Hilltop Holdings Inc.: Form 10-Q for the period ended Sep 30, 2012

The following discussion should be read in conjunction with the consolidated historical financial statements and notes appearing elsewhere in this Quarterly Report on Form 10-Q and the financial information set forth in the tables below.

Unless the context otherwise indicates, all references in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, to the “Company”, “Hilltop”, “HTH”, “we”, “us”, “our” or “ours” or similar words are to Hilltop Holdings Inc. (formerly known as Affordable Residential Communities Inc.) and its direct and indirect wholly-owned subsidiaries.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, included in this report that address results or developments that we expect or anticipate will or may occur in the future, that are preceded by, followed by or include the words “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases, including such things as our business strategy, our financial condition, our litigation, our efforts to make strategic acquisitions, our liquidity and sources of funding, our capital expenditures, our products, market trends, operations and business, are forward-looking statements.

These forward-looking statements are based on our beliefs, assumptions and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If an event occurs or further changes, our business, business plan, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Certain factors that could cause actual results to differ include, among others:

• fluctuations in the market price of our common stock and the related effect on the value of the merger consideration offered to PlainsCapital Corporation shareholders;
• business uncertainties and contractual restrictions while the contemplated merger with PlainsCapital Corporation is pending;
• the possibility that the proposed merger with PlainsCapital Corporation does not close when expected or at all because required regulatory or other approvals and other conditions to closing are not received or satisfied on a timely basis or at all;
• required modifications to the terms of the proposed merger with PlainsCapital Corporation to obtain approvals or satisfy conditions;
• diversion of management time on merger related issues;
• changes in the financial condition and results of operations of PlainsCapital Corporation, including its failure to sustain its current revenues and earnings;
• inability to identify other suitable acquisition opportunities;
• the adverse impact of external factors, such as changes in interest rates, inflation and consumer confidence;
• the condition of capital markets;
• actual outcome of the resolution of any conflict;
• our ability to use net operating loss carryforwards to reduce future tax payments;
• the impact of the tax code and rules on our financial statements;
• failure of NLASCO, Inc.’s insurance subsidiaries to maintain their respective A.M. Best ratings;
• failure to maintain NLASCO, Inc.’s current agents;
• lack of demand for insurance products;
• cost or availability of adequate reinsurance;
• changes in key management;
• severe catastrophic events in our geographic area;
• failure of NLASCO, Inc.’s reinsurers to pay obligations under reinsurance contracts;
• failure of NLASCO, Inc. to maintain sufficient reserves for losses on insurance policies;
• failure to successfully select and implement NLASCO, Inc.’s new information technology system; and
• failure of NLASCO, Inc. to maintain appropriate insurance licenses.

For a further discussion of these and other risks and uncertainties that could cause actual results to differ materially from those contained in our forward-looking statements, please refer to “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 9, 2012, and other filings we have made with the Securities and Exchange Commission. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements and those risk factors, and there can be no assurance that the actual results or developments anticipated by us will be realized, or even substantially realized, and that they will have the expected consequences to, or effects on, us and our business or operations. Forward-looking statements made in this report speak as of the date of this report or as of the date specifically referenced in any such statement set forth in this report. Except to the extent required by law, we undertake no obligation to update or revise any forward-looking statements in this report.

GENERAL STRUCTURE OF THE COMPANY

We are a holding company that has endeavored, and continues to endeavor, to make opportunistic acquisitions or effect a business combination. At September 30, 2012, Hilltop Holdings Inc. had approximately $524 million of available cash and cash equivalents that could be used for this purpose. No assurances, however, can be given that we will be able to identify suitable targets, consummate acquisitions or a combination or, if consummated, successfully integrate or operate the acquired business.

Hilltop indirectly owns all of the outstanding shares of NLASCO, Inc., or NLASCO. NLASCO, in turn, owns National Lloyds Insurance Company, or NLIC, and American Summit Insurance Company, or ASIC, both of which are licensed property and casualty insurers operating in multiple states. In addition, NLASCO also owns the NALICO General Agency that operates in Texas. NLIC commenced business in 1949 and currently operates in 14 states with its largest market being the State of Texas. NLIC carries a financial strength rating of “A” (Excellent) by A.M. Best. ASIC was formed in 1955 and currently operates in 13 states, its largest market being the State of Arizona. ASIC carries a financial strength rating of “A” (Excellent) by A.M. Best. Both of these companies are regulated by the Texas Department of Insurance.

Our common stock is listed on the New York Stock Exchange, or the NYSE, under the symbol “HTH”.

OVERVIEW OF RESULTS

For the three months ended September 30, 2012, net loss attributable to common stockholders was $4.0 million, or $0.07 per share, as compared to a net income of $0.2 million, or $0.00 per share, for the same period in 2011. Net loss attributable to common stockholders increased by $4.3 million for the three months ended September 30, 2012, as compared to the same period in 2011, primarily due to higher loss and loss adjustment expenses of $6.3 million, higher policy acquisition and other underwriting expenses of $2.0 million, offset by higher net premiums earned of $2.7 million, lower general and administrative expenses of $1.0 million and higher income tax benefit of $0.6 million.

For the nine months ended September 30, 2012, net loss attributable to common stockholders was $14.4 million, or $0.25 per share, as compared to a net loss of $11.6 million, or $0.20 per share, for the same period in 2011. Net loss attributable to common stockholders increased by $2.8 million for the nine months ended September 30, 2012, as compared to the same period in 2011, primarily due to higher loss and loss adjustment expenses of $10.9 million, higher policy acquisition and other underwriting expenses of $4.1 million and lower income tax benefit of $0.8 million, offset by higher net premiums earned of $10.6 million and higher net investment income of $2.3 million.

BUSINESS OBJECTIVES AND OPERATING STRATEGIES

Strategic Acquisitions. Hilltop has sought, and continues to seek, to make opportunistic acquisitions with its cash and, if necessary or appropriate, from additional equity or debt financing sources. In connection with this strategy, on May 8, 2012, we entered into a definitive agreement and plan of merger with PlainsCapital Corporation. In accordance with the merger agreement, PlainsCapital Corporation will become a wholly owned subsidiary of us. The purchase consideration to PlainsCapital Corporation shareholders includes approximately 27.5 million shares of our common stock and approximately $318 million of cash. PlainsCapital Corporation’s and our respective shareholders approved the merger; however, regulatory approval is pending. No assurance can be given at this time as to when or if this transaction will be consummated.

Insurance Operations. NLASCO specializes in providing fire and homeowners insurance for low value dwellings and manufactured homes, primarily in Texas and other areas of the south, southeastern and southwestern United States. NLASCO targets underserved markets that require underwriting expertise that many larger carriers have been unwilling to develop given the relatively small volume of premiums produced by local agents. Within these markets, NLASCO attempts to capitalize on its superior local knowledge to identify profitable underwriting opportunities. NLASCO believes that it distinguishes itself from competitors by delivering products that are not provided by many larger carriers, providing a high level of customer service and responding quickly to the needs of its agents and policyholders. NLASCO applies a high level of selectivity in the risks it underwrites and uses a risk-adjusted return approach to capital allocation. NLASCO seeks to consistently generate underwriting profits.

Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they purchase insurance. A.M. Best assigned NLIC and ASIC a financial strength rating of “A” (Excellent). An “A” rating is the third highest of 16 rating categories used by A.M. Best. In evaluating a company’s financial and operating performance, A.M. Best reviews a company’s profitability, leverage and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its liabilities for losses and loss adjustment expenses, or LAE, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and is not an evaluation directed at investors. This rating assignment is subject to the ability to meet A.M. Best’s expectations as to performance and capitalization on an ongoing basis, including with respect to management of liabilities for losses and LAE, and is subject to revocation or revision at any time at the sole discretion of A.M. Best. NLASCO cannot ensure that NLIC and ASIC will maintain their present ratings.

RESULTS OF OPERATIONS

Comparison of the Three Months Ended September 30, 2012 to the Three Months Ended September 30, 2011

Revenue. Revenue for the three months ended September 30, 2012 was $42.8 million, as compared to $40.6 million for the same period in 2011. Net premiums earned were $37.7 million for the three months ended September 30, 2012, as compared to $34.9 million for the same period in 2011. The higher volume of earned premiums of $2.7 million was largely due to higher volume of gross earned premiums of $3.4 million, offset by an increase in the cost of reinsurance of $0.6 million. Net investment income was $3.3 million for the three months ended September 30, 2012, as compared to $3.1 million for the same period in 2011. Net realized gains on investments decreased $0.8 million during the three months ended September 30, 2012, as compared to the same period in 2011, due to the sale of held-to-maturity securities in the three months ended September 30, 2011. Other income was $1.9 million for the three months ended September 30, 2012, as compared to $1.8 million for the same period in 2011.

Underwriting Results. The following table shows the components of the Company’s underwriting (loss) gain for the three months ended September 30, 2012 and 2011. The Company’s underwriting gain or loss consists of net premiums earned, less loss and LAE and policy acquisition and other underwriting expenses. The underwriting results are discussed below (in thousands).

The loss and LAE ratio is loss and LAE divided by net premiums earned for the same period. The underwriting expense ratio is policy acquisition and other underwriting expense less agency expenses, divided by net premiums earned for the same period. Combined ratio gives you the sum of both ratios.

Loss and LAE increased $6.3 million in the three months ended September 30, 2012 as compared to the same period in 2011. This increase is primarily due to an increase in current accident year losses of $4.0 million, which is attributable to the frequency and severity of wind and hail claims. Losses from weather events in the three months ended September 30, 2012 increased $3.2 million, as compared to the same period in 2011, due to losses from April, May and June 2012 of $6.8 million from weather events, as compared to $3.6 million in weather events from April and May of 2011.

The Company seeks to consistently generate underwriting profitability. Management evaluates NLASCO’s loss and LAE ratio by bifurcating the losses to derive catastrophic and non-catastrophic loss ratios. The non-catastrophic loss ratio excludes Property Claims Services (PCS) events that exceed $1.0 million of losses to NLASCO. Catastrophic events, including those that do not exceed our reinsurance retention, affect the Company’s loss ratios. For the three months ended September 30, 2012, catastrophic events that did not exceed our reinsurance retention accounted for $6.8 million of the total loss and loss adjustment expense, as compared to $3.6 million for the same period in 2011. Excluding catastrophic events, our combined ratios for the three months ended September 30, 2012 and 2011 would have been 96.1% and 89.3%, respectively.

For the three months ended September 30, 2012, the Company had development in losses related to two 2008 catastrophes, Hurricane Ike and Hurricane Dolly, of $0.3 million, compared to favorable development of $7.2 million for the same period in 2011. The redundancy in losses in the three months ended September 30, 2011 relate primarily to the reduction of Hurricane Ike reserves of $7.0 million in September 2011. For the three months ended September 30, 2012, the Company incurred losses of $0.1 million related to a catastrophic wind and hail storm in Arizona that occurred in October of 2010, compared to $0.2 million for the same period in 2011. These losses have no effect on net loss and LAE incurred because the catastrophic events exceeded our retention and are fully recoverable from reinsurers. The primary financial effect is the net change in reinstatement premium payable to the affected reinsurers. For the three months ended September 30, 2012, the Company incurred $30 thousand dollars in reinstatement premiums, as compared to a $0.3 million reduction in reinstatement premium for the same period in 2011.

Premiums. The property and casualty insurance industry is very competitive and is affected by soft and hard market business cycles. During a soft market, price competition tends to increase as insurers are willing to reduce premium rates in order to maintain growth in premium volume. The soft market makes it more difficult to attract new business, as well as retain exposures that are adequately priced. Although we recognize the need to remain competitive in the marketplace, the Company remains committed to its disciplined underwriting philosophy accepting only risks that are appropriately priced, while declining risks that it believes are under priced for the level of coverage provided.

Direct premiums written by major product line for the three months ended September 30, 2012 and 2011, are presented in the table below (in thousands).

Total direct premiums written increased for the three months ended September 30, 2012 for all insurance products, except for other, primarily due to expanded distribution of additional insurance products and growth on existing insurance products. Higher value homeowners and commercial insurance products generated $0.6 million in direct premiums written for the three months ended September 30, 2012. Direct premiums written in Texas, Oklahoma, Georgia and Tennessee increased a combined total of $1.1 million on existing products in the three months ended September 30, 2012, as compared to the same period in 2011.

Net premiums written by major product line for the three months ended September 30, 2012 and 2011, are presented in the table below (in thousands).

Total net premiums written increased $1.8 million for the three months ended September 30, 2012, for all insurance products, except for other, due to an increase in volume of direct written premiums of $2.1 million, offset by an increase in catastrophic reinsurance costs of $0.6 million.

Net premiums earned by major product line for the three months ended September 30, 2012 and 2011, are presented in the table below (in thousands).

Net premiums earned for the three months ended September 30, 2012 increased $2.7 million, as compared to the same period in 2011, which is a result of higher direct written premiums of $2.1 million for the quarter ended September 30, 2012, as well as growth in written premiums experienced in prior periods. Direct premiums written have increased over the last four quarters and are $10.6 million higher for the twelve months ended September 30, 2012 as compared to the same period in 2011. The consistent growth in direct premiums written should generate increased premiums earned in future periods.

Loss and Loss Adjustment Expenses. Loss and LAE are recognized based on formula and case basis estimates for losses reported with respect to direct business, estimates of unreported losses based on past experience and deduction of amounts for reinsurance placed with reinsurers. Loss and LAE for the three months ended September 30, 2012 was $30.1 million, as compared to $23.8 million for the same period in 2011. The increase is primarily a result of increased severity of wind and hail losses from April, May and June 2012 weather events.

The loss and LAE ratio is calculated by taking the ratio of incurred losses and LAE to net premiums earned for the same period. The loss and LAE ratio for the three months ended September 30, 2012 and 2011 was 80.0% and 68.1%, respectively.

Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the three months ended September 30, 2012 and 2011 were as follows (in thousands):

Total policy acquisition and other underwriting expenses, excluding agency expenses, were $12.9 million for the three months ended September 30, 2012, as compared to $11.0 million for the same period in 2011. Policy acquisition and other underwriting expenses increased $2.0 million primarily due to the write down of a policy administration system the Company was unable to successfully implement of $1.7 million in the three months ended September 30, 2012.

General and Administrative Expense. General and administrative expense for the three months ended September 30, 2012 was $2.8 million, as compared to $3.8 million for the same period in 2011. The decrease is primarily due to a decrease in professional services related to acquisition costs at the holding company of $1.0 million.

Depreciation and Amortization Expense. Depreciation and amortization expense for the three months ended September 30, 2012 and 2011 was $0.3 million and $0.4 million, respectively.

Interest Expense. Interest expense for the three months ended September 30, 2012 remained largely unchanged, it was $2.1 million as compared to $2.2 million for the three months ended September 30, 2011, a decrease of $0.1 million, or 4.5%.

Income Taxes. The Company had a $1.9 million income tax benefit for the three months ended September 30, 2012, compared to $1.3 million tax benefit for the same period in 2011. The increase in income tax benefit is primarily due to the increased loss from operations.

Net Loss Attributable to Common Stockholders. As a result of the foregoing, our net loss attributable to common stockholders was $4.0 million for the three months ended September 30, 2012, as compared to net income of $0.2 million for the three months ended September 30, 2011. The principal reasons for the loss in the third quarter of 2012 was the development on weather events from April, May and June 2012, as well as increased frequency and severity of wind and hail losses.

Comparison of the Nine Months Ended September 30, 2012 to the Nine Months Ended September 30, 2011

Revenue. Revenue for the nine months ended September 30, 2012 was $124.3 million, as compared to $111.8 million for the same period in 2011. Net premiums earned were $109.0 million for the first nine months in 2012, as compared to $98.4 million for the first nine months in 2011. The higher volume of earned premiums of $10.6 million is primarily attributable to our marketing efforts and new homeowners products, offset by an increase in the cost of catastrophic reinsurance. Net investment income was $9.7 million for the first nine months of 2012, as compared to $7.4 million for the same period in 2011, such increase due to earnings on the loan transaction with SWS Group, Inc. and higher yields on cash and investments at NLASCO. Net realized gains decreased $0.8 million during the nine months ended September 30, 2012, due to the sale of securities in September 2011. Other income was $5.5 million for the first nine months in 2012, as compared to $5.1 million for the same period in 2011.

Underwriting Results. The following table shows the components of the Company’s underwriting loss for the nine months ended September 30, 2012 and 2011. The Company’s underwriting gain or loss consists of net premiums earned, less loss and LAE and policy acquisition and other underwriting expenses. The underwriting results are discussed below (in thousands).

The loss and LAE ratio is loss and LAE divided by net premiums earned for the same period. The underwriting expense ratio is policy acquisition and other underwriting expense less agency expenses, divided by net premiums earned for the same period. Combined ratio gives you the sum of both ratios.

Loss and LAE increased $10.9 million for the nine months ended September 30, 2012, as compared to the same period in 2011. This increase is primarily due to the increased frequency and severity of current accident year wind and hail losses. Wind and hail losses increased $11.1 million during the nine months ended September 30, 2012 as compared to the same period in 2011. Net premiums earned increased 10.8% in the nine months ended September 30, 2012, as compared to the same period in 2011, due to a $10.6 million increase in volume of written premiums over the last twelve months. Loss and LAE expenses increased 13.4% in the nine months ending September 30, 2012, as compared to 2011, due to higher incurred losses associated with wind and hail storms that occurred in Texas and Oklahoma and additional losses associated with a 10.8% increase in earned premiums. Policy acquisition and other underwriting expenses increased 11.8% for the nine months ended September 30, 2012, as compared to 2011, which is a direct result of increased direct written premiums.

The Company seeks to consistently generate underwriting profitability. Management evaluates NLASCO’s loss and LAE ratio by bifurcating the losses to derive catastrophic and non-catastrophic loss ratios. The non-catastrophic loss ratio excludes Property Claims Services (PCS) events that exceed $1.0 million of losses to NLASCO. Catastrophic events, including those that do not exceed our reinsurance retention, affect the Company’s loss ratios. For the nine months ended September 30, 2012, catastrophic events that did not exceed our reinsurance retention accounted for $20.8 million of the total loss and loss adjustment expense, as compared to $19.2 million for the same period in 2011. Excluding catastrophic events, our combined ratios for the nine months ended September 30, 2012 and 2011 would have been 99.3% and 96.9%, respectively.

For the nine months ended September 30, 2012, the Company had favorable development in losses related to two 2008 catastrophes, Hurricane Ike and Hurricane Dolly. The Company also incurred losses in 2012 related to a catastrophic wind and hail storm in Arizona from October of 2011. Gross benefit incurred from these catastrophes was $0.2 million for the nine months ended September 30, 2012, compared to $3.7 million for the same period in 2011. The favorable development in the losses in the nine months ended September 30, 2012 relate primarily to reduction of Hurricane Dolly reserves and settlements of $0.5 million, offset by additional reporting of Arizona claims of $50 thousand. These losses have no effect on net loss and LAE incurred because the catastrophic events exceeded our retention and are fully recoverable from reinsurers. The primary financial effect of additional losses is additional reinstatement premium payable to the affected reinsurers. For the nine months ended September 30, 2012 and 2011, the Company recorded reinstatement premiums benefit of $0.1 million and expense of $0.2 million, respectively.

Premiums. The property and casualty insurance industry is very competitive and is affected by soft and hard market business cycles. During a soft market, price competition tends to increase as insurers are willing to reduce premium rates in order to maintain growth in premium volume. The soft market makes it more difficult to attract new business, as well as retain exposures that are adequately priced. Although we recognize the need to remain competitive in the marketplace, the Company remains committed to its disciplined underwriting philosophy accepting only risks that are appropriately priced, while declining risks that it believes are under priced for the level of coverage provided. Due to several catastrophic events and elevated reinsurance costs, NLASCO exited underwriting wind coverage along the Texas seacoast in March 2011.

Direct premiums written by major product line for the nine months ended September 30, 2012 and 2011, are presented in the table below (in thousands).

Total direct premiums written increased for the nine months ended September 30, 2012, for all insurance products, except for other, due to expanded distribution of additional insurance products and growth on existing insurance products. New homeowners and commercial insurance products generated $1.9 million in direct written premiums for the nine months ended September 30, 2012. Direct premiums written in Texas, Oklahoma, Georgia, Arizona and Tennessee increased $5.4 million on existing products in the nine months ended September 30, 2012, as compared to the same period in 2011.

Net premiums written by major product line for the nine months ended September 30, 2012 and 2011, are presented in the table below (in thousands).

Total net premiums written increased for the nine months ended September 30, 2012 for all lines of business due to higher direct written premiums of $7.7 million and a decrease in ceded premiums of $0.3 million.

Net premiums earned by major product line for the nine months ended September 30, 2012 and 2011, are presented in the table below (in thousands.)

Net premiums earned for the nine months ended September 30, 2012 were up as compared to the same period in 2011 due to the increase in net premiums written of $8.1 million, and a decrease in the change in unearned premiums of $2.5 million.

Loss and Loss Adjustment Expenses. Loss and LAE are recognized based on formula and case basis estimates for losses reported with respect to direct business, estimates of unreported losses based on past experience and deduction of amounts for reinsurance placed with reinsurers. Loss and LAE for the nine months ended September 30, 2012 was $91.7 million, as compared to $80.9 million for the same period in 2011. The increase is a result of wind and hail that occurred in 2012 in Texas, in which increased frequency and severity created an additional $11.1 million of losses.

The loss and LAE ratio is calculated by taking the ratio of incurred losses and LAE to net premiums earned for the same period. The loss and LAE ratio for the nine months ended September 30, 2012 and 2011 was 84.1% and 82.2%, respectively.

Policy Acquisition and Other Underwriting Expenses. Policy acquisition and other underwriting expenses for the nine months ended September 30, 2012 and 2011 were as follows (in thousands).

Total policy acquisition and other underwriting expenses, excluding agency expenses, are up $3.9 million due to the increase in amortization of deferred policy acquisition costs of $3.2 million and an increase in other underwriting expenses of $0.9 million. Other underwriting expenses increased due to the write down of a policy administration system the Company was unable to successfully implement of $1.7 million. The increase in amortization of deferred policy acquisition costs is a result of $7.7 million higher direct written premiums.

General and Administrative Expense. General and administrative expense for the nine months ended September 30, 2012 and 2011 was $7.3 million.

Depreciation and Amortization Expense. Depreciation and amortization expense was $1.0 million for the nine months ended September 30, 2012, and $1.3 for the same period in 2011.

Interest Expense. Interest expense for the nine months ended September 30, 2012 was $6.4 million, as compared to $6.7 million for the same period in 2011. The decrease is due to the reduction of $6.9 million in debt.

Income Taxes. The Company had a $7.0 million income tax benefit for the nine months ended September 30, 2012, compared to a $7.8 million benefit for the same period in 2011. The decrease in income tax benefit is primarily due to non deductible acquisition costs at the parent holding company.

Net Loss Attributable to Common Stockholders. As a result of the foregoing, our net loss attributable to common stockholders was $14.4 million for the nine months ended September 30, 2012, as compared to $11.6 million net loss for the nine months ended September 30, 2011. The principal reason for the loss in the first nine months of 2012 is incurred losses related to increased frequency and severity of wind and hail storms in the current year.

LIQUIDITY AND CAPITAL RESOURCES

General

Hilltop is a holding company whose assets primarily consist of the stock of its subsidiaries and invested assets with a combined value of approximately $916 million at September 30, 2012. At September 30, 2012, the Company had invested approximately $574 million in cash and cash equivalents, consisting of approximately $524 million owned by the parent company and $50 million owned by NLASCO and its subsidiaries. These deposits are in excess of the Federal Deposit Insurance Corporation insurance limit; however, the Company does not believe that it is exposed to any significant credit risk on cash based on the size and financial strength of the financial institutions in which the funds are held.

On May 8, 2012, we entered to a definitive merger agreement with PlainsCapital Corporation, whereby it will become a wholly owned subsidiary of us. The purchase consideration to PlainsCapital Corporation shareholders includes approximately 27.5 million shares of our common stock and approximately $318 million of cash. After giving effect to the merger and its related transaction expenses, we expect to have approximately $200 million of available cash at the parent company.

If the merger agreement is terminated under certain circumstances, we will be required to pay PlainsCapital Corporation a termination of $17.5 million. Accordingly, upon such an event, our available cash would be reduced by $17.5 million.

At September 30, 2012, we had approximately $574 million of cash and cash equivalents and $216 million of investments, as compared to approximately $579 million of cash and cash equivalents and $224 million of investments as of December 31, 2011.

As of September 30, 2012, our short-term liquidity needs included funds to pay our insurance claims and funds to service our debt.

Restrictions on Dividends and Distributions

Aside from investment income on Hilltop’s invested assets and available cash, as a holding company, Hilltop relies on dividends and other permitted distributions from its subsidiaries. The payment of dividends from Hilltop’s insurance subsidiaries, NLIC and ASIC, are subject to significant limitations under debt agreements, which limit their ability to declare and pay dividends in the event of a default.

Additionally, under Texas State Insurance Law for property and casualty companies, all dividends must be distributed out of earned surplus only. Furthermore, without the prior approval of the Commissioner of the Texas Department of Insurance, dividends cannot be declared or distributed from our insurance companies that exceed the greater of ten percent of the company’s surplus, as shown by its last annual statement on file with the Commissioner, and 100% of net income for such period. At September 30, 2012, the maximum additional dividends that may be paid by our insurance companies to NLASCO in 2012 without regulatory approval is approximately $11.9 million.

Regulations of the Texas Department of Insurance require insurance companies to maintain minimum levels of statutory surplus to ensure their ability to meet their obligations to policyholders. At September 30, 2012, the Company’s insurance subsidiaries had statutory surplus in excess of the minimum required.

Also, the National Association of Insurance Commissioners, or NAIC, has adopted risk-based capital, or “RBC”, requirements for insurance companies that establish minimum capital requirements relating to insurance risk and assesses credit risk, interest rate risk and business risk. The formula is used by the NAIC and certain state insurance regulators as an early warning tool to identify companies that require additional scrutiny or regulatory action. At September 30, 2012, the Company’s insurance subsidiaries’ RBC ratios exceeded the level at which regulatory action would be required.

We believe that restrictions on the payments of dividends by our subsidiary insurance companies will not have a material impact on our ability to carry out our normal business activities, including debt payments on our senior exchangeable notes.

Sources and Uses of Funds

Our liquidity requirements are primarily met by positive cash flow from our normal operations, available cash, and investment activity. Primary sources of cash from insurance operations are premiums and other considerations, net investment income and investment sales and maturities. Primary uses of cash include payments of benefits, operating expenses, and purchases of investments.

Our primary investment objective is to preserve capital. Our strategy is to purchase securities in sectors that represent the most attractive relative value. Bonds, cash and short-term investments constitute $727.9 million, or 92.4%, of our investments at September 30, 2012. Although there is no intent to dispose of these investments at this time, our bonds are substantially in readily marketable securities.

Our management generally meets monthly to review the performance of investments and monitor market conditions for investments that would warrant any revision to investment guidelines.

Cash used in operations was $13.4 million for the nine months ended September 30, 2012, primarily due to a net loss of $14.4 million, increases in deferred income taxes of $7.0 million, $1.7 million increase in deferred acquisition costs and $2.1 million increase in premium and agents balances, offset by an increase in unearned premiums of $6.1 million, decrease in reinsurance recoverables of $3.4 million, an increase in loss and loss adjustment expense reserves of $1.2 million and an increase in depreciation and amortization of $1.0 million. Cash used in operations was $4.0 million for the nine months ended September 30, 2011, primarily due to a net loss of $11.6 million, increases in deferred income taxes of $6.7 million, $2.6 million increase in deferred acquisition costs, decrease in loss and loss adjustment expense reserves of $3.8 million and $3.0 million increase in premium and agents balances, offset by an increase in depreciation and amortization of $1.3 million, unearned premiums increase of $10.4 million, decrease in reinsurance recoverables of $15.7 million and changes in operating assets and liabilities of $2.7 million.

Cash provided by investing activities was $10.2 million in the nine months ended September 30, 2012 primarily due to proceeds from sales and maturities of available-for-sale securities of $13.2 million, offset by purchases of available-for-sale securities of $2.9 million. Cash used in investing activities was $61.3 million in the nine months ended September 30, 2011 primarily due to purchases of available-for-sale securities of $25.5 million and other investments of $50.0 million, offset by proceeds from sales of available-for-sale securities of $3.2 million, proceeds from maturities of available-for-sale securities of $3.8 million and proceeds from sales of held-to-maturity securities of $7.3 million.

Cash used in financing activities was $1.2 million for the nine months ended September 30, 2012, due to repurchase of common stock. There were no financing activities for the nine months ended September 30, 2011.

We believe that existing cash and investment balances, when combined with anticipated cash flows from operations and dividends from our insurance companies, will be adequate to meet our expected liquidity needs for the reasonably foreseeable future. We will continue to pursue and investigate possible strategic opportunities. In regards to strategic acquisitions, we may need to secure external financing. We cannot assure you that we will be successful in obtaining any such financing or in the implementation of our business plan.

Inflation

Inflation in the U.S. has been relatively low in recent years and did not have a material impact on our results of operations for the nine months ended September 30, 2012 and 2011. Although the impact of inflation has been relatively insignificant in recent years, it remains a factor in the United States economy and may increase the cost of acquiring or replacing property and equipment and the costs of labor and utilities.

COMMITMENTS

NLASCO’s loss reserves do not have contractual maturity dates. However, based on historical payment patterns, the following table estimates when management expects the loss reserves to be paid. The timing of claim payments is subject to significant uncertainty. NLASCO maintains a portfolio of investments with varying maturities to provide adequate cash flows for the payment of claims.

(in thousands)

33

Our future income, cash flows and fair values relevant to financial instruments are dependent upon market interest rates. Market risk relates to the risk of loss from adverse changes in market prices and interest rates. We may use some derivative financial instruments to manage, or hedge, interest rate risks related to our borrowings from time to time. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of the nine months ended September 30, 2012, we had no derivative financial instruments.

As of September 30, 2012, our total debt outstanding was approximately $131 million, comprised of approximately $83.9 million, or 64%, subject to fixed interest rates and $47.5 million, or 36%, subject to variable interest rates.

If LIBOR and the prime rate were to increase by one eighth of one percent (0.125%), the increase in interest expense on the variable rate debt would decrease future earnings and cash flows by approximately $59,000 annually.

Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of any change in overall economic activity that could occur in that environment. Further, in the event of a change of that magnitude, we may take actions to further mitigate our exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.

The fair value of debt outstanding as of September 30, 2012 was approximately $139 million.

The following table sets forth certain information with respect to our indebtedness outstanding as of September 30, 2012 (in thousands).

(a) Disclosure Controls and Procedures. The Company’s management, with the supervision and participation of the Company’s Chief Executive Officer and Chief Accounting Officer, has evaluated the effectiveness of the design and operation of Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Accounting Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 and are effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes in internal control over financial reporting. There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934) during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

We may write-off intangible assets, such as goodwill.

As a result of purchase accounting for our acquisition of NLASCO, Inc., our consolidated balance sheet at September 30, 2012, contained intangible assets designated as goodwill and other identifiable intangible assets, definite life aggregating $29.2 million. On an ongoing basis, we evaluate whether facts and circumstances indicate any impairment of value of intangible assets. As circumstances change, we cannot assure you that the value of these intangible assets will be realized by us. If we determine that a material impairment has occurred, we will be required to write-off the impaired portion of intangible assets, which could have a material adverse effect on our results of operations in the period in which the write-off occurs.

In the future we may determine to record an allowance against all or a portion of our deferred tax asset, which would result in a non-cash charge.

In the event that the contemplated merger with PlainsCapital Corporation is not consummated, management may determine that is more likely than not that we will not realize all or a portion of the benefits of our deferred tax asset. Our deferred tax asset at September 30, 2012, was $15.0 million. If an allowance is determined to be necessary in the judgment of management, it will result in a non-cash charge in the amount of the allowance recorded during that period.