ratio of paid losses and LAE to total incurred losses and LAE of 74.6% as ofDecember 31, 2022 in combination with and the rapidly declining number of open claims (reduced by 74.2%) since the Valuation Date underscores the strength of our reserve position on Section B. The following chart sets forth the Section B reinsurance structure, the paid and incurred losses and LAE positions within the structure as ofDecember 31, 2022 , and the reduction in open claims from the Valuation Date throughDecember 31, 2022 :
[[Image Removed: skwd-20221231_g8.jpg]]
[[Image Removed: skwd-20221231_g9.jpg]]
Expense Ratio
The following table sets forth the components of the expense ratio for the years
ended
2022 2021
% of % of
Net Earned Net Earned
($ in thousands) Expenses Premiums Expenses Premiums
Net policy acquisition expenses $ 65,695 10.6 % $ 47,061 9.4 %
Other operating and general expenses 116,476 18.9 % 91,437 18.3 %
Underwriting, acquisition and insurance
expenses 182,171 29.5 % 138,498 27.7 %
Commission and fee income (5,199) (0.8) % (3,973) (0.8) %
Total net expenses $ 176,972 28.7 % $ 134,525 26.9 %
The expense ratio increased 1.8 points when compared to the same 2021 period.
The increase in the expense ratio was primarily driven by changes in our mix of
business resulting in higher net policy acquisition expenses combined with
higher operating expenses due to our continued investment in new underwriters
and underwriting teams.
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Table of Conte nt s
Investment Results
The following table sets forth the components of net investment income and net
investment (losses) gains for the years ended
2022 2021
Net Net
Investment Net Investment Net
($ in thousands) Income Yield Income Yield
Cash and short-term investments(1) $ 1,443 0.8 % $ 180 0.1 %
Core fixed income 16,544 3.0 % 8,812 2.3 %
Opportunistic fixed income 16,784 9.2 % 12,571 8.6 %
Equities 2,160 1.4 % 3,083 2.5 %
Net investment income $ 36,931 3.4 % $ 24,646 2.7 %
Net unrealized gains (losses) on securities
still held $ (15,058) $ 15,251
Net realized (losses) gains (647) 1,856
Net investment (losses) gains $ (15,705) $ 17,107
(1) excludes restricted cash
Net investment income was$36.9 million for the year endedDecember 31, 2022 , compared to$24.6 million for the same 2021 period. The increase in net investment income was driven by (i) a larger asset base in our core fixed income portfolio as we increase our allocation to this part of our investment portfolio, (ii) higher net investment yields in our core fixed income portfolio of 3.0% compared to 2.3% for the same 2021 period, and (iii) an increase in income from the opportunistic fixed income portfolio due to market appreciation of underlying investments. Our investment portfolio had a net investment yield of 3.4% for the year endedDecember 31, 2022 compared to 2.7% for the same 2021 period. Investments
Composition of Investment Portfolio
The following table sets forth the components of our investment portfolio at
carrying value at
2022 2021
Fair % of Fair % of
($ in thousands) value total value total
Cash and short-term investments(1)
Core fixed income 607,572 53.9 %
458,351 46.2 %
Opportunistic fixed income 196,021 17.3 %
168,058 17.0 %
Equities 157,506 14.0 %
158,033 15.9 %
Total investment portfolio$ 1,127,805 100.0 %
(1) Excludes restricted cash
Our fixed maturity securities, comprised of both core fixed income and opportunistic fixed income, comprised 71.2% and 63.2% of our total investment portfolio as ofDecember 31, 2022 and 2021, respectively, and had a weighted average effective duration of 3.1 years and 2.8 years as ofDecember 31, 2022 and 2021, respectively, and an average core fixed income credit rating of "AA" (Standard & Poor's ) as ofDecember 31, 2022 and 2021, respectively.
Core fixed income
The core fixed income portfolio consists primarily of investment grade fixed income securities which are predominantly highly-rated and liquid bonds. Our objective is to earn attractive risk-adjusted returns with a low risk of loss of principal. The portfolio is managed by third party managers. The average duration of the portfolio was approximately 4.3 years and 4.3 years, respectively, as ofDecember 31, 2022 and 2021. 40 -------------------------------------------------------------------------------- Table of Conte nt s The following table sets forth the components of our core fixed income portfolio atDecember 31, 2022 and 2021: 2022 2021 % of total % of total ($ in thousands) Fair value fair value Fair value fair value U.S. government securities$ 48,541 8.0 %$ 49,263 10.7 % Corporate securities and miscellaneous 235,129 38.7 % 154,163 33.6 % Municipal securities 57,727 9.5 % 56,942 12.5 % Residential mortgage-backed securities 119,856 19.7 % 103,735 22.6 % Commercial mortgage-backed securities 36,495 6.0 % 14,484 3.2 % Asset-backed securities 109,824 18.1 % 79,764 17.4 % Core fixed income securities, available for sale$ 607,572 100.0 %$ 458,351 100.0 % The weighted average credit rating of the portfolio was "AA" byStandard & Poor's Financial Services, LLC ("Standard & Poor's") atDecember 31, 2022 and 2021. The following table sets forth the credit quality of our core fixed income portfolio atDecember 31, 2022 and 2021, as rated byStandard & Poor's or equivalent designation: 2022 2021 ($ in thousands) Fair value % of total Fair value % of total AAA$ 283,733 46.7 %$ 223,404 48.7 % AA 74,604 12.3 % 67,157 14.7 % A 134,175 22.1 % 87,337 19.1 % BBB 88,369 14.5 % 76,835 16.8 % BB and Lower 26,691 4.4 % 3,618 0.8 % Total core fixed income$ 607,572 100.0 %$ 458,351 100.0 % Opportunistic fixed income The opportunistic fixed income portfolio is managed by Arena which is affiliated with Westaim, our largest shareholder. The opportunistic fixed income portfolio consists of separately managed accounts, limited partnerships, promissory notes and equity interests. The underlying securities are primarily floating rate senior secured loans, comprised of short duration, collateralized, asset-oriented credit investments designed to generate attractive risk-adjusted returns. Investments are backed by a significant amount of collateral and contain strong covenants with a typical loan-to-value of 66% or better. The limited partnerships are subject to future increases or decreases in asset value and may exhibit volatile results as asset values are monetized and the resultant income is distributed. As ofDecember 31, 2022 , the opportunistic fixed income portfolio consisted of three components: diversified asset based lending (54.6%), commercial mortgage loans (26.5%) and cash and cash equivalents (18.9%). The diversified asset based lending portfolio includes floating rate senior secured asset-based loans with significant amounts of collateral and strong covenants.
The following table sets forth the components of our opportunistic fixed income
portfolio by industry sector at
2022 2021
Fair % of Fair % of
($ in thousands) Value Total Value Total
Real Estate $ 90,370 46.1 % $ 75,305 44.8 %
Oil & Gas 20,725 10.6 % 20,321 12.1 %
Banking, Finance & Insurance 13,870 7.1 % 13,683 8.1 %
Other sectors(1) 34,072 17.4 % 16,936 10.1 %
Cash and cash equivalents(2) 36,984 18.8 % 41,813 24.9 %
Opportunistic fixed income $ 196,021 100.0 % $ 168,058 100.0 %
(1) Other Sectors primarily includes Aerospace & Defense, Business Services, Retail, Commercial & Industrial and Environmental.
(2) Includes cash on settlements that have not yet been redeployed.
The average duration of the portfolio is approximately 1.4 years and 1.5 years
as of
41 -------------------------------------------------------------------------------- Table of Conte nt s Equities The equities portfolio primarily consists of domestic preferred stocks, common equities, exchange traded funds, limited partnerships, limited liability corporations and other types of equity interests 76.3% of which are publicly traded. During 2021, we initiated a tail-risk management strategy that is designed to provide some protection for the equity portfolio if there is a significant decline in the S&P 500 within a 30 day period. We continued this strategy in 2022 and as ofDecember 31, 2022 , the annual cost of the strategy was approximately$3.0 million . The portfolio is directed internally and includes both self-managed investments and portfolios managed by third-party investment management firms.
The following table sets forth the components of our equities portfolio by
security type at
2022 2021
Fair % of total Fair % of total
($ in thousands) value fair value value fair value
Domestic common equities $ 76,929 48.8 % $ 82,895 52.5 %
International common equities 34,468 21.9 % 16,911 10.7 %
Preferred stock 8,772 5.6 % 18,166 11.5 %
Other(1) 37,337 23.7 % 40,061 25.3 %
Equities $ 157,506 100.0 % $ 158,033 100.0 %
(1) Other includes limited partnerships, limited liability companies and other equity interests
Market Risk Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in interest rates, equity prices, foreign currency exchange rates and commodity prices. The primary components of market risk affecting us are credit risk and interest rate risk. We do not have significant exposure to foreign currency exchange rate risk or commodity risk.
Credit risk
Credit risk is the potential loss resulting from adverse changes in an issuer's ability to repay its debt obligations. We have exposure to credit risk as a holder of debt instruments in our core fixed income and opportunistic fixed income portfolios. Our risk management strategy and investment policy is to invest primarily in debt instruments of high credit quality issuers and to limit the amount of credit exposure with respect to particular ratings categories and any one issuer. AtDecember 31, 2022 , our core fixed income portfolio had an average rating of "AA," with approximately 81% of securities in that portfolio rated "A" or better by at least one nationally recognized rating organization. Our policy is to invest in investment grade fixed income securities which are high quality and liquid, providing a stable income stream, supplemented by opportunistic fixed income and equity securities, with the objective of further enhancing the portfolio's diversification and risk-adjusted returns. AtDecember 31, 2022 , approximately 4.4% of our core fixed income portfolio was unrated or rated below investment-grade. Through our investment managers, we monitor the financial condition of all of the issuers of securities in our portfolio. In addition, we are subject to credit risk with respect to our third-party reinsurers. Although our third-party reinsurers are obligated to reimburse us to the extent we cede risk to them, we are ultimately liable to our policyholders on all risks we have ceded. As a result, reinsurance contracts do not limit our ultimate obligations to pay claims covered under the insurance policies we issue, and we might not collect amounts recoverable from our reinsurers. We address this credit risk by seeking to purchase reinsurance from reinsurers that are rated at least "A-" (Excellent) or better byA.M. Best . We also perform, along with our reinsurance broker, periodic credit reviews of our reinsurers. AtDecember 31, 2022 , 99% of our reinsurance recoverables were either derived from reinsurers rated A- (Excellent) byA.M. Best , or better, or were collateralized through funds held, trusts and letters of credit by the reinsurer. If one of our reinsurers suffers a credit downgrade, we may consider various options to lessen the risk of asset impairment, including commutation, novation and letters of credit. Interest rate risk Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. The primary market risk to our investment portfolio is interest rate risk associated with investments in fixed income securities. Fluctuations in interest rates have a direct effect on the market valuation of these securities. When market interest rates rise, the fair value of our securities decreases. Conversely, as interest rates fall, the fair value of our securities increases. We manage this interest rate risk by investing in securities with varied maturity dates and by managing the duration of our 42 -------------------------------------------------------------------------------- Table of Conte nt s investment portfolio in directional relation to the duration of our reserves. Expressed in years, duration is the weighted average payment period of cash flows, where the weighting is based on the present value of the cash flows. We set duration targets for our core fixed income investment portfolio after consideration of the estimated duration of our liabilities and other factors. Our fixed maturity securities had a weighted average effective duration of 3.1 years as ofDecember 31, 2022 . We had fixed income securities that were subject to interest rate risk with a fair value of$607.6 million atDecember 31, 2022 . Our opportunistic fixed income securities are excluded from our interest rate sensitivity analysis as they are primarily floating rate and treated as held to maturity securities. The following table sets forth what changes might occur in the value of our core fixed income portfolio given hypothetical changes in interest rates as ofDecember 31, 2022 : Estimated % Estimated Increase Estimated Change (Decrease) ($ in thousands) Fair Value in Fair Value in Fair Value 300 basis point increase$ 540,703 $ (66,869) (11.0) % 200 basis point increase$ 560,411 $ (47,161) (7.8) % 100 basis point increase$ 582,701 $ (24,871) (4.1) % No change$ 607,572 $ - 0.0 % 100 basis point decrease$ 635,026 $ 27,454 4.5 % 200 basis point decrease$ 665,062 $ 57,490 9.5 % 300 basis point decrease$ 697,679 $ 90,107 14.8 % Changes in interest rates will have an immediate effect on comprehensive income and stockholders' equity but will not ordinarily have an immediate effect on net income. Actual results may differ from the hypothetical change in market rates assumed in the table above. This sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical losses in fair value. Equity price risk Equity price risk represents the potential economic losses due to adverse changes in equity security prices. AtDecember 31, 2022 , approximately 16.4% of the fair value of our investment portfolio (excluding cash and cash equivalents and short-term investments) was invested in equity securities. We manage equity price risk through portfolio diversification and maintain a tail-risk management strategy that is designed to provide some protection for the equity portfolio if there is a significant decline in the S&P 500 within a 30 day period.
Other Items
Income Taxes
Income tax expense was$10.4 million for the year endedDecember 31, 2022 compared to$10.0 million for the year endedDecember 31, 2021 . Our effective tax rate was 20.9% for the year endedDecember 31, 2022 , compared to 20.7% for the year endedDecember 31, 2021 . The change in our effective tax rate in 2022 when compared to 2021 was primarily due to the relationship of taxable to non-taxable income. The Company's provision for income taxes generally does not deviate substantially from the statutory tax rate. The effective tax rate may vary slightly from the statutory rate due to tax adjustments for tax-exempt income and dividends-received deduction. See Note 14, "Income Taxes" to our consolidated financial statements included in Item 8 of this Form 10-K for a reconciliation between our actual federal income tax expense and the amount computed at the indicated statutory rate for the years endedDecember 31, 2022 and 2021.
Liquidity and Capital Resources
Sources and Uses of Funds
We are organized as a holding company with our operations primarily conducted by our wholly-owned insurance subsidiaries, HSIC, IIC, and GMIC, which are domiciled inTexas , and OSIC, which is domiciled inOklahoma . Accordingly, the holding company may receive cash through (1) corporate service fees from our operating subsidiaries, (2) payments pursuant to our consolidated tax allocation agreement, (3) dividends from our subsidiaries, subject to certain limitations discussed below regarding dividends from our insurance subsidiaries, (4) loans from banks, (5) draws on a revolving loan agreement, and (6) issuance of equity and debt securities. We also may use the proceeds from these sources 43
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Table of Conte nt s
to contribute funds to insurance subsidiaries in order to support premium
growth, pay dividends and taxes and for other business purposes.
Skyward Service Company receives corporate service fees from the operating subsidiaries to reimburse it for most of the operating expenses that it incurs. Reimbursement of expenses through corporate service fees is based on the actual costs that we expect to incur with no mark-up above our expected costs. We file a consolidatedU.S. federal income tax return with our subsidiaries, and under our corporate tax allocation agreement, each participant is charged or refunded taxes according to the amount that the participant would have paid or received had it filed on a separate return basis with the Internal Revenue Service (the "IRS"). Applicable state insurance laws restrict the ability of the insurance subsidiaries to declare stockholder dividends without prior regulatory approval. Applicable state insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Dividend payments are further limited to that part of available policyholder surplus which is derived from net profits on an insurer's business. Insurance regulators have broad powers to prevent reduction of statutory surplus to inadequate levels, and there is no assurance that dividends of the maximum amounts calculated under any applicable formula would be permitted. State insurance regulatory authorities that have jurisdiction over the payment of dividends by our insurance subsidiaries may in the future adopt statutory provisions more restrictive than those currently in effect. Our insurance subsidiaries did not pay dividends to us for the years endedDecember 31, 2022 or 2021. See Note 25, "Regulatory Matters" to our consolidated financial statements included in Item 8 of this Form 10-K for further information regarding our insurance companies.
As of
investments compared to
We believe that we have sufficient liquidity available to meet our operating
cash needs and obligations and committed capital expenditures for the next
12 months.
Cash Flows
Our most significant source of cash is from premiums received from our insureds, which, for most policies, we receive at the beginning of the coverage period, net of the related commission amount for the policies. Our most significant cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that generally earn interest and dividends. We also use cash to pay for operating expenses such as salaries, rent and taxes and capital expenditures such as technology systems. We use reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid. The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, and as a result their timing can influence cash flows from operating activities in any given period. Management believes that cash receipts from premiums and proceeds from investment income are sufficient to cover cash outflows in the foreseeable future. The following table sets forth our cash flows for the years endedDecember 31, 2022 and 2021: ($ in thousands) 2022 2021
Cash and cash equivalents provided by (used in):
Operating activities$ 208,938 $ 175,285 Investing activities (193,381) (183,014) Financing activities 2,180 1,380 Change in cash and cash equivalents$ 17,737 $ (6,349) The increase in cash provided by operating activities in 2022 and 2021 was primarily due to the timing of premium receipts, claim payments and reinsurance activity. Cash flows from operations in each of the past two years were used primarily to fund investing activities.
The change in net cash used in investing activities from 2022 to 2021 was
primarily driven by increases in the purchases of fixed maturities.
44 -------------------------------------------------------------------------------- Table of Conte nt s Credit Agreements OnDecember 11, 2019 , we entered into a credit agreement withProsperity Bank which provided us with a$50.0 million term loan (the "Term Loan") and a$50.0 million revolving line of credit (the "Revolver") with additional capacity up to$75.0 million . The Term Loan The interest rate on the Term Loan is the lesser of the one-month LIBOR (4.39% onDecember 31, 2022 ) plus the "Applicable Margin," which is defined as 1.65%, or the Highest Lawful Rate. The "Highest Lawful Rate" is defined as the lesser of (a) (i) the "weekly ceiling" as defined within Section 303.003 of theTexas Finance code, as amended or (ii) the "annualized ceiling" as defined within Section 303.103 of the Texas Finance Code, as amended and (b) (i) 24% if the principal is less than$250 thousand or (ii) 28% if the principal is greater than$250 thousand . Interest-only payments are due and payable on a quarterly basis throughDecember 31, 2024 . As ofDecember 31, 2022 the principal balance on the Term Loan was$50.0 million , which is dueDecember 31, 2024 .
The Revolver
The interest rate on the Revolver is the lesser of the prime rate, as published by theWall Street Journal , or the one-month LIBOR (4.39% onDecember 31, 2022 ) plus the Applicable Margin, which is defined as the lesser of 1.65%, or the Highest Lawful Rate. The revolving promissory note includes a fee of 0.25% on the unused portion. Interest-only payments are due and payable on a quarterly basis throughDecember 31, 2024 . As ofDecember 31, 2022 , there was no outstanding balance on the Revolver compared to a contractual capacity of$50.0 million . Subject to lender approval, we have a right to increase the capacity to$75.0 million .
Borrowings under the Term Loan and Revolver may be used to refinance debt and
for general corporate purposes.
Included in the Credit Agreement is a provision that allows for us to issue up to$20.0 million of letters of credit ("LOCs"). Any amounts drawn on the LOCs must either be repaid, or the balance constitutes additional borrowings under the Revolver. As ofDecember 31, 2022 , there were no LOCs issued.
Trust Preferred
InAugust 2006 , we received$58.0 million of proceeds from a debenture offering through a statutory trust,Delos Capital Trust (the "Trust"). The sole asset of the Trust consists of Fixed/Floating Rate Junior Subordinated Deferrable Interest Debentures (the "Trust Preferred") with a principal amount of$59.8 million issued by us and cash of$1.8 million from the issuance of Trust common shares purchased by us equal to 3% of the Trust capitalization. The Trust Preferred are an unsecured obligation, are redeemable, and have a maturity date ofSeptember 15, 2036 . Interest on the Trust Preferred is payable quarterly at an annual rate based on the three-month LIBOR (4.77% atDecember 31, 2022 ), plus 3.4%. Subordinated Debt InMay 2019 , we issued unsecured subordinated notes (the "Notes") with an aggregate principal amount of$20.0 million . Interest on the subordinated notes is 7.25% fixed for the first 8 years and 8.25% fixed thereafter. Early retirement of the debt ahead of the eight (8) year commitment requires all interest payments to be paid in full, as well as the return of all capital. Principal payment is due at maturity onMay 24, 2039 and interest is payable quarterly. AtDecember 31, 2022 andDecember 31, 2021 , the ratio of total debt outstanding, including the Term Loan, the Revolver, the Trust Preferred and the Notes, to total capitalization (defined as total debt plus stockholders' equity, plus any temporary equity) was 23.4% and 23.2%, respectively.
Contractual Obligations and Commitments
The following table sets forth our contractual obligations and commercial
commitments by due date as of
Payments due by period
Less Than One Year
($ in thousands) Total One Year or More
Reserves for losses and LAE
Long-term debt
129,794 -
129,794
Interest on debt obligations 110,879 9,383 101,496
Operating lease obligations
9,199 2,206 6,993 Total$ 1,391,629 $ 305,236 $ 1,086,393 45
-------------------------------------------------------------------------------- Table of Conte nt s Reserves for losses and LAE represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. Estimating reserves for losses and LAE is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by period are based on our own, industry and peer group claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period will be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on reserves for losses and LAE are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on reserves for paid and unpaid losses and LAE totaled$581.4 million and$536.3 million atDecember 31, 2022 andDecember 31, 2021 , respectively.
Critical Accounting Policies and Estimates
We identified the accounting estimates below as critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. For a detailed discussion of our accounting policies, see Note 2, "Summary of Significant Accounting Policies" to our consolidated financial statements included in Item 8 of this Form 10-K.
Reserves for unpaid losses and LAE
The reserves for unpaid losses and LAE is the largest and most complex estimate in our consolidated balance sheet. The reserves for unpaid losses and LAE represent our estimated ultimate cost of all unreported and reported but unpaid insured claims and the cost to adjust these losses that have occurred as of or before the balance sheet date. We do not discount our reserves for losses and LAE to reflect estimated present value. We estimate the reserves using individual case-basis valuations of reported claims and statistical analyses and various actuarial procedures. Those estimates are based on our historical information, industry and peer group information and our estimates of future trends in variable factors such as loss severity, loss frequency and other factors such as inflation. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Additionally, during the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, the ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and the related LAE may vary significantly from the estimate included in our financial statements.
We categorize our reserves for unpaid losses and LAE into two types: case
reserves and IBNR.
The following table sets forth our gross and net reserves for unpaid losses and
LAE at
2022
2021
($ in thousands) Gross % of Total Net % of Total Gross % of Total Net % of Total Case reserves$ 485,143 42.5 %$ 269,273 38.2 %$ 451,446 46.1 %$ 239,013 40.0 % IBNR 656,614 57.5 % 436,498 61.8 % 528,103 53.9 % 359,198 60.0 % Total$ 1,141,757 100.0 %$ 705,771 100.0 %$ 979,549 100.0 %$ 598,211 100.0 % Case reserves are established for individual claims that have been reported to us. We are notified of losses by our insureds or their agents or our brokers. Based on the information provided, we establish case reserves by estimating the ultimate losses from the claim, including defense costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with advice from internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses. In limited circumstances, we utilize the services of TPAs to assist in the adjustment of claims. Our internal claims managers oversee TPA activities and monitor their individual claim handling activities to our prescribed standards. 46 -------------------------------------------------------------------------------- Table of Conte nt s Our IBNR reserves are developed in accordance with Actuarial Standards of Practice promulgated by theAmerican Academy of Actuaries . Our reserve review is performed by our Reserve Committee that utilizes several accepted loss reserving methods to arrive at our best estimate of loss reserves. We give consideration to the relative strengths and weaknesses of each of the methods in deriving our actuarial best estimate of the liabilities. Where we have limited years of loss experience compared to the period over which we expect losses to be reported, we use industry and/or peer-group data in addition to our own data as a basis for selecting the parameters underlying our reserving methods. We monitor loss emergence daily. We carefully consider other internal or external factors such as underwriting, claims handling, economic, or environmental changes that could adversely affect the accuracy of the assumptions underlying our standard actuarial methods and when necessary we will adjust these assumptions, methods, and/or procedures to ensure that they appropriately reflect these changing conditions. The duration of loss reserves was 2.2 years as ofDecember 31, 2022 . Our Reserve Committee includes our Chief Actuary,Chief Risk Officer , Chief Financial Officer and Chief Claims Officer. The Reserve Committee meets quarterly to review the actuarial reserving recommendations made by the Chief Actuary and uses their best judgment to determine the best estimate to be recorded for the reserve for losses and LAE on our balance sheet. In establishing the quarterly actuarial recommendation for the reserves for losses and LAE, our actuary estimates an initial expected ultimate loss ratio for each of our underwriting divisions. Input from our underwriting and claims departments, including premium pricing assumptions and historical experience, is considered by our actuary in estimating the initial expected loss ratios. Multiple actuarial methods are used to estimate the reserve for losses and LAE. These methods utilize, to varying degrees, the initial expected loss ratio, detailed statistical analysis of past claims reporting and payment patterns, claims frequency and severity, paid loss experience, industry loss experience, and changes in market conditions, policy forms, exclusions, and exposures. The actuarial methods used to estimate losses and LAE reserves are: •Reported and/or Paid Loss Development Methods - Ultimate losses are estimated based on historical reported and/or paid loss reporting patterns. Reported losses are the sum of paid and case losses. Industry development patterns are substituted for historical development patterns when sufficient historical data is not available. •Reported Bornhuetter-Ferguson Methods - Ultimate losses are estimated as the sum of cumulative reported losses and estimated IBNR losses. IBNR losses are estimated based on historical development patterns and one or more of the following: expected average severity and estimated ultimate claims counts, expected pure premium, and expected loss ratios underlying our loss cost multipliers. •Paid Bornhuetter-Ferguson Method - Under this method, ultimate losses are estimated as the sum of cumulative paid losses and estimated unpaid losses. Unpaid losses are estimated based on the expected loss ratios underlying our loss cost multipliers, and selected industry development patterns of paid losses. We utilize each of these methods in our comprehensive review of reserves. When evaluating reserves related to less mature policy years, we utilize the Bornhuetter-Ferguson Method as the primary method for our ultimate loss indications. As we move to more mature policy years, we transition to the Reported and/or Paid Loss Development Methods. We primarily rely on reported methods where case reserving is consistently applied across policy years, however, when there is a change in reserving philosophy we will blend both reported and paid methods in our evaluation of ultimate loss indications. Our reserves are driven by several important factors, including litigation and regulatory trends, legislative activity, climate change, social and economic patterns and claims inflation assumptions. Our reserve estimates reflect current inflation in legal claims' settlements and assume we will not be subject to losses from significant new legal liability theories. Our reserve estimates assume that there will not be significant changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business, but no assurance can be given that our attempt to quantify such inputs will be accurate or successful. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting and payment patterns could differ from our expected reporting and payment patterns, which are based on our own data and industry data. Accordingly, the ultimate settlement of losses and the related LAE may vary significantly from the estimates included in our financial statements. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in the results of current operations. The table below quantifies the impact of potential reserve deviations from our carried reserve atDecember 31, 2022 . We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. In the selection of the volatility factors, we have considered the potential impact of changes 47 -------------------------------------------------------------------------------- Table of Conte nt s in current loss trends, pricing trends, and other actuarial reserving assumptions. The aggregate development depicted in the sensitivity analysis is consistent with the average development in recent calendar periods and a reasonable depiction of the potential volatility of the reserve estimates for the current calendar period. We believe that potential changes such as these would not have a material impact on our liquidity. ($ in thousands) December 31, 2022 Potential Impact on 2022 Net Ultimate Net Loss and Ultimate LAE Incurred Net Loss Accident Sensitivity Losses and and LAE Pre-tax Stockholders' Sensitivity Year Factor LAE Reserve income Equity(1) Sample increases 2022 4.0 %$ 379,083 $ 288,748 $ 15,163 $ 11,979 2021 3.0 % 324,882 182,085 9,746 7,700 2020 2.0 % 295,599 78,813 5,912 4,670 Prior 1.0 % - 156,787 1,568 1,239 Sample decreases 2022 (4.0) % 379,083 288,748 (15,163) (11,979) 2021 (3.0) % 324,882 182,085 (9,746) (7,700) 2020 (2.0) % 295,599 78,813 (5,912) (4,670) Prior (1.0) % - 156,787 (1,568) (1,239)
(1) The effective rate was consistent with the
The amount by which estimated losses differ from those originally reported for a period is known as "development." Development is unfavorable when the losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed.
Goodwill and intangible assets are recorded as a result of a business combination.Goodwill represents the excess of the purchase price over the fair value of the assets acquired and liabilities assumed. We amortize identifiable intangible assets with a finite useful life over the period that the intangible asset is expected to contribute directly or indirectly to its future cash flows; however, we do not amortize indefinite lived intangible assets.
We evaluate goodwill and identifiable intangible assets for recoverability
annually in the fourth quarter or on an interim basis should events or changes
in circumstances indicate that a carrying amount may not be recoverable.
To test for impairment, a qualitative assessment is performed to determine if it
is more likely-than-not that the fair value of a reporting unit is less than its
carrying value, including goodwill. This initial assessment includes, among
other factors, consideration of: (i) past, current and projected future earnings
and equity; (ii) recent trends and market conditions; and (iii) valuation
metrics involving similar companies that are publicly traded and acquisitions of
similar companies, if available. If the more likely-than-not threshold is met, a
quantitative impairment test is performed by comparing the estimated fair value
with the carrying value. If the carrying value of the net assets associated with
the reporting unit exceeds the fair value of the reporting unit, goodwill is
considered impaired and will be determined as the amount by which the reporting
unit's carrying value exceeds its fair value, not to exceed the carrying amount
of goodwill.
Our reporting unit is at the underwriting division level; this is one level
below the consolidated group where the underwriting division represents a
business and discrete financial information is available and reviewed regularly
by underwriting management. Determining the fair value of its reporting units is
subjective in nature and involves the use of significant estimates and
assumptions, including projected net cash flows, discount and long-term growth
rates.
We determine the fair value of our reporting units based on an income approach
and market approach, whereby the fair value of the reporting unit is derived
from the present value of estimated future cash flows associated with the
reporting unit. The assumptions about estimated cash flows include factors such
as future premiums, loss and LAE expenses, general and administrative expenses
and industry trends. We consider historical rates and current market conditions
when determining the discount and long-term growth rates to use in its analysis.
48
--------------------------------------------------------------------------------
Table of Conte nt s
We consider other valuation methods if the facts and circumstances indicate
these methods provide a more representative approximation of fair value. Changes
in these estimates based on evolving economic conditions or business strategies
could result in material impairment charges in future periods. We base our fair
value estimates on assumptions we believes to be reasonable. Actual results may
differ from those estimates.
Recent Accounting Pronouncements
We currently qualify as an "emerging growth company" under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Accordingly, we are provided the option to adopt new or revised accounting guidance either (i) within the same periods as those otherwise applicable to non-emerging growth companies or (ii) within the same time periods as private companies. We have elected to avail ourselves of this extended transition period and, as a result, we will not be required to adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. We will remain an emerging growth company until the earliest of (i) the last day of the fiscal year in which we have total annual gross revenues of$1.235 billion or more; (ii) the last day of our fiscal year following the fifth anniversary of the date of the completion of this offering; (iii) the date on which we have issued more than$1 billion in nonconvertible debt during the previous three years; and (iv) the date on which we are deemed to be a large accelerated filer under the rules of theSEC . InJune 2016 , the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 326). ASU 2016-13 requires organizations to estimate credit losses on certain types of financial instruments, including receivables and available-for-sale debt securities, by introducing an approach based on expected losses. The expected loss approach will require entities to incorporate considerations of historical information, current information, and reasonable and supportable forecasts. The guidance is effective for fiscal years beginning afterDecember 15, 2022 . The Company will adopt this ASU effectiveJanuary 1, 2023 using the modified retrospective approach. The Company expects to recognize an increase in the allowance for uncollectible reinsurance of approximately$2.3 million and an increase in accumulated deficit of approximately$2.3 million , net of tax.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Qualitative and Quantitative Disclosures about Market Risk are included in Item
7 of this Form 10-K under "Investments-Market Risk."
49
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Table of Conte nt s
Hallmark Announces Fourth Quarter and Fiscal 2022 Results
HALLMARK FINANCIAL SERVICES INC – 10-K – Management's Discussion and Analysis of Financial Condition and Results of Operations.
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