Heritage Insurance Holdings, Inc. Q3 FY2022 Earnings Call

Good morning, and thank you for joining us today. We invite you to visit the Investors section of our website, investors.heritagepci.com where the earnings release and our earnings call will be archived. These materials are available for replay or review at your convenience. Today's call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based upon management's current expectations and are subject to uncertainty and changes in circumstances. In our earnings press release and our SEC filings, we detail material risks that may cause our future results to differ from our expectations. Our statements are as of today, and we have no obligation to update any forward-looking statements we may make. For a description of the forward-looking statements and the risks that could cause our results to differ materially from those described in the forward-looking statements, please refer to our annual report on Form 10-K, earnings release and other SEC filings. Our comments today will also include non-GAAP financial measures. The reconciliation of and other information regarding these measures can be found in our press release. With me on the call today is Ernie Garateix, our Chief Executive Officer. I will now turn the call over to Ernie.

Thank you, Kirk, and thank you for joining our call today. We'll discuss our third quarter 2022 results during this call. I will provide an overview of our strategic initiatives. Kirk will provide an update on key financial performance metrics. And then we will open the call for Q&A. Our thoughts continue to be with all those impacted by Hurricane Ian, which made landfall in Florida on September 28. We remain committed to assisting our policyholders, and I'm proud of the hundreds of employees we've mobilized and deployed to respond to this event. Our customers have been loyal to us based on the promise to deliver a service in their time of need. We are committed to fulfilling that commitment by providing timely payments of valid and covered claims. Our experienced claims team has deep catastrophe handling experience, which includes distinguishing causes of loss from wind versus flood. We continue to execute strategic initiatives that will enable Heritage to achieve consistent, long-term quarterly earnings and drive shareholder value. Our initiatives, which are described in our earnings release, include rate adequacy and selective underwriting, product selection and capital allocation, and diversification of our portfolio of policies throughout 16 states. Getting appropriate rates for our coverage offer is paramount. We continue to take rates in all our markets to keep up with the cost of reinsurance, the higher frequency of weather events, and higher repair and replacement costs driven by inflation of products and services. These higher rates are the primary driver of our 13.6% increase in the average premium per policy throughout the book, and we expect this trend to continue. We continue to derisk and diversify our policy mix outside of Florida. These efforts have led to the growth of premiums in force in all states outside of Florida. In addition, total insured values outside of Florida represent approximately 75% of our portfolio, up from 71% at this time last year. Our underwriting continues to be more selective, and we continuously evaluate coverage changes so our product serves our markets, but also produces margin. A considerable market disruption has caused us to tighten our underwriting criteria while also restricting new business in our over-concentrated markets. Even with the tightening of our criteria and limiting new business, our premiums in force are at a historic high of $1.24 billion at the end of the quarter. We seek to align our capital with our products and geographies that maximize long-term returns. Correspondingly, we will exit products in states that we don't believe can generate long-term returns or have limited upside potential. I am pleased with our progress in this area. However, we continue to evaluate our portfolio and expect to make more changes going forward as we focus on both short- and long-term returns. Reinsurance capacity and pricing is a factor in how we allocate capital by product and state. The cost of reinsurance is expected to increase, and capacity constraints are on the horizon. We appreciate our reinsurance trading partners with whom we have developed a long-term consistent relationship. Given the expected pricing and capacity for catastrophe reinsurance going forward, we will continue to evaluate and adjust our portfolio to manage exposure concentration. This includes the amount of new business we expect to write and the amount of existing business we may renew while maintaining compliance with individual state regulations. Product selection is also key to our long-term success. As we reduce business in products or geographies that don't provide sufficient margin, we are entering markets we believe offer opportunity for our company and our customers. For example, we entered the California and Florida markets on an excess and surplus lines basis, which allows us to be nimble and responsive to pricing and product offerings. We continue to analyze and evaluate the challenging markets in which we operate, and we'll look to expand our excess and surplus line capabilities in other states and markets. Despite the negative impact Hurricane Ian had on our third quarter 2022 results, we are pleased with the progress we continue to make towards sustainable profitability. Rate increases continued to meaningfully benefit written premiums throughout the book of business, and we remain committed to proactively and appropriately raising rates to offset higher costs for reinsurance as well as higher loss costs. We are taking underwriting actions to improve profitability. This concludes my remarks. Let me now turn things over to Kirk Lusk for a review of the results in the quarter and key financial performance metrics.

Thank you, Ernie. Good morning, everyone. The third quarter net loss totaled $48.2 million or $1.83 per diluted share compared to a net loss of $16.4 million or $0.59 per diluted share in the prior year quarter. This loss was primarily attributable to a $40 million net retained loss for Hurricane Ian that was previously announced on October 13, and without which, our net loss and LAE for the quarter would have declined by $14.8 million or 10.6% from the prior year quarter. The company has received close to 14,000 claims associated with Hurricane Ian, and we project ultimate gross losses, including loss adjustment expense, of $655 million. At this level, we expect that ultimate loss from Hurricane Ian will remain well within the second layer of our cat excel tower. The third quarter was also impacted by a $10.7 million tax valuation allowance related to Osprey Re and its Internal Revenue Code Select Section 953(d) election for which we are able to recover the valuation allowance as Osprey generates future net income. As Ernie mentioned, in-force premiums are at their highest level at $1.24 billion, up 5.8% while policies in-force are down 6.9% and CIB is up 2.1%. The increase in premiums and decrease in policy count reflects the amount of rate earning through the portfolio and tightening underwriting. In-force premiums in all states other than Florida grew by 14.4%. Policies in-force decreased by 18.8% for Florida admitted personal lines policies. While personal lines Florida in-force premium was down 7.8%, we grew our commercial lines premium by 18.2% over the prior year period. The increase in our commercial portfolio while decreasing our personal portfolio in Florida results from our effort to shift capital to those lines of business and geographies that generate sufficient returns and away from lines that do not. Total revenue for the quarter declined 1% from the prior year quarter, reflecting an increase in ceded premium of 12.4% exceeding the increase in gross earned premiums of 4.2%. The ceded premium ratio ended the quarter at 48.1%, up 3.3 points from 44.8% in the prior year quarters. The increase primarily stems from higher cost of our 2022 to 2023 catastrophe excess of loss program. The increase in this program was driven by higher rates online as well as higher total insured value. In addition, other income is down due to a reduction in policy fees associated with fewer policies in-force, which is partially offset by an increase in investment income with higher interest rates. The net current accident year weather losses of $63.8 million ended the quarter up 24.2% from $51.4 million in the prior year quarter. As mentioned, current accident catastrophe weather losses included $40 million of net current accident quarter catastrophe losses attributable to Hurricane Ian, up 150.5% from $16.0 million in the prior year quarter and $23.8 million of other weather losses, down 32.8% from $35.4 million in the prior year quarter. Attritional losses were also up slightly in the quarter, most notably in the Northeast. Expenses are up due to acquisition costs related to the increase in gross written premium with a net expense ratio driven higher by the reduction in net earned premium. The net combined ratio for the quarter was 133.3%, up 20.8 points from 112 in the prior year quarter, driven by higher net loss ratio and net expense ratio just mentioned. Our focus on profitability will continue to drive reductions in policy count along with rate increases anticipated to align with inflation, reinsurance, and loss costs. Abusive litigated claims practices inflation continued to be our primary concern for first lines business in Florida, and we have taken underwriting actions aimed at reducing the adverse impact of market challenges and inflation. We are also restricting underwriting to address the surging policies that certain markets are becoming more dislocated. We're also including inflation guard on all states. Our book value per share is $4.54, but when adding back the unrealized losses in the investment portfolio, the adjusted book value is $6.65. With over $297 million in cash and cash equivalents, we don't anticipate a need to sell any of these investments in advance of maturity with the abundant cash held outside our investment portfolio. Our duration is short at 3.4 years, and the average credit rating on our invested fixed asset income portfolio is A+. As such, we expect the unrealized losses to decline as investments mature. We operate by navigating some very challenging markets and are focused on generating an underwriting profit while remaining unfettered in that pursuit. We will continue to analyze and evaluate our portfolio to optimize returns and reduce volatility. We are dissatisfied with our stock price and do not believe it reflects the true value of the company. We firmly believe that each of our current operating companies are worth more than the total market capitalization of the company. Management and the Board are committed to providing shareholder value and will take the steps necessary to drive that value. We remain focused on sustainable profitability and long-term shareholder returns. As I stated before, we will consider all options to realize the value of our entities and will also take the actions necessary to improve margins. That concludes our prepared remarks. Operator, we are ready to begin the question-and-answer portion of the call.

The first question comes from Mark Hughes from Truist.

Kirk, how much cash is in the holding company?

$30 million.

And then what is the surplus within the insurance operations?

Yes. The total surplus among all entities is $261 million.

Then how do you look at the capital adequacy in terms of the underwriting leverage, $261 million? How much more business could you put on? Or is the idea here to taper? I guess you've continued to grow premiums and you're growing commercial in Florida. How do you view that capital adequacy?

Yes. I think when we look forward, I mean, our count, we anticipate that is going to continue to decrease. And we are taking substantial rates on top of our inflation guard factors. And that really is what's driving our premium increase. When we look at going forward, we actually think that our count is going to continue to decrease. And I think our exposures are probably going to be leveling off a little bit.

And then for reinsurance, refresh me on how much multiyear reinsurance you have in place, how much of your power will you have to buy this year or next year?

Yes. We do have a cat bond for the Northeast tower, and that would be the extent of our multiyear.

So most of your spending will be on the market.

Yes. Correct.

Are there any expectations for the Florida legislative session? Are there any particular fixes or strategies being discussed that you are aware of?

So we have been discussing with legislators the one-way feed statute and doing something on the cat bond and they're all considering all those items, but those items are being discussed now and being strategized for a special session at this point.

Yes. One other comment I'd just make on going back to the reinsurance piece is we did defer on the RAP program last year. So that is available for us this year, which would assist below the FHCF.

And keep in mind, the FHCF accounts for almost 50% of the reinsurance program.

Our next question comes from Paul Newsome from Piper Sandler.

Did you mention the RBC ratios in the subsidiaries, or did I miss that? I'm sorry if I did.

Yes. At year-end, RBCs for HPCIC was just a little over $310. Zephyr was in the $440 range and NBIC was in the $420 range.

And that's as of last year's year-end.

That's as of year-end. I mean, it is calculated kind of on an annualized basis based upon a 12-month rolling basis. So that's why we look at where it was versus the surplus.

Right. So presumably, those numbers will be different in the fourth quarter given the losses.

Yes. Considering the losses, we expect that Zephyr will still remain well above $400. For NBIC and Heritage, we are planning to provide them with some additional capital or expense forgiveness in the fourth quarter. That is already included in our expectations.

Could you talk about what would happen if Hurricane Nicole ends up being a significant event from the insurance perspective? Is it very much the same as what happened with Ian? Or does it have other changes?

Yes. From a retention standpoint, our match retention on a second event would be $32 million. Anything over $20 million would require us to cover $0.40 on the dollar. Therefore, at $30 million, it would be $26 million, and at $40 million, it would be $32 million. This would represent the extent of our retention, depending on the severity of that specific storm.

Great. Can you talk all about the difference in profitability between Florida and non-Florida? How much of the difference in the profit?

We view ourselves as a single segment for reporting purposes, so we look at the whole picture. Our goal is to achieve rate adequacy across all areas, which includes every state, jurisdiction, and product. The rate increases we have implemented, particularly in the Northeast, Southeast, and somewhat in Hawaii, reflect our commitment to achieving this rate adequacy.

Any thoughts on the current rate levels you are experiencing compared to what you believe the current inflation impact is on the business? It seems there hasn't been much progress in closing the gap. Inflation has consistently been high, and there have been significant price increases over the past couple of years. What is your perspective on the underlying claims inflation compared to the current situation?

Yes. We believe the underlying claims inflation is slightly over 10%, possibly even exceeding 11%. This has been factored into our pricing. Additionally, there is another layer of inflation on top of that. Initially, our efforts to adjust rates to keep up with inflation were slower, but we are now making significant progress. When we analyze the rate earned through the portfolio year-over-year, it saw an increase in 2022 compared to 2021. Furthermore, as we move into 2023, this increase is projected to be much more substantial than in previous years. A significant portion of the rate adjustments we have implemented is beginning to show results in 2023 and even into 2024.

There are no more questions in the queue. This concludes the question-and-answer session. I would now like to hand the conference back to Ernie Garateix for any closing remarks.

We thank everybody for joining the call today. And I hope everyone has a great day.

Conference has now concluded. Thank you for attending today's presentation. You may now disconnect.