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HCI Group (NYSE:HCI), formerly known as Homeowners Choice, Inc., is a holding company with subsidiaries engaged in property and casualty insurance business in the state of Florida. The Company derives substantially all of its revenue and profits from its regulated insurance entity, Homeowners Choice Property & Casualty Insurance Company. The Company faces significant risks unappreciated by investors and policyholders.

  1. HCI's superior profitability and ROE result from cutting corners on reinsurance coverage rather than sound underwriting
  2. HCI lacks proper second event reinsurance coverage and may face regulatory action in the case of a significant hurricane event in Florida
  3. Questionable insider dealings raise corporate governance concerns
  4. Insiders have been consistently selling stock
  5. HCI trades at almost 3 times its book value; far more expensive than insurers operating in the same market such as United Insurance Holdings Corp (NASDAQ:UIHC).

Background

HCI was incorporated in 2006 following waves of devastating hurricanes that led to mass exodus of insurance companies providing homeowners insurance in the state. The most notable exit was made by State Farm in 2009. Florida's homeowners became increasingly reliant on the state owned Citizens Properties Insurance to provide homeowners insurance and the state insurance regulator has approved numerous new private market entrants in an attempt to involve private sector companies to provide homeowners insurance to Florida residents. Since incorporation, Homeowners Choice has managed to grow rapidly by taking advantage of the take-out program offered by the state owned Citizens; it currently owns roughly 15,000 policies following the acquisition of HomeWise. As of December 31st, 2012, Homeowners Choice has 10.9 million shares outstanding and a book value of $121 million. The company trades at almost 3 times book value, largely because of its ability to rapidly grow its gross premium by acquiring policies from Citizens as well as other Florida home insurers. United Insurance Holdings Corp (UIHC), in comparison, trades at a far more modest 1.1x book. Homeowners Choice has managed to generate substantial return on equity since its incorporation. But if Homeowners Choice is able to be so profitable writing homeowners insurance, why would bigger insurance companies ever exit this market? Is State Farm acting dumb or are there unobserved caveats in Homeowners Choice's business model?

In a press release dated January 27th, 2009, State Farm announced it is exiting the property insurance market in Florida citing its inability to raise premiums to cover future catastrophe risks. The Company voluntarily gave up over 700,000 policies as a result of its exit. In the same year, Homeowners Choice almost doubled its gross premium to $110 million. It begs curiosity as to how a 3-year old property insurance company sees profits in a sector while one of the world's best and largest insurance companies is running for the door. Is Homeowners Choice making money because of smart underwriting and hedging of catastrophe risks or is the Company simply rolling the dice and has been getting lucky? Filings with Florida Office of Insurance Regulation provide insightful answers to the puzzle.

Homeowners Choice has been underpreparing for major CAT risks when benchmarked against similar property insurers in the state of Florida. Further, related party dealings involving the CEO, insiders and the CEO's family members raise serious questions about the integrity of certain reinsurance contracts entered into between the regulated insurance entity and the Company's Bermuda-based captive reinsurer. Moreover, the potential future reform of Florida Hurricane Catastrophe Fund will likely add additional uncertainties to Homeowners' business model.

Do Homeowners Choice's Reinsurance Contracts Adequately Shield the Company from Catastrophe Risks?

Homeowners Choice has significant coastal exposures which obviously renders itself to significant hurricane risks. With the 2013 Atlantic hurricane season officially starting 2013, scientists are predicting it to be the busiest hurricane season since 2005. Models predict greater than 60% chance of a major hurricane hitting the state of Florida.

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The management of Homeowners Choice certainly would like the investors to believe that the Company has completely transferred all CAT risks to reinsurers and thus, profits the Company has made in the past came from excellent underwriting rather than taking on undue risks. In a recent investor presentation at Roth, CEO Paresh Patel stated the following:

"People always seem to think we made money because the wind didn't blow or there wasn't a hurricane last year. That isn't how insurance in our business model works. The people who make money when there isn't a hurricane are the reinsurers because what we do is we transfer the hurricane risks to third party reinsurers"

Mr. Patel is certainly right about one thing, an insurer like Homeowners Choice should adequately transfer all hurricane risks to reinsurers given its lack of reserves. Yet comparison of regulatory filings between Homeowners and its competitors show significant differences when it comes to preparing for catastrophe risks. Two of Homeowners Choice's competitors in the Florida market are Tower Hill Insurance and ASI Assurance. A comparison between reinsurance structures of Tower Hill, ASI and Homeowners Choice should raise alarm for investors of Homeowners Choice. Both Tower Hill and ASI's reinsurance contracts provide significant capacity for second event and even third event while Homeowners Choice's reinsurance program provides virtually non-existent capacity in case of a second event. The latest available filing for the 2011-2012 period shows only Layer 2 was available for reinstatement at 100% of premium while all other layers have no reinstatement options. (All documents presented below are regulatory documents filed with the Florida Office of Insurance Regulation)

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Figure 1 Tower Hill 2010/2011

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Figure 2 Tower Hill 2012/2013

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Figure 3 ASI 2011/2012

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Figure 4 Homeowners Choice 2011/2012

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Figure 5 Homeowners Choice 2011/2012 Details

Furthermore, another publicly listed comparable property insurer, United Insurance Holdings Corp. also has substantial second event coverage. For fiscal year 2012, HCI collected a total gross premium of 233 million and ceded 76 million for reinsurance, roughly 32% of the total premium it collected. By comparison, in 2012, UIHC collected a total of 226 million in gross premium and ceded 104 million for reinsurance, or 46%. Such practices may result in short-term profitability of the Company but they should be especially alarming for the state insurance regulator and HCI's policyholders.

Before delving in further to explain the reinstatement clause in a reinsurance contract, it is my view that Homeowners Choice simply is not a suitable investment for investors without such level of understanding.

The reinstatement clause in reinsurance contracts affords insurers to reinstate the contracts after one occurrence. Without proper reinstatement coverage, Homeowners Choice will become uncovered by reinsurance should a significant hurricane hits early in the season. Further, a significant amount of reinsurance coverage for Homeowners came from FHCF (Florida Hurricane Catastrophe Fund) which currently lacks the ability to reinstate after a loss. Therefore, while Homeowners Choice on the surface appears to be well covered by reinsurance insuring the Company against 1 in 100-year hurricane, it in fact faces risks that are unobserved by many equity market participants. Further, it is especially troubling from an insurance regulator's perspective that Homeowners Choice is underpaying for reinsurance contracts, which lack reinstatement coverage while affording an over 3% dividend for the Company's shareholders.

Homeowners Choice is no stranger to media coverage. As recently as February this year, ABC Action News had an investigative report discussing concerns some industry observers share about the Company. Weiss Ratings gave the insurance unit a "D" and its analyst thinks the insurer has significant weakness and could negatively impact policyholders. Weiss views Homeowners Choice among the weakest of the so-called take-out insurers that have been encouraged to remove policies from Citizens' portfolio. Garvin Magor, the senior analyst at Weiss opined "Seven years on, they are still not, in our opinion, able to deal with a severe catastrophe." I certainly share the opinion of Mr. Magor on the company. Additional troubling points were raised in the report. The Company spent $13.7 million to buy two marinas and adjacent property in Pinella County, which is vulnerable to storms. So the very assets the Company has to insure against storms are vulnerable to storms? Hopefully HCI is not acting as the insurer on those investment properties but I suspect they are.

In addition to lacking reinstatement options on its reinsurance contracts, Homeowners Choice is certainly not practicing the extreme caution some of its peers are doing when it comes to the potential shortfall of FHCF. The ability of FHCF to handle a major catastrophe has been the subject of significant media attention recently. Many industry experts, including the Executive Director of FHCF have been calling for immediate reform of FHCF because there's real danger of FHCF not being able to cover all of its liabilities. A bill was most recently introduced into the House Insurance and Banking subcommittee sponsored by state representative Bill Hager. In the staff analysis of the bill, it was noted that some insurers were in fact purchasing private reinsurance duplicating FHCF coverage to insure against any short falls in the fund. This introduces an additional layer of risk ignorance on the side of Homeowners' management and certainly shows an element of lack of best practices when it comes to properly protecting itself against relevant risks.

Homeowners Choice currently has an "A" rating from ratings agency Demotech, but Demotech simply is not the gold standard when it comes to insurance rating. In fact, it has faced accusations of being inflated. One Florida takeout insurer, Magnolia Insurance, was carrying an "A" rating from Demotech shortly before it was ordered into receivership in 2010. The prime rating agency is A.M. Best and Homeowners Choice is not rated by it. By comparison, Tower Hill was downgraded by A.M. Best in 2009 for large part because A.M. Best is very skeptical of FHCF's ability to fund claims.

The state of Florida has not dealt with a major hurricane for the past seven years and many companies operating the takeout model have managed to take on significant number of policies while claiming it had transferred all the risks to the reinsurers. The underlying reality appears to be very different. In my opinion, Homeowners Choice certainly has not transferred all catastrophe risks to the reinsurers as claimed by the CEO and a potential catastrophe will likely wreak havoc on both shareholders and policyholders.

Problematic Insiders Dealings

In addition to the property and casualty insurance business, Homeowners Choice also has a Bermuda-based captive reinsurer called Claddaugh Casualty Insurance Company. The Company uses the reinsurer unit to reinsure 100% of sub-LAC layer as well as a portion of other tranches. For the year 2011/2012, Company's filing per figure 5 shows it used Claddaugh to reinsure $5.8 million at a ROL (rate on line) of 85%. In other words, the regulated insurance entity paid Claddaugh $4.93 million dollar to insure against a potential hurricane incident and should the event occur, the maximum liability for Claddaugh is $5.8 million. The money never left the Company because Claddaugh is a subsidiary of HCI. In addition to the sub-LAC layer, Claddaugh is also involved in two additional tranches - 5% of Agg tranche and 13.5% of Layer 1. The total risks Claddaugh insured is approximately $12 million but the two additional layers are at much lower ROL and the likelihoods of those payouts are correspondingly much lower. The 85% ROL on the sub-LAC layer appears to be extremely high but given it was essentially moving money from one pocket to another pocket, as long as the Florida insurance regulator approves the transaction, shareholders of Homeowners Choice should have no complaints. The situation becomes somewhat different this year. Disclosed in the 10-K filed with the SEC, an unrelated entity Moksha Re started getting involved in retrocession contracts with the Company's Bermuda-based reinsurer.

"On June 1, 2012, Claddaugh Casualty Insurance Company, Ltd. ("Claddaugh"), the Company's Bermuda-based captive reinsurer, entered into a reinsurance treaty with Moksha Re SPC Ltd. and multiple capital partners ("Moksha") whereby a portion of the business assumed from the Company's insurance subsidiary, Homeowners Choice Property & Casualty Insurance Company, Inc. ("HCPCI"), is ceded by Claddaugh to Moksha. With respect to the 2012-2013 treaty year, which covers the period from June 1, 2012 through May 31, 2013, Moksha assumed $13.8 million of the total covered exposure for approximately $4.0 million in premiums, a rate which management believes to be competitive with market rates available to Claddaugh. The $4.0 million premium was fully paid by Claddaugh in June 2012. Moksha capital partners deposited an aggregate of $9.8 million into a trust account along with the $4.0 million premium paid by Claddaugh to fully collateralize Moksha's exposure. Trust assets may be withdrawn by HCPCI, the trust beneficiary, in the event amounts are due under the 2012-2013 Moksha reinsurance agreement. Among the Moksha capital partner participants, the Company's chief executive officer and the Company's vice president of investor relations contributed $700,000 and $200,000, respectively. In addition, members of the chief executive officer's immediate family contributed $942,500. The remaining capital partner participants, who are multiple parties unrelated to the Company, contributed the balance of $7,960,000."

This time around, Company insiders, their family members and other "unrelated" capital providers started entering into the lucrative reinsurance business at Claddaugh. While it appears Moksha capital partners assumed a total of $13.8 million in exposure in exchange for roughly $4 million, the layer of exposure assumed by such entity is completely unclear and undisclosed. If Moksha capital partners assumed similar reinsurance agreement as the one between Claddaugh and Homeowners Choice, the related parties may not be acting in the best interest of the shareholders. The disclosure certainly lacks transparency and calls into question management's credibility. Why does the Company need outsiders to assume the $13.8 million in risks when it spent $13.7 million on waterfront properties? Finally, the recent change of auditor may serve as an additional red flag for investors.

Additionally, insider action in the open market is worrisome as well. Director Martin Traber has been consistently selling shares since November 2012.The management including the CEO does not appear to have significant stake in the Company either. The recent reported holdings of the CEO came from a share grant as part of his compensation package.

Potential Impact of FHCF Reform

A discussion involving the FHCF is beyond the scope of this article, but the current bill in the Florida House of Representatives certainly bears significance for companies such as Homeowners Choice, which requires state reinsurance to stay in business. The current bill proposes a reduction of the mandatory coverage from $17 billion to $14 billion in the next three years. The bill would also reduce the Cat Fund's offer of coverage to insurers from a maximum of 90 percent this year to 75 percent in 2016. Significantly, the bill also contemplates increasing the industry's co-pay from its current level of 10 percent to 25 percent over the same time period. Given the state of Florida's role in the property reinsurance market, such reduction in government subsidized programs will undoubtedly raise the costs of reinsurance for home insurers like Homeowners Choice.

Conclusion

In summary, Homeowners Choice is a timely short with one of the busiest hurricane season in full swing given its inadequate reinsurance coverage. The insider dealings raise further corporate governance issues and the long-term profitability prospects are not only impacted by potential regulatory actions involving its inadequate reinsurance but also by the impending downsizing of the FHCF that could drive up costs of its reinsurance programs.

Source: HCI Group: Inadequate Reinsurance Coverage Poses Potentially Catastrophic Risks To Shareholders, Policyholders And Taxpayers