Amerisafe Inc: Form 10-Q for the period ended Sep 30, 2022

The following discussion should be read in conjunction with the accompanying unaudited consolidated financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form 10-Q, together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2021.

We begin our discussion with an overview of our Company to give you an understanding of our business and the markets we serve. We then discuss our critical accounting policies. This is followed with a discussion of our results of operations for the three and nine months ended September 30, 2022 and 2021. This discussion includes an analysis of certain significant period-to-period variances in our consolidated statements of operations. Our cash flows and financial condition are discussed under the caption “Liquidity and Capital Resources.”

Business Overview

AMERISAFE is a holding company that markets and underwrites workers’ compensation insurance through its insurance subsidiaries. Workers’ compensation insurance covers statutorily prescribed benefits that employers are obligated to provide to their employees who are injured in the course and scope of their employment. Our business strategy is focused on providing this coverage to small to mid-sized employers engaged in hazardous industries, principally construction, trucking, logging and lumber, agriculture, manufacturing, telecommunications, and maritime. Employers engaged in hazardous industries pay substantially higher than average rates for workers’ compensation insurance compared to employers in other industries, as measured per payroll dollar. The higher premium rates are due to the nature of the work performed and the inherent workplace danger of our target employers. Hazardous industry employers also tend to have less frequent but more severe claims as compared to employers in other industries due to the nature of their businesses. We provide proactive safety reviews of employers’ workplaces. These safety reviews are a vital component of our underwriting process and also promote safer workplaces. We utilize intensive claims management practices that we believe permit us to reduce the overall cost of our claims. In addition, our audit services ensure that our policyholders pay the appropriate premiums required under the terms of their policies and enable us to monitor payroll patterns that cause underwriting, safety or fraud concerns. We believe that the higher premiums typically paid by our policyholders, together with our disciplined underwriting and safety, claims and audit services, provide us with the opportunity to earn attractive returns for our shareholders.

We actively market our insurance in 27 states through independent agencies (including retail and wholesale brokers and agents), as well as through our wholly owned insurance agency subsidiary. We are also licensed in an additional 20 states, the District of Columbia and the U.S. Virgin Islands.

Critical Accounting Policies

Understanding our accounting policies is key to understanding our financial statements. Management considers some of these policies to be very important to the presentation of our financial results because they require us to make significant estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. Some of the estimates result from judgments that can be subjective and complex and, consequently, actual results in future periods might differ from these estimates.

Management believes that the most critical accounting policies relate to the reporting of reserves for loss and loss adjustment expenses, including losses that have occurred but have not been reported prior to the reporting date, amounts recoverable from reinsurers, premiums receivable, assessments, deferred policy acquisition costs, deferred income taxes, credit losses on investment securities and share-based compensation. These critical accounting policies are more fully described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2021.

Results of Operations

The following table summarizes our consolidated financial results for the three and nine months ended September 30, 2022 and 2021.

(dollars in thousands, except per share data)

(unaudited)

(1) The net combined ratio is calculated by dividing the sum of loss and loss adjustment expenses incurred, underwriting and certain other operating costs, commissions, salaries and benefits, and policyholder dividends by net premiums earned in the current period.

(2) Return on average equity is calculated by dividing the annualized net income by the average shareholders’ equity for the applicable period.

(3) Book value per share is calculated by dividing shareholders’ equity by total outstanding shares, as of the end of the period.

Consolidated Results of Operations for Three Months Ended September 30, 2022 Compared to September 30, 2021

Gross Premiums Written. Gross premiums written for the quarter ended September 30, 2022 were $68.2 million, compared to $67.2 million for the same period in 2021, an increase of 1.5%. The increase was attributable to a $5.5 million increase in premiums resulting from payroll audits and related premium adjustments for policies written in previous quarters. This increase was offset by a $3.7 million decrease in annual premiums on voluntary policies written during the period and a $0.7 million decrease in assumed premium from mandatory pooling arrangements. The effective loss cost multiplier, or ELCM, for our voluntary business was 1.53 and 1.53 for the quarter ended September 30, 2022 and 2021, respectively.

Net Premiums Written. Net premiums written for the quarter ended September 30, 2022 were $65.7 million, compared to $64.8 million for the same period in 2021, an increase of 1.4%. The increase was primarily attributable to the increase in gross premiums written. As a percentage of gross premiums earned, ceded premiums were 3.6% for the third quarter of 2022 compared to 3.4% for the third quarter of 2021. For additional information, see Item 1, “Business—Reinsurance” in our Annual Report on Form 10-K for the year ended December 31, 2021.

Net Premiums Earned. Net premiums earned for the third quarter of 2022 were $67.8 million, compared to $67.6 million for the same period in 2021, an increase of 0.2%. The increase was primarily attributable to the increase in net premiums written during the period.

Net Investment Income. Net investment income for the quarter ended September 30, 2022 was $7.0 million, compared to $6.0 million for the same period in 2021, an increase of 15.4%. The increase was due to higher investment yields on fixed income securities and cash balances compared to prior year. Average invested assets, including cash and cash equivalents, were $1.0 billion in the quarter ended September 30, 2022 compared to an average of $1.2 billion for the same period in 2021, a decrease of 9.9%. The pre-tax investment yield on our investment portfolio was 2.7% per annum during the quarter ended September 30, 2022 compared to 2.1% per annum during the same period in 2021. The tax-equivalent yield on our investment portfolio was 3.2% per annum for the quarter ended September 30, 2022 and 2.5% for the same period in 2021. The tax-equivalent yield is calculated using the effective interest rate and the appropriate marginal tax rate. Due to the increase in interest rates, the market value of our bond portfolio decreased during the quarter.

Net Realized Gains (Losses) on Investments. Net realized gains on investments for the three months ended September 30, 2022 were $0.6 million compared to immaterial net realized losses for the same period in 2021. Net realized gains in the third quarter of 2022 were mostly attributable to the sale of equity securities.

Net Unrealized Gains (Losses) on Equity Securities. Due to declines in the equity markets, the market value of our equity securities decreased by $4.1 million for the three months ended September 30, 2022 compared to a decline of $0.8 million for the same period in 2021.

Loss and Loss Adjustment Expenses Incurred. Loss and loss adjustment expenses (LAE) incurred totaled $37.7 million for the three months ended September 30, 2022, compared to $29.7 million for the same period in 2021, an increase of $8.1 million, or 27.2%. The current accident year loss and LAE incurred were $48.1 million compared to $48.7 million for the same period in 2021. Our loss and LAE ratio for accident year 2022 is estimated at 71.0% of net premiums earned, down from 72.0% initially set for accident year 2021, and is based on long-term claim frequency and severity trends, as well as medical inflation. We recorded favorable prior accident year development of $10.4 million in the third quarter of 2022, compared to favorable prior accident year development of $19.0 million in the same period of 2021, as further discussed below in “Prior Year Development.” Our net loss ratio was 55.6% in the third quarter of 2022, compared to 43.9% for the same period of 2021.

Underwriting and Certain Other Operating Costs, Commissions and Salaries and Benefits. Underwriting and certain other operating costs, commissions and salaries and benefits for the quarter ended September 30, 2022 were $19.6 million, compared to $17.9 million for the same period in 2021. This increase was primarily due to a contingent profit sharing commission benefit of $1.0 million in last year's third quarter, a $0.5 million increase in compensation expense, and a $0.3 million increase in commission expense. Offsetting these amounts were a decrease of $0.3 million in mandatory pooling arrangement fees and a decrease of $0.3 million in accounts receivable write-offs mostly on assumed premium from mandatory pooling arrangements. Our expense ratio was 28.9% in the third quarter of 2022 compared to 26.5% in the third quarter of 2021.

Income Tax Expense. Income tax expense for the three months ended September 30, 2022 was $2.1 million, compared to $5.6 million for the same period in 2021. The effective tax rate for the Company was 15.5% in the quarter ended September 30, 2022 and 22.6% for the same period in 2021. The decrease in the effective tax rate was due to a higher proportion of income from tax-exempt investments compared to the same period of 2021.

Consolidated Results of Operations for Nine Months Ended September 30, 2022 Compared to September 30, 2021

Gross Premiums Written. Gross premiums written for the nine months ended September 30, 2022 were $220.5 million, compared to $222.4 million for the same period in 2021, a decrease of 0.9%. The decrease was attributable to a $13.6 million decrease in annual premiums on voluntary policies written during the period and a $1.6 million decrease in assumed premium from mandatory pooling arrangements. These decreases were partially offset by a $12.9 million increase in premiums resulting from payroll audits and related premium adjustments for policies written in previous quarters. The ELCM for our voluntary business was 1.52 and 1.53 for the nine months ended September 30, 2022 and 2021, respectively.

Net Premiums Written. Net premiums written for the nine months ended September 30, 2022 were $212.6 million, compared to $215.0 million for the same period in 2021, a decrease of 1.1%. The decrease was primarily attributable to the decrease in gross premiums written. As a percentage of gross premiums earned, ceded premiums were 3.7% for the first nine months of 2022 compared to 3.4% in the same period of 2021. The increase in ceded premiums as a percentage of gross premiums earned is a result of a change in our 2022 reinsurance treaties. For additional information, see Item 1, “Business—Reinsurance” in our Annual Report on Form 10-K for the year ended December 31, 2021.

Net Premiums Earned. Net premiums earned for the nine months ended September 30, 2022 were $205.6 million, compared to $208.3 million for the same period in 2021, a decrease of 1.3%. The decrease was primarily attributable to the decrease in net premiums written during the period.

Net Investment Income. Net investment income for the first nine months of 2022 was $19.6 million, compared to $19.4 million for the same period in 2021, an increase of 1.1%. The increase was due to slightly higher investment yields on fixed income securities and cash balances. Average invested assets, including cash and cash equivalents were $1.1 billion in the nine months ended September 30, 2022 compared to an average of $1.2 billion in the same period in 2021, a decrease of 8.6%. The pre-tax investment yield on our investment portfolio was 2.5% per annum during the nine months ended September 30, 2022 compared to 2.2% per annum for the same period in 2021. The tax-equivalent yield on our investment portfolio was 3.2% per annum for the first nine months of 2022 compared to 2.5% in the same period in 2021. The tax-equivalent yield is calculated using the effective interest rate and the appropriate marginal tax rate. Due to the rise in interest rates, the market value of our bond portfolio decreased during the nine months ended September 30, 2022.

Net Realized Gains (Losses) on Investments. Net realized gains on investments for the nine months ended September 30, 2022 were $2.4 million compared to net realized gains of $1.5 million for the same period in 2021. Net realized gains in the first nine months of 2022 were attributable to sales of equity and fixed maturity securities classified as available-for-sale. Net realized gains in the first nine months of 2021 were attributable to sales of fixed maturity securities classified as available-for-sale.

Net Unrealized Gains (Losses) on Equity Securities. Due to declines in the equity markets, the value of our equity securities declined by $13.0 million for the nine months ended September 30, 2022 compared to an increase of $8.0 million for the same period in 2021.

Loss and Loss Adjustment Expenses Incurred. Loss and LAE incurred totaled $115.8 million for the nine months ended September 30, 2022, compared to $101.6 million for the same period in 2021, an increase of $14.2 million, or 14.0%. The current accident year loss and LAE incurred were $146.0 million compared to $149.9 million for the same period in 2021. Our loss and LAE ratio for accident year 2022 is estimated at 71.0% of net premiums earned, down from 72.0% initially set for accident year 2021, and is based on long-term claim frequency and severity trends, as well as medical inflation. We recorded favorable prior accident year development of $30.2 million in the first nine months of 2022, compared to favorable prior accident year development of $48.3 million in the same period of 2021, as further discussed below in “Prior Year Development.” Our net loss ratio was 56.3% in the first nine months of 2022, compared to 48.8% for the same period of 2021.

Underwriting and Certain Other Operating Costs, Commissions and Salaries and Benefits. Underwriting and certain other operating costs, commissions and salaries and benefits for the nine months ended September 30, 2022 were $54.6 million, compared to $55.3 million for the same period in 2021, a decrease of 1.3%. This decrease was primarily due to a decrease in insurance related assessments of $2.4 million and a $1.0 million decrease in accounts receivable write-offs. The decrease in insurance related assessments included a benefit of $3.8 million in 2022 due to a return of assessments from the Minnesota Workers’ Compensation Reinsurance Association. Partially offsetting these amounts were a $0.9 million decrease in a contingent profit sharing commission benefit in 2021, a $0.6 million increase in professional fees, a $0.4 million increase in systems costs, and a $0.3 million increase in travel and travel related items. Our expense ratio was 26.6% in the first nine months of 2022 and 2021.

Income Tax Expense. Income tax expense for the nine months ended September 30, 2022 was $7.2 million, compared to $15.3 million for the same period in 2021. The effective tax rate for the Company decreased to 17.1% for the nine months ended September 30, 2022 from 19.7% for the nine months ended September 30, 2021. The decrease in the effective tax rate is due to a higher proportion of income from tax-exempt investments for the nine months ended September 30, 2022 compared with the nine months ended September 30, 2021.

Liquidity and Capital Resources

Our principal sources of operating funds are premiums, investment income and proceeds from sales and maturities of investments. Our primary uses of operating funds include payments of claims and operating expenses. Currently, we pay claims using cash flow from operations and invest the remaining funds.

Net cash provided by operating activities was $36.1 million for the nine months ended September 30, 2022, which represented a $6.6 million increase from $29.4 million in net cash provided by operating activities for the nine months ended September 30, 2021. This increase in operating cash flow was due to a a $8.8 million decrease in underwriting expenses paid, a $6.3 million decrease in federal taxes paid, and a $4.8 million decrease in losses paid. Offsetting these amounts were a $6.9 million decrease in premium collections, a $4.1 million decrease in reinsurance recoveries, and a $2.3 million decrease in investment income.

Net cash provided by investing activities was $14.4 million for the nine months ended September 30, 2022, compared to net cash provided by investment activities of $48.9 million for the same period in 2021. Cash provided by sales and maturities of investments totaled $209.6 million for the nine months ended September 30, 2022, compared to $225.5 million for the same period in 2021. A total of $193.3 million in cash was used to purchase investments in the nine months ended September 30, 2022, compared to $175.8 million in purchases for the same period in 2021.

Net cash used in financing activities in the nine months ended September 30, 2022 was $30.2 million compared to net cash used in financing activities of $17.0 million for the same period in 2021. In the nine months ended September 30, 2022, $18.0 million of cash was used for dividends paid to shareholders compared to $16.9 million in the same period of 2021. In the nine months ended September 30, 2022, repurchases of outstanding shares of our common stock totaled $12.2 million, compared to none for the same period in 2021.

Investment Portfolio

Our investment portfolio, including cash and cash equivalents, totaled $1.0 billion at September 30, 2022 and December 31, 2021. Purchases of fixed maturity securities are classified as available-for-sale or held-to-maturity at the time of purchase based on the individual security. The Company has the ability and positive intent to hold certain investments until maturity. Therefore, fixed maturity securities classified as held-to-maturity, as defined by FASB ASC Topic 320, Investments-Debt and Equity Securities, are recorded at amortized cost net of allowance for credit losses. Our equity securities and fixed maturity securities classified as available-for-sale were reported at fair value.

The composition of our investment portfolio, including cash and cash equivalents, as of September 30, 2022, is shown in the following table:

(in thousands)

Our debt securities classified as available-for-sale are “marked to market” as of the end of each calendar quarter. As of that date, unrealized gains and losses that are not credit related are recorded to Accumulated Other Comprehensive Income (Loss). Any available-for-sale credit related losses would be recognized as a credit loss allowance on the balance sheet with a corresponding adjustment to earnings, limited by the amount that the fair value is less than the amortized cost basis. Both the credit loss allowance and adjustment to net income can be reversed if conditions change.

For our debt securities classified as held-to-maturity, non-credit related unrecognized gains and losses are not recorded in the financial statements until realized. Effective upon the adoption of ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses, management is required to estimate held-to-maturity expected credit related losses and recognize a credit loss allowance on the balance sheet with a corresponding adjustment to earnings. Any adjustments to the estimated expected credit related losses are recognized through earnings and adjustments to the credit loss allowance.

Prior Year Development

The Company recorded favorable prior accident year development of $10.4 million in the three months ended September 30, 2022. The table below sets forth the favorable development for the three and nine months ended September 30, 2022 and 2021 for accident years 2017 through 2021 and, collectively, for all accident years prior to 2017.

(in millions)

The table below sets forth the number of open claims as of September 30, 2022 and 2021, and the number of claims reported and closed during the three and nine months then ended.

The number of open claims at September 30, 2022 decreased by 95 claims as compared to the number of open claims at September 30, 2021. At September 30, 2022, our incurred amounts for certain accident years, particularly 2017 through 2020, developed more favorably than management previously expected. The revisions to the Company’s reserves reflect new information gained by claims adjusters in the normal course of adjusting claims and is reflected in the financial statements when the information becomes available. It is typical for more serious claims to take several years or longer to settle and the Company continually revises estimates as more information about claimants’ medical conditions and potential disability becomes known and the claims get closer to being settled. Multiple factors can cause both favorable and unfavorable loss development. The favorable loss development we experienced across accident years was largely due to favorable case reserve development from closed claims and claims where the worker had reached maximum medical improvement.

The assumptions we used in establishing our reserves were based on our historical claims data. However, as of September 30, 2022, actual results for certain accident years have been better than our assumptions would have predicted. We do not presently intend to modify our assumptions for establishing reserves in light of recent results. However, if actual results for current and future accident years are consistent with, or different than, our results in these recent accident years, our historical claims data will reflect this change and, over time, will impact the reserves we establish for future claims.

Our reserves for loss and loss adjustment expenses are inherently uncertain and our focus on providing workers’ compensation insurance to employers engaged in hazardous industries results in our receiving relatively fewer but more severe claims than many other workers’ compensation insurance companies. As a result of this focus on higher severity, lower frequency business, our reserve for loss and loss adjustment expenses may have greater volatility than other workers’ compensation insurance companies. For additional information, see Item 1, “Business—Loss Reserves” in our Annual Report on Form 10-K for the year ended December 31, 2021.

Market risk is the risk of potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk, interest rate risk, and equity price risk. We currently have no exposure to foreign currency risk.

Since December 31, 2021, there have been no material changes in the quantitative or qualitative aspect of our market risk profile. For additional information regarding the Company’s exposure to certain market risks, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2021.

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to provide reasonable assurance that information we are required to disclose in reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms specified by the SEC. We note that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving the stated goals under all potential future conditions.

Because of its inherent limitations, management does not expect that our disclosure controls and procedures and our internal controls over financial reporting will prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with policies and procedures may deteriorate. Any control system, no matter how well designed and operated, is based upon certain assumptions and can only provide reasonable, not absolute assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to errors or fraud will not occur or that all control issues and instances of fraud, if any within the Company, have been detected.

There have not been any changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.