Afternoon. Welcome to the HCI Group's second quarter 2013 earnings call. My name is Latonya, and I will be your conference operator this afternoon. Before we begin today's call, I would like to remind everyone that this conference call is being recorded and will be available for replay through August 9th, starting later this evening. I would now like to turn the call over to Les Holland, Investor Relations at HCI Group. Sir, please proceed.
Thank you. Good afternoon. Welcome to HCI Group's second quarter 2013 earnings call. With me today are Paresh Patel, our Chairman and Chief Executive Officer, Richard Allen, our Chief Financial Officer, and Scott Wallace, President of our Insurance Division. Richard will review our financial performance for the second quarter and first six months of the year. Paresh will give a brief update. Finally, we will open the call to your questions. To access today's webcast, please visit the Investor Relations section of our corporate website at www.hcigroup.com. Before we begin, I would like to take the opportunity to remind our listeners that today's presentation and responses to questions may contain forward-looking statements made pursuant to the Private Securities Litigation Reform Act of 1995. Words such as anticipate, estimate, expect, intend, plan, and project, and similar words and expressions are intended to signify forward-looking statements.
Forward-looking statements are not guarantees of future results and conditions, rather are subject to various risks and uncertainties. Some of these risks and uncertainties are identified in the company's filings with the Securities and Exchange Commission. Should any risks or uncertainties develop into actual events, these developments could have material adverse effects on the company's business, financial conditions, and results of operation. HCI Group, Inc. disclaims all obligations to update any forward-looking statements. I will turn the call over to Richard Allen, our Chief Financial Officer. Richard?
Thank you, Les. Good afternoon, everyone. For the second quarter of 2013, income available to common stockholders totaled $16.2 million, or $1.40 diluted earnings per common share. This compares to $7.2 million or $0.74 diluted earnings per common share for the same quarter of 2012. For the first six months of 2013, income available to common stockholders totaled $36.6 million or $3.20 diluted earnings per common share. This compares with $14 million or $1.60 diluted earnings per common share in the first six months of 2012. Gross premiums earned in the second quarter of 2013 increased 52.4% to $82 million from $53.8 million in the same quarter of 2012. For the first six months of 2013, gross premiums earned increased 51.7% to $164.5 million from $108.5 million in the first half of 2012.
This increase was primarily due to revenue from policies acquired from Citizens in November of 2012. Net premiums earned for the second quarter of 2013 increased 54.7% to $57.3 million from $37.1 million in the same year-ago period. For the first six months of 2013, net premiums earned increased 52.1% to $117.9 million compared with $77.5 million for the same period of 2012. Premiums ceded in the second quarter of 2013 were 34% of our gross premiums earned, compared with 31.1% in the second quarter of 2012. For the six-month period ended June 30th, 2013, premiums ceded were 28.3% of gross earned premiums compared to 28.6% in the same period a year ago. For the quarter ended June 30th, 2013, net investment income was $295,000 compared to $302,000 in the same period of 2012.
For the first six months of 2013, net investment income was $434,000 compared to $824,000 a year ago. Losses and loss adjustment expenses in the second quarter of 2013 totaled $17.4 million compared with $16.2 million in the same period a year ago. For the first six months of 2013, losses and loss adjustment expenses totaled $33.3 million. This compares with $35.4 million in the first half of 2012. Other operating expenses, which include a variety of general and administrative expenses, totaled $7.4 million during the second quarter of 2013. This compares with $4.4 million in the second quarter of 2012. For the six months ended June 30th, 2013, other operating expenses totaled $13.5 million versus $8.7 million for the comparable period of 2012. Turning to our financial ratios.
Our loss ratio applicable to the second quarter of 2013, which we define as losses and loss adjustment expenses related to net premiums earned, was 30.4%, compared with 43.7% in the second quarter of 2012. For the first six months of 2013, the loss ratio was 28.2%, compared with 45.6% in the same year-ago period. We are constantly monitoring claim activities for development of trends in frequency, severity, and causes of loss for the potential impact on incurred losses and loss adjustment expenses. We use this data to refine and improve our underwriting guidelines. The expense ratio applicable to the second quarter of 2013, which we define as underwriting expenses, interest, and other operating expenses related to net premiums earned, totaled 27% compared to 28.7% in the same year-ago period.
The expense ratio applicable to the six months ended June 30th, 2013, was 24% compared with 28.1% in the same period of 2012. Expressed as a total of all expenses related to net premiums earned, the combined loss and expense ratio to net premiums earned in the second quarter of 2013 was 57.4%, compared with 72.4% in the same year-ago period. For the first six months of 2013, the combined loss and loss expense ratio to net premiums earned was 52.2%, compared with 73.7% in the same period of 2012. Turning to the balance sheet. Our cash and cash equivalents at the quarter end totaled $296.8 million, compared with $230.2 million at December 31st, 2012. Unearned premiums at June 30th, 2013, were $191.4 million, compared to $154.2 million at December 31st of 2012.
Our reserves for losses and loss adjustment expenses totaled $44.7 million at June 30th, 2013, compared with $41.2 million at December 31st. As you can see, we have had successful underwriting results thus far in 2013 with continued strengthening of our balance sheet. I'd like to turn the call over to Paresh.
Thank you, Richard. Yesterday, July 31st, 2013, marked the fifth anniversary of HCI being a publicly traded company. Over that time, our diligent commitment to underwriting, expense management, as well as opportunities expansion, has propelled the company from being a startup to being one of the top P&C insurance providers in the state of Florida. Looking at the highlights for the quarter, as approved by our shareholders in May, we began doing business under the name HCI Group. This name more accurately represents the future of the company given our diverse yet complementary business activities which include property and casualty insurance, information technology, real estate, and reinsurance. The rebranding also helps avoid confusion between our largest subsidiary, Homeowners Choice Property & Casualty Insurance Company, and our other non-property and casualty insurance enterprises. Our overall strategic focus, however, does remain insurance.
Having said that, we are equally excited about the future and our other enterprises like Exzeo and Greenleaf Capital. I would like to read the following statement. Subsequent to the end of the quarter, we filed an 8-K that outlined our 2013-2014 reinsurance program. The gross premium cost of the program to the HCI Group is approximately $134 million. However, because of special provisions in certain of the reinsurance agreements, which include premium and coverage adjustments in the event losses are minimal or zero, we expect to recognize net reinsurance premiums ceded of approximately $113 million from June 1, 2013, through May 31st, 2014, assuming no losses occur during that period.
The difference between the gross and net amounts is recognized as a benefit over the treaty year and will be reversed and charged to earnings in the event we experience a catastrophic loss that exceeds our coverage limits provided under the related agreements. As of June 30th, 2013, we have recognized a benefit of approximately $1.3 million in connection with these agreements. With that, I will turn over for additional questions and comments. Thank you.
Victoria?
Thank you. Thank you, sir. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Once again, ladies and gentlemen, that's star one to ask a question at this time. One moment, please, while we poll for our first question. Our first question comes from Casey Alexander with Gilford Securities. Please proceed with your question.
Hi. I have a few questions. First of all, in relation to the reinsurance, you said you received a benefit already of $1.3 million in the June quarter. Where does that show up in the income statement? Does that show up as a reduction of premiums ceded? In other words, would premiums ceded have been $25.9 million had you not had this arrangement?
Correct, Casey.
Okay. Would the difference between the 134 and the 113 sort of show up ratably month by month over the course of the year, assuming that there are no catastrophic losses, and then if there was a catastrophic loss, that $1.3 million would be recaptured by the reinsurance company?
Casey, the reason we brought this thing up in the conference call, et cetera, is just to make sure everybody understands how these things work. I'll try to answer the question because it's taken Richard and the finance department several hours to explain to me so I could translate this hopefully into non-accounting terminology. Okay?
Here's the simplest way of looking at this thing. We've spent $134 million in cash that's going to go out for reinsurance over the course of the year, right?
Yep.
Given the provision in some of the contracts, if there are no losses, which if you sort of think about the last five years, there have been no losses in those.
Right
treatments, right? If no losses occur, hypothetically, this is not exactly what the agreement says, but if it was just all over one year, it would mean that at the end of the year, the reinsurers would send $21 million back. Call it reduced premiums, call it profit commission, call it whatever you want, but in effect, $21 million would be coming back. Right? The question is, at that point, going forward, are you going to look at $113 million or $134 million of expenses? There's an accounting provision which basically says that you cannot assume a catastrophe is going to happen before it happens. Therefore, you have to presume that you're going to have this upcoming year be event-free up to and until the day that event occurs, yeah?
Consequently, you can only book the contract in your accounting as if no losses are going to occur until a loss occurs, in which case, at that point, you reverse out, you true it up as such, yeah?
Right.
Right. Just to put this in simple terms, if a storm had happened on June 30th, which would have reversed out a possibility of getting that $21 million back, right? What would happen at that point is we would basically take that extra $1.3 million charge because of money we've already accrued, plus going forward, we'd amortize $134 million as opposed to $113 million.
Okay.
Okay? It gets a little bit messy, that's why we're now trying to put up both the gross number, the net number, and also how much we've accrued to date. Yeah?
It sounds like there's a difference between the GAAP accounting on this and the cash accounting then as it reaches the company.
Yes.
Yeah. All right. Well, Richard, you and I'll discuss this in more depth later, just to make, because for modeling purposes, it makes it quite difficult. The proceeds from the Aon Benfield case, did those arrive in this quarter, or are they arriving in some future quarter?
The case is still under appeal. When it is fully settled, we will receive the cash.
Okay. No cash has been received from that. In the company's real estate portfolio, have there been any new developments during this quarter that are material to the company?
I don't think so. Well, I think, when did we close on Ocala?
Two.
Yeah. The general answer is no.
Okay. You haven't closed the backup building in Ocala yet?
Yes. If I remember, that was closed in the first quarter.
That was closed in the previous quarter. Okay. That's fine.
Yes.
You continue to have, versus historical benchmarks, very low loss and loss adjustment expense ratio on policy acquisition ratios of percentage of gross and net premiums. It is low enough that I am almost required as a function of diligence to ask, is that sustainable and for how long? Because the number is well below what would be considered a historical benchmark for Florida homeowners' insurance companies. Can you give me some color on that?
Sure thing. I will talk about the loss ratios, and I will let Richard talk about the acquisition cost part of it, okay?
Okay, great.
In terms of the loss ratios, and as Richard said in his comments, we continue to look at this thing to see if we ever see a turn going the other way in terms of development becoming adverse, because we have been focused as to why this is happening this way for some time as well. What fundamentally we seem to be noticing is there has been a material difference in the mix of claims, and consequently, therefore, the average cost per claim comes down, and that very quickly starts multiplying. Really, it is to do with what was all this talk a couple of years ago about the sinkhole problems, et cetera.
Right.
Even that, I think SB 408 and all those kinds of things that were done a couple of years ago, you're now starting to see the effects of that roll through people's books, yeah?
That's what's causing the claims mix difference is what's causing the loss ratio to come down. Again, we are equally diligent in terms of keeping an eye on it because we want to make sure that it's not anything other than that that's causing it, yeah?
Right.
Okay.
Richard, the policy acquisition costs?
Policy acquisition cost, Casey, you've got to remember that in the prior calls, we've discussed the earned premiums related to the November takeout were not subject-
Right
to any acquisition costs. As those policies renew under HC, under Homeowners Choice policies, the acquisition cost will increase accordingly.
On that line, we could expect after the policies have aged a year to start to see the policy acquisition cost move back towards more normal historical levels?
Yes.
Okay.
You've got to remember, too, that in January of last year, we changed the recognition of policy acquisition cost and deferral.
Right.
Where all you can defer now is just commissions and premium taxes. Prior to that, there were some expenses involved.
Mm-hmm. Okay.
That has lowered from 2011 levels. 2012 moving forward will be lower than those prior years.
Okay. Paresh, it seems pretty clear, based upon everything that we've read, that Citizens' approach to how they offer policy takedowns has changed. Could you discuss how HCI's approach in terms of how they look at deals with Citizens may or may not have changed as a result of that?
Casey, when you say that Citizens' takedowns has changed, are you talking about the one-off deals they've been doing in the early part of this year?
Yeah.
Yeah. Speaking about that, we've seen that, et cetera, and unfortunately for the companies that have done that have also had all kinds of adverse publicity, et cetera, that have occurred with that. We've seen all of those things going on. From our perspective, we seem to do quite well just with the programs that's been in place for the last 6 years. It doesn't really become material for us to want there to be a different change, et cetera. I think just the special deals and stuff, and I think they may be actually at this point coming to an end because I think even Citizens has taken a lot of negative press on the matter.
Right.
Yeah.
Without getting into specifics, I know that you have the cash hoard set aside for special opportunities. Obviously, we wouldn't talk about names, but have any acquisition opportunities been presented to the company, and anything that you at least have under consideration?
Okay. I'm going to split the answer to that question in two parts in terms of have things been presented to us. I think a week doesn't go by without something being presented to us, either within Florida or outside Florida, that kind of thing. Having said that, obviously, we are not announcing closing on anything at this point, yeah?
Okay. All right. Well, thank you for taking my questions, and a very good quarter. Congratulations.
Thank you.
Thank you, Casey.
Once again, ladies and gentlemen, to ask a question, please press star one on your telephone keypad. Our next question comes from Cliff Orr with Privet Fund Management. Please proceed with your question.
Hi there, Cliff.
Cliff, your line is live, you can speak.
Good afternoon, gentlemen. Thanks very much for taking my call. I'd love to hear you talk a little bit about the top line moving forward with the clearing house coming into effect in early January 2014. I think there are questions surrounding how that's going to be implemented and executed, but the general understanding that I've received is that all new policies will go into sort of a system through which participating carriers can, quote, "bid on that policy" for about a 48-hour period, and then only if the quotes are not within 15% of Citizens will it go to Citizens. Just trying to think about the increased transparency associated with that and how that may ultimately affect the number of policies that Citizens holds, and then next derivative, how many takeouts they may be able to conduct at that point, and the profitability associated with those takeouts.
How are you thinking about that and maybe altering the policy generation business model, if at all, given the changing dynamics with respect to Citizens?
Okay. A number of questions in that. I'll start with the last part first, the thing about policy business generation, et cetera. We are, at this point, having 140,000, give or take a little, policies that we have. We are as much focused on retaining the policies we've got as opposed to having to keep getting new ones, et cetera, because we have a recurring revenue stream here as well. We do sit from a different position than we would've looked at this had this occurred, say, five years ago, when we were still ramping up. One aspect that's unique to us in this matter.
The other side of this, in terms of Citizens and the clearing house and everything else, I think while this train is leaving the station, everybody's going down that path, there are a couple of big variables that are unknown, and as to how things will play out. I think the clearing house was designed as a concept to give Citizens the ability to say no to a policy, right? Which is not entirely the same as therefore somebody's going to step up and take that policy. How all of this plays out and how this plays out in the political world remains to be seen, especially as we still have a hurricane season to go through before we get to that point. We continue to monitor it and watch it, and we talk to the Citizens people about it regularly.
We are really, at this point, taking a wait and see attitude, because usually when these things occur, how people have perceived it was going to turn out versus how it actually turns out tends to be slightly different historically, yeah.
Okay, great. Relatedly, with these more recent takeouts over the past several months, curious if you've perceived any change in Citizens' preferred method for depopulation. By that, I mean it appears they're trying to jettison policies prior to hurricane season rather than perhaps after hurricane season, once that catastrophe risk has passed. Is that a fair assessment, or do you have a different view?
I have a different view. I think in defense of the Citizens folks, I think they've been on a mission to reduce the size of Citizens for about 18 months to two years now. I think they're looking at any and every way they can think of to reduce the size of Citizens, right? I'm not here to tell you whether that's good public policy or bad public policy. I'm just telling you that policy seems to be the policy that seems to be coming out of Citizens at this point. They're encouraging anything and everything they can think of to reduce the policy count inside Citizens. I think they're agnostic as to which time of the year the reduction occurs. Okay. Who's next?
Okay, thanks very much. I appreciate the commentary.
Thank you.
Our next question comes from Carson Yost with Yost Capital. Please proceed with your question.
Hi there, Paresh. I just had a quick question on the number of policies in force at the end of the quarter, is the first question. The second question is, can you just talk about churn on both the newly acquired policies and the preexisting policies? Thanks.
Okay. Scott's handing me a piece of paper, so I'll just tell you from that. I think.
I hope you read my Buffett book I sent you, by the way, most importantly.
I did.
Oh, good.
Yeah. In terms of policy count, we are in that part of the year where our policy count's sort of going down month after month. I think end of the second quarter, we were below 140,000, probably between 135,000-140,000. It's been decreasing slightly. In terms of retention rates, et cetera, I think we are right around 90%. It's as good as it's ever been, and I think we're getting retention both in that blended 90%. That tells us that both the takeout and the renewal policies are all basically staying with us. We're very happy about that, obviously.
Great job.
Okay.
Once again, ladies and gentlemen, to ask a question, please press *1 on your telephone keypad. Our next question comes from Edward Hemmelgarn with Shaker Investments. Please proceed with your question.
Yeah, thanks. In terms of--, there are a couple of questions. One, you talked about a 90% policy retention rate. What kind of organic new policy, outside of purchases from Citizens, is occurring?
We continue to write policies. I think what we tend to find is that the organic growth is more a function of how hard we want to push to get new business. As we've done over the years, now that we're in hurricane season, et cetera, we tend not to want to grow the business between now and probably the end of September, end of October kind of timeframe. The question you're asking, if I just sort of told you we're writing very little organic new business, sounds like, oh, my God, how can you do this? Well, the reality of this is, we're writing very little because we're not trying to write a lot. If we actually did try to write a lot, I suspect we could do that as well.
I guess then, another question is, over the last 12 months, so a cycle, outside of the Citizens takeout, what was your organic new policy growth rate?
Not much. Probably in the region of about 4,000 or 5,000.
Okay.
In the yeah.
Would you expect that to change as you mature as a company? I suspect at some point in time, the opportunities to take out from Citizens will decrease, to balance out the losses that you're having, and to start growing.
I think the way we've always stated this thing, and we've got five years of doing this at this point, is that we usually start out setting a target size of the business that we want to get to, and then we say, what is the ideal of getting there? Usually, there's three ways of getting there. You either get there by doing a takeout, you can do it there by organic growth, or you can get there by doing an acquisition. A number of people look at all of these things and have some dogma as to which is a preferred method and which is better or which is worse. We've always looked at it as which is the most cost-efficient method of getting to that number we want to get to, and that's the path we take.
We had grown into expanding the organic growth business a couple of years ago, in late 2011, as everybody knows, we got the HomeWise acquisition. Just that acquisition put more policies in one fell swoop on the books than years of organic growth would've done. We had to go digest that. Last year, we did the takeout, which was the opportunistic way of growing for this year, and that's what we did. In terms of which path we would use next year, it's really a function of what's available to us.
Okay. That's a good answer. Second, then, is in terms of the $21 million difference, would that be retained by the reinsurance if there was just one event?
No. That $21 million is based on however many events over however many years kind of thing. These are multi-year contracts, which roll forward year to year.
That's numerous contracts.
Yeah. As numerous contracts. You should see our reinsurance contracts. We've got a stack of them at this point.
Size of a library.
Yeah.
Okay. All right. Gee, I remember you told me that they overlapped. Okay. We really won't know exactly what that number will be until the season is over and you can tell us?
It may actually be into multiple years because yes. That's why going forward, we are going to tell you what that accrual number is.
Okay.
Really, look, let me elaborate on this a little bit further at this point. The real reason that we've gone into these complicated contracts is everybody prices reinsurance on an expected loss basis, right? Consequently, oh, we think there'll be one hurricane every three years, and here's a price for reinsurance for that.
Where we've taken this to the next step is to say, okay, we will pay you that, but if the losses don't occur, we want to have provisions whereby some of the money comes back. Right? Nothing to do given how many years we've paid reinsurance and how little we've collected back, which actually to date is zero. Yeah?
Yes.
That's why we've got these clauses in there. Unfortunately, accounting wise, they wanted us to book the lower number. It is.
Okay
what GAAP says, yeah?
You've got a recapture if there is none, but the reinsurance has uncapped exposure if there's multiple events.
Well, it.
There's no upper limit.
It's between the 134 versus 113, yeah?
No, I meant is that reinsurance available to you whether there's one or 10 events?
It depends on which treaty is involved.
Yeah. We've got three-year treaties with four events. We've got five-year treaties with aggregate limits on them and two events per year.
Right.
We've got single-year, single shot treaties. Each treaty has its own. It's almost like we're putting the reinsurance tower like a mosaic together at this point, yeah?
Okay. All right. Lastly, then, in the event of, let's say a hurricane, is there a maximum exposure you have?
Well, I think the usual number that everybody refers to is what's your retention before the reinsurance tower kicks in. At this point, it's $11 million is what the retention number is. Yeah.
Okay.
Okay?
Okay. That's in general, $11 million per event?
In general, yes. By the time you get to the third event, it sort of all depends on what the first two events were, yeah?
Okay. All right.
Okay.
That's reasonable. Okay. All right, thanks.
Good.
Our next question comes from Gregory Macosko with Lord Abbett. Please proceed with your question.
Yes. Thank you. Just to follow up on that, the $21 million differential, that is over a number of years. Am I hearing that right? You would not recognize that if there's no event. You would not recognize that this year. There'd only be a portion of it this year, and it would roll forward. Is that right? It's rolled from behind too, right?
I think it's $21 million for this year.
$21 million is this treaty year.
Oh, this year. Okay. When this year's done and say there's no event or a partial or whatever comes out, that'll be recognized, and then you'll go forward sort of on a new basis, and none of that 2020 carry forward.
Some of it may carry forward because of the multi-
Multi-year
nature of the contracts. What happens is that if we go this year event free, some of that $21 million will be used to actually provide additional reinsurance for us next year.
I see. Right, you'll recognize it, then use it. I understand.
Yeah. It's that kind of thing. As this thing rolls out, what it does is it's basically starting to fix our reinsurance costs for several years down the road. One of the things that everybody's always been worried about the business is the volatility year-to-year of whatever the rates are for insurance, yeah?
Okay. Are you thinking of, obviously, every year is a new year, are you rethinking your reinsurance strategy in any way? Should we expect changes there maybe within the next year or two, or is it going to be on the same basis going forward?
Greg, this is why I like having questions from you. You set them up so beautifully. What's coloring our thinking and where we are now, right, is when we started out as a public company five years ago, et cetera, there used to be lots of concern that if there was an event, not only would you be making any money for the year, you would have losses for the year, plus you would possibly have a balance sheet event on your hands in terms of how much your capital would be reduced, et cetera. As we've grown and matured, we've sort of gone for and retained less risk. We've sort of eliminated the balance sheet risk to a great degree. Then we were trying to sort of say, despite an event, we would like to make sure that we will be profitable for the year.
That's now evolved that if you look at what our quarterly earnings seem to be pre-tax, you could probably take a single event and maybe even stay profitable for the quarter. We've sort of built moats around the business, so to speak. What you're seeing, and this is why, unfortunately, this reinsurance stuff is getting complicated. We're trying to hedge away the fact that if there's an event this year, reinsurance rates next year could be much greater or something of that nature. That's why we're getting into these multi-year contracts, and we have the profit potential if there were no losses, et cetera, so that we know that the business has a fixed expense component and not variable every June 1 as to what the reinsurance market's doing. Does that make sense?
Yes, it does. The point is your overall strategy, that's evolved, and you're not going to do anything different in terms of You'll work with the same companies in offshore, et cetera.
Absolutely. We are developing and growing those relationships just to ensure that we've had such a string of profitable quarters. Why would you do anything to risk that, yeah?
Right. Okay. You mentioned Exzeo. Maybe I missed it, how is that? That's a longer term idea. What's the progress there, and what should we be hearing about now?
It's actually progressing as expected, which is going to take a little while. We've started to use the Exzeo software within the insurance operations for the company and made it available to a lot of the vendors and other parties that we deal with. It's slowly gaining traction out there in the marketplace. These things take a little bit of time to get there, yeah.
Right. Okay. It's progressing on, and are you taking losses or is there expenses there? Is there a break-even period or anything?
I think it's not a question of break-even in that sense, because the whole way the software business works, it tends to be more of a payoff and a multiple valuation kind of thing as opposed to cash flow. The cash flow that it is consuming hasn't materially changed over the last 18 months or so. The cash requirements of Exzeo have been baked into our earnings and balance sheet for 18 months at this point. It's just a normal part of our operating expenses.
Okay. Thank you. Thank you very much.
Our next question comes from Andrew Shapiro with Lawndale Capital. Please proceed with your question.
Yeah. Hi. A few follow-ups on this whole clearinghouse thing and also in the nature of your business, and these policies. First off, of the policies you picked to acquire, is there a bias for profitability and that you select, that you can choose and do choose, let's say fewer larger value homes versus many lower value homes? Are those policies because of per dollar value on a single policy, are those policies more profitable for you, upfront and in terms of loss ratios?
Andrew, clearly we select for profitability, and really the way of looking at that is that's what's called underwriting, right? You're basically selecting to say what risks as you represent it, and as you look at them, provide you enough premium to be compensated for the risk you're taking.
Right.
We obviously do that, we look at any number of criteria to try and screen policies to make sure that whatever we take on, actually, by the way, this applies regardless of whether we do a takeout, whether we do an acquisition, or whether we do organic policy growth. We make sure that everything we add to the book passes a stringent test that tells us that we have a profitable policy on the books. The criteria is not entirely to do just with the size of the house. It also depends on where it is, construction type, any number of other things. Consequently, it's not just the dollar figure that makes the difference, yeah?
In general, do you find the policies on a $2 million home to be more profitable than policies on a $1 million home?
Well, actually, let me just help you out with that, right? We have limitations that we don't actually write homes that have coverage above $1 million, and the sweet spot of our book is that I think the average exposure we have on a HO-3 is around $300,000.
Okay. Well, that's good because obviously one of the terms of that clearinghouse is that they're going to be dumping out the homes in excess of $1 million. The second thing is, do you have plans as this clearinghouse kicks in? You presently don't. You have these really low policy acquisition ratios because I'm assuming you just run really lean and mean on new policy development or marketing infrastructure because you have this one very large seller where you're getting a lot of policies. As and if the clearinghouse evolves where Citizens shrinks or the policies left within Citizens aren't what you're looking for, is your internal strategy, your business plan, your strategic plan to build or acquire a new policy acquisition infrastructure, and how much might that cost?
Okay. As far as the policy acquisition infrastructure, I think we already actually have it. We've had it, and to answer an earlier question, we've had this thing and we've developed it over the years. Whether we actually use it or not is a different question, and historically, the last couple of years, we have not put it to its test and put it out there because we haven't had a need to do so. I'll give you another example of how we look at that differently. We've done takeouts in the fall in every year in our existence except for 2011. Why didn't we do a takeout in 2011? Because we did the acquisition of HomeWise, and that was the method of growth that year. That's why we weren't passing an opinion as to whether takeouts were good or bad.
We just had a better opportunity, that's what we went after. When you even look at what we've done in terms of takeouts, I think you will see that there are years where we did very small takeouts and other years where we did large ones. What all those variables are is just because you can do a takeout doesn't mean that the opportunity is there and the profitability is going to be there in acquiring those policies. The growth or the shrinking of the business is we're more focused on the market dynamics, and we have multiple levers with which to pull, in which direction we want to go to.
Another factor to that point that I can point to is, I think if you looked at our policy count from about January 2009 through about November 2011, the policy count didn't materially go up by much. However, our profitability went up tremendously, because those are other things that we do. It's not entirely always about growth and policy count. It's also about optimizing your book, improving the book, finding the bottom 5% of your policyholders and replacing them with 5% newer policyholders, which should not increase your policy count or your exposure, but could have a marked improvement on your profitability. This is a lot more involved than just what's a top-line number.
Yeah?
Finally, it's another clearinghouse kind of question. As the policies now that are considered for Citizens will go into an auction, or into the clearing house, do you anticipate HCI potentially evaluating, bidding, and participating during that 48-hour period for those policies, or only looking at these policies that remain in Citizens that path through the clearing house process?
Let me answer the question this way. This whole idea of the clearing house, right? A lot of people, obviously at Citizens, legislature, et cetera, have put a lot of effort into coming up with a concept and implementing a mechanism for doing that. There is a interesting observation in the sense of, if these policies were so wonderful, why didn't they take them out of Citizens in November this year, or November last year, or November the year before? There's a presumption that when you put them up for auction, all these new insurers would show up and say, "Hey, I've got to take this policy now," as if I was totally unaware that policy existed before you put it up in the clearing house.
The reality of this is, I think most of these policies are known to most of the insurers and have been for several years. It's not entirely a given fact that as soon as they put up the clearing house, that these policies will suddenly find a new home. It may not occur.
Oh, yeah.
Yeah?
I understand. You're talking about the bulk that's inside of Citizens already when they come up for renewal, right?
Yes.
Okay.
The bulk that's in there for renewal.
I hear you.
And-
I understand the point you're making there. How about with new policies, where historically, the State Farm agent basically shops the broker, whoever they have the best deals with, the broker shows the homeowner this policy, then there's Citizens. They don't otherwise generally shop it. The clearing house is obviously going to mandate much more of a shopping situation for new policies. Would you be bidding for those, or you would just wait and see if they stay within and stick with Citizens?
Let me make a generic statement, that whenever we see an opportunity to take a good policy in whatever method, we always do so. The clearing house just opens up yet another method of doing so if it were to come to that. As far as that State Farm thing and the State Farm agents automatically put policies into Citizens, just a little bit of color on this. Seem that we've done, at this point, nine takeouts. That urban legend that the State Farm agents are busily dumping policies into Citizens, well, when you're doing a takeout in November like we did last year, one would logically go look at those policies and say, "Let me take those out," mainly because we've got two-thirds of State Farm agents under contract. We could take those policies out.
I just got to tell you, when I went looking for them last year, those policies weren't there. I don't know why, but they aren't there. Consequently, this whole idea that these captive agents are dumping policies into Citizens that other people would take, I believed that once upon a time as well. I went looking for the evidence, I don't find the evidence. It's an interesting dilemma. I'm sure we'll discover the facts of this starting of the new year, yeah?
Mm-hmm. Okay.
Okay?
Great. Thank you.
Thank you.
Our next question comes from Cliff Orr, Privet Fund Management. Please proceed with your question.
Thanks for taking my follow-up, gentlemen. Had a question related to reinsurance and sort of how you think about capital allocation. I was curious, I saw on the 8-K you released on the reinsurance program that the captive reinsurance company is ceding a little over $9 million of premium to management-owned entities. Just from sort of a parent company perspective, to the extent that management clearly views that as attractively priced risk, why not, given the excess liquidity at the parent, retain that attractively priced risk for the benefit of shareholders versus management-owned entities. Just trying to think about and would like to hear how you sort of balance that consideration versus the ROI for liquidity at the parent company. Thanks very much.
Okay. Great question. I think slightly off target a little bit in the sense of, let's separate the two items in terms of risk retention by the HCI Group, and then we'll talk about the management. Well, let's talk about the management entities. The management entities are basically entities we've set up because kept telling us that you couldn't do reinsurance at the prices that were there, and we've set these things up, and they actually do have an effect of providing downward pressure on our reinsurance costs. The reason for that being is that because of these entities, we are buying less in the open market, and these entities do not get a better deal than anybody else in the open market. In fact, they get a slightly worse deal. Consequently, it's beneficial to the HCI Group. Okay?
Having said that, in terms of risk retention and how much we're retaining, very simple way of explaining this. There was a time when HCI used to, say, for the sake of argument, make $70 million a year pre-tax income. You could, at that point, risk $70 million of capital in the captive and earn $30 million more in profit by reducing the premium payout to third parties. Now, instead of making $7 million pre-tax, you're making $10 million pre-tax. It's a beautiful increase in profitability. You're risking $7 million of capital in case an event were to occur. That was then. Where we are now is that if you're looking at $70 million of pre-tax income, does it make sense to risk another $7 million to go from 70 to 73?
That simple logic and rationale has meant that even though as we've increased more and more capital, the risk that is retained by Claddagh has been flat or increasing very small year-over-year. Claddagh's lack of growth is not because, quote unquote, there are management-run entities that are taking that risk. Claddagh's lack of growth is because we just look at the opportunity we and the risk-reward profile, and we are more and more looking at what we have here as a wonderful business that's functioning perfectly, and why would you over-leverage it? Does that help?
I understand what you're saying. I'm just trying to think about, I guess I think of it less in terms of the scale of earnings and the lower effect given earnings are now higher as I do. Each incremental investment decision should stand on its own, sort of irrespective of the scale of overall earnings.
I think opinions vary, right? Because put it this way, if you look at the revenues that were spent, even assuming that 130 in amortization we're doing, but let's use 134, the higher number. You could have reduced that by 20 or $30 million by retaining additional risk in Claddagh. Right? However, because we had that $40 million money that we raised in the bond offering in January, which has been untouched, we could have quite happily retained that and made that number less. However, we would much rather conserve that cash because one of these days there will be an event, and the greatest opportunity that we're going to have is to be financially strong the day after the event. Because look at it on a different level. We talk about clearing house and things going away that way.
Nobody has outlawed hurricanes in the state of Florida. When the next hurricane hits, there will be tremendous opportunity for those people that have financial wherewithal to pick up growth like you wouldn't believe. We are as much thinking about those things and putting ourselves in a conservative stance waiting for that day. It may come this year, it may come three years from now, but that day will come.
Essentially you're saying you feel like the potential return on that cash is higher, waiting on an inevitable event to come rather than retaining incremental risk this year?
Yeah.
Okay. I appreciate thanks for your thoughts on the issue.
Yeah.
Our last question comes from Casey Alexander with Gilford Securities. Casey, you can proceed.
Casey?
They had us on mute, we have no more further questions in the queue, I'll turn it back over to you for closing comments.
Okay. Thank you all for participating with the conference. I apologize once again for making our reinsurance programs and things so complicated. We are doing this because we are trying at this point to ensure that this company keeps that streak of profitable quarters going for as far into the future as we can. Whether we succeed or not, we're definitely going to try to make sure we keep this streak going. Thank you.
Thank you, LaToya. At this time, we will be closing down.
This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.