UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED September 30, 2014
OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM ___________________TO _______________________
 
Commission File number 0-2500111
 
Federated National Holding Company
(Exact name of registrant as specified in its charter)

Florida
 
65-0248866
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification Number)

14050 N.W. 14th Street, Suite 180, Sunrise, Florida 33323
(Address of principal executive offices) (Zip Code)

800-293-2532
(Registrant's telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o
 
Indicate by check mark whether the registrant has electronically submitted and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $.01 par value –14,008,844 outstanding as of October 30, 2014
 


FEDERATED NATIONAL HOLDING COMPANY

INDEX

PART I: FINANCIAL INFORMATION
PAGE
     
ITEM 1
3
     
ITEM 2
36
     
ITEM 3
59
     
ITEM 4
61
     
PART II: OTHER INFORMATION
 
     
ITEM 1
62
     
ITEM 1A
62
     
ITEM 2
62
     
ITEM 3
62
     
ITEM 4
62
     
ITEM 5
62
     
ITEM 6
63
     
64
 
- 2 -

PART I: FINANCIAL INFORMATION
Item 1 Financial Statements
 
FEDERATED NATIONAL HOLDING COMPANY
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

   
Period Ending
 
   
September 30, 2014
   
December 31, 2013
 
ASSETS
 
(Dollars in Thousands)
 
Investments
       
Debt maturities, available for sale, at fair value
 
$
275,387
   
$
174,912
 
Debt maturities, held to maturity, at amortized cost
   
7,352
     
7,214
 
Equity securities, available for sale, at fair value
   
36,463
     
38,584
 
                 
Total investments
   
319,202
     
220,710
 
                 
Cash and short term investments
   
45,926
     
41,446
 
Prepaid reinsurance premiums
   
39,202
     
7,592
 
Premiums receivable, net of allowance for credit losses of $143 and $143, respectively
   
28,112
     
22,414
 
Reinsurance recoverable, net
   
9,235
     
2,742
 
Deferred policy acquisition costs
   
10,980
     
16,708
 
Deferred income taxes, net
   
-
     
1,006
 
Income taxes receivable
   
2,130
     
-
 
Property, plant and equipment, net
   
1,670
     
929
 
Other assets
   
5,135
     
3,194
 
Contingent quota-share profit sharing
   
14,000
     
-
 
                 
Total assets
 
$
475,592
   
$
316,741
 
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Unpaid losses and LAE
 
$
73,109
   
$
61,016
 
Unearned premiums
   
186,638
     
128,343
 
Premiums deposits and customer credit balances
   
7,094
     
3,833
 
Claims payments outstanding
   
7,182
     
6,203
 
Income taxes payable
   
-
     
2,379
 
Deferred income taxes, net
   
1,964
     
-
 
Accounts payable and accrued expenses
   
7,631
     
6,473
 
Deferred quota-share profit sharing
   
12,250
     
-
 
                 
Total liabilities
   
295,868
     
208,247
 
                 
Shareholders' equity:
               
Common stock, $0.01 par value. Authorized 25,000,000 shares; issued and outstanding 13,594,962 and 10,901,716, respectively
   
136
     
109
 
Preferred stock, $0.01 par value. Authorized 1,000,000 shares; none issued or outstanding
   
-
     
-
 
Additional paid-in capital
   
125,433
     
80,525
 
Accumulated other comprehensive income
               
Unrealized net gains on investments, available for sale
   
6,093
     
5,964
 
Total accumulated other comprehensive income
   
6,093
     
5,964
 
Retained earnings
   
48,062
     
21,896
 
Total shareholders' equity
   
179,724
     
108,494
 
Total liabilities and shareholders' equity
 
$
475,592
   
$
316,741
 
 
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
- 3 -

FEDERATED NATIONAL HOLDING COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
   
(Dollars in Thousands)
   
(Dollars in Thousands)
 
Revenue:
               
Gross premiums written
 
$
92,032
   
$
60,741
   
$
280,487
   
$
175,609
 
Gross premiums ceded
   
(129,298
)
   
(49,936
)
   
(179,137
)
   
(78,179
)
                                 
Net premiums written
   
(37,266
)
   
10,805
     
101,350
     
97,430
 
                                 
Increase in prepaid reinsurance premiums
   
80,013
     
29,318
     
86,900
     
29,870
 
Increase in unearned premiums
   
(8,229
)
   
(12,762
)
   
(58,295
)
   
(57,981
)
                                 
Net change in prepaid reinsurance premiums and unearned premiums
   
71,784
     
16,556
     
28,605
     
(28,111
)
                                 
Net premiums earned
   
34,518
     
27,361
     
129,955
     
69,319
 
Commission income
   
1,173
     
637
     
3,350
     
1,989
 
Finance revenue
   
392
     
241
     
1,051
     
584
 
Direct written policy fees
   
2,238
     
1,632
     
6,417
     
4,594
 
Net investment income
   
1,450
     
800
     
3,758
     
2,382
 
Net realized investment gains
   
659
     
780
     
4,047
     
2,480
 
Other income
   
970
     
466
     
1,540
     
618
 
Quota-share profit sharing
   
1,750
     
-
     
1,750
     
-
 
                                 
Total revenue
   
43,150
     
31,917
     
151,868
     
81,966
 
                                 
Expenses:
                               
Losses and LAE
   
15,126
     
14,436
     
60,476
     
36,583
 
Operating and underwriting expenses
   
6,732
     
3,411
     
14,600
     
10,066
 
Salaries and wages
   
4,022
     
2,709
     
10,520
     
7,375
 
Amortization of deferred policy acquisition costs
   
5,815
     
6,576
     
23,095
     
15,370
 
                                 
Total expenses
   
31,695
     
27,132
     
108,691
     
69,394
 
                                 
Income before provision for income tax expense
   
11,455
     
4,785
     
43,177
     
12,572
 
Provision for income tax expense
   
4,228
     
1,504
     
15,973
     
4,411
 
                                 
Net income
 
$
7,227
   
$
3,281
   
$
27,204
   
$
8,161
 
                                 
Net income per share - basic
 
$
0.57
   
$
0.41
   
$
2.35
   
$
1.02
 
                                 
Net income per share - diluted
 
$
0.56
   
$
0.39
   
$
2.28
   
$
0.99
 
                                 
Weighted average number of common shares outstanding - basic
   
12,624,746
     
8,066,773
     
11,562,709
     
8,023,505
 
                                 
Weighted average number of common shares outstanding - diluted
   
12,956,407
     
8,345,924
     
11,934,057
     
8,260,435
 
                                 
Dividends paid per share
 
$
0.03
   
$
0.03
   
$
0.09
   
$
0.08
 
 
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
- 4 -

FEDERATED NATIONAL HOLDING COMPANY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
   
(Dollars in Thousands)
   
(Dollars in Thousands)
 
                 
Net income
 
$
7,227
   
$
3,281
   
$
27,204
   
$
8,161
 
                                 
Change in net unrealized (losses) gains  on investments available for sale
   
(1,883
)
   
2,658
     
359
     
331
 
                                 
Comprehensive income before tax
   
5,344
     
5,939
     
27,563
     
8,492
 
                                 
Income tax benefit (expense)  related to items of other comprehensive income
   
615
     
(1,000
)
   
(229
)
   
(125
)
                                 
Comprehensive income
 
$
5,959
   
$
4,939
   
$
27,334
   
$
8,367
 

SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
- 5 -

FEDERATED NATIONAL HOLDING COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in Thousands)
 
Cash flow from operating activities:
       
Net income
 
$
27,204
   
$
8,161
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Amortization of investment premium or discount, net
   
2,909
     
1,135
 
Depreciation and amortization of property plant and equipment, net
   
334
     
190
 
Net realized investment gains
   
(4,047
)
   
(2,480
)
Recovery for uncollectible premiums receivable
   
-
     
(34
)
Non-cash compensation
   
72
     
188
 
Changes in operating assets and liabilities:
               
Premiums receivable
   
(5,698
)
   
(12,053
)
Prepaid reinsurance premiums
   
(31,610
)
   
5,339
 
Reinsurance recoverable, net
   
(6,494
)
   
818
 
Income taxes recoverable
   
(2,130
)
   
(829
)
Deferred income tax expense, net of other comprehensive income
   
2,741
     
3,361
 
Policy acquisition costs, net of amortization
   
5,728
     
(5,881
)
Other assets
   
(1,941
)
   
171
 
Contingent quota-share profit sharing
   
(1,750
)
   
-
 
Unpaid losses and LAE
   
12,093
     
2,042
 
Unearned premiums
   
58,295
     
57,981
 
Premium deposits and customer credit balances
   
3,261
     
1,383
 
Income taxes payable
   
(2,379
)
   
-
 
Claims payments outstanding
   
979
     
(1,177
)
Accounts payable and accrued expenses
   
1,158
     
4,785
 
Net cash provided by operating activities
   
58,725
     
63,100
 
Cash flow used by investing activities:
               
Proceeds from sale of investment securities
   
65,869
     
93,079
 
Purchases of investment securities available for sale
   
(162,864
)
   
(129,349
)
Purchases of property and equipment
   
(1,074
)
   
(542
)
Net cash used by investing activities
   
(98,069
)
   
(36,812
)
Cash flow provided (used) by financing activities:
               
Exercised stock options
 
$
1,433
   
$
358
 
Dividends paid
   
(1,038
)
   
(903
)
Issuance of common stock
   
43,116
     
-
 
Tax benefit related to non-cash compensation
   
313
     
108
 
Net cash provided (used) by financing activities
   
43,824
     
(437
)
Net increase in cash and short term investments
   
4,480
     
25,851
 
Cash and short term investments at beginning of period
   
41,446
     
21,143
 
Cash and short term investments at end of period
 
$
45,926
   
$
46,994
 

SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
- 6 -

FEDERATED NATIONAL HOLDING COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
Nine Months Ended September 30,
 
(continued)
 
2014
   
2013
 
   
(Dollars in Thousands)
 
Supplemental disclosure of cash flow information:
       
Cash paid during the period for:
       
Income taxes
 
$
18,185
   
$
1,870
 
Non-cash investing and finance activities:
               
Accrued dividends payable
 
$
350
   
$
250
 

SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
- 7 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements
 
(1) Organization and Business

In this Quarterly Report on Form 10-Q, “FNHC” and the terms “Company”, “we”, “us” and “our” refer to Federated National Holding Company and its subsidiaries, unless the context indicates otherwise. We changed our name on September 11, 2012, pursuant to approval received at our annual shareholders’ meeting, from 21st Century Holding Company so that our parent company and other subsidiary companies’ names are consistent with our primary insurance subsidiary and the name under which we have been writing insurance for more than 20 years.

FNHC is an insurance holding company that controls substantially all steps in the insurance underwriting, distribution and claims processes through our subsidiaries and our contractual relationships with our independent agents and general agents.

We are authorized to underwrite, and/or place through our wholly owned subsidiaries, homeowners’ multi-peril (“homeowners”), commercial general liability, federal flood, personal auto and various other lines of insurance in Florida and various other states. We market and distribute our own and third-party insurers’ products and our other services through a network of independent agents.

Our insurance subsidiary is Federated National Insurance Company (“FNIC”). FNIC is licensed as an admitted carrier in Florida. An admitted carrier is an insurance company that has received a license from the state department of insurance giving the company the authority to write specific lines of insurance in that state. These companies are also bound by rate and form regulations, and are strictly regulated to protect policyholders from a variety of illegal and unethical practices, including fraud. Admitted carriers are also required to financially contribute to the state guarantee fund, which is used to pay for losses if an insurance carrier becomes insolvent or unable to pay the losses due their policyholders. Through contractual relationships with a network of approximately 3,600 independent agents, of which approximately 2,100 actively sell and service our products, FNIC is authorized to underwrite homeowners’, commercial general liability, fire, allied lines and personal and commercial automobile insurance in Florida. FNIC is licensed as an admitted carrier in Alabama, Louisiana, Georgia and Texas and underwrites commercial general liability insurance in those states. Federated National also underwrites  homeowners’ insurance in Louisiana and Alabama, commencing in October of 2014. Additionally, we underwrite personal automobile insurance in Georgia and Texas.

FNIC is also licensed as a non-admitted carrier in Nevada and South Carolina and can underwrite commercial general liability insurance in these states. Currently there are no operations in Nevada or South Carolina. A non-admitted carrier, sometimes referred to as a “excess and surplus lines” carrier, is permitted to do business in a state and, although it is strictly regulated to protect policyholders from a variety of illegal and unethical practices, including fraud, non-admitted carriers are subject to considerably less regulation with respect to policy rates and forms. Non-admitted carriers are not required to financially contribute to and benefit from the state guarantee fund, which is used to pay for losses if an insurance carrier becomes insolvent or unable to pay the losses due their policyholders.

We have entered into a Coexistence Agreement effective August 30, 2013 (the “Coexistence Agreement”) with Federated Mutual Insurance Company (“Federated Mutual”) pursuant to which, among other things, we may continue to use “Federated National” until at least August 30, 2020, after which time we have agreed to either cease using “Federated” in commerce or otherwise adopt and use trade names that are not confusingly similar to Federated Mutual’s trademarks.  We continue to develop our brand under the “FedNat” name, which is the name by which agents generally know us.

As of September 30, 2014, we have satisfied all applicable conditions of the consent order we entered into in January 2011 (the "Consent Order") with the Florida Office of Insurance Regulation ("Florida OIR"). We entered into the consent order in connection with the merger of our one of our wholly owned insurance subsidiaries, American Vehicle Insurance Company, into FNIC, with FNIC continuing the operations of both entities. As of the date of this Report, the only operational restriction that remains in effect is a requirement to obtain OIR approval prior to writing commercial multi peril business or any new commercial property business, including condo associations, under any other line of business for which FNIC is authorized. FNIC currently has no commercial multi peril policy premium in force and the current commercial habitation book of business is fully earned.
 
- 8 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements
 
During the three months ended September 30, 2014, 90.5%, 3.4%, 2.5% and 3.6% of the premiums we underwrote were for homeowners’, commercial general liability, federal flood, and automobile insurance, respectively. During the three months ended September 30, 2013, 89.1%, 4.3%, 2.9% and 3.7% of the premiums we underwrote were for homeowners’, commercial general liability, federal flood, and automobile insurance, respectively.

During the nine months ended September 30, 2014, 91.2%, 3.4%, 2.2% and 3.2% of the premiums we underwrote were for homeowners’, commercial general liability, federal flood, and automobile insurance, respectively. During the nine months ended September 30, 2013, 89.0%, 4.6%, 2.8% and 3.6% of the premiums we underwrote were for homeowners’, commercial general liability, federal flood, and automobile insurance, respectively.

During the three months ended September 30, 2014, $19.0 million or 22.8% of the $83.3 million of the homeowners’ premiums we underwrote were produced under an agency agreement with Ivantage Select Agency, Inc. (“ISA”), an affiliate of Allstate Insurance Company, that grants Allstate agents the authority to offer certain FNIC products. The $19.0 million of homeowners’ premiums produced under this agreement with ISA represents 65.1% of the total increase in the sale of homeowners’ policies during the three months ended September 30, 2014. During the three months ended September 30, 2013, $10.9 million or 20.1% of the $54.1 million of the homeowners’ premiums we underwrote were produced under the agreement with ISA. This network of agents began writing for FNIC in March 2013.

During the nine months ended September 30, 2014, $49.4 million or 19.3% of the $255.9 million of the homeowners’ premiums we underwrote were produced under the agreement with ISA. The $49.4 million of homeowners’ premiums produced under this agreement with ISA represents 49.7% of the total increase in the sale of homeowners’ policies during the nine months ended September 30, 2014. During the nine months ended September 30, 2013, $19.1 million or 12.2% of the $156.4 million of the homeowners’ premiums we underwrote were produced under the agreement with ISA.
 
- 9 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Our business, results of operations and financial condition are subject to fluctuations due to a variety of factors. Abnormally high severity or frequency of claims in any period could have a material adverse effect on us. When our estimated liabilities for unpaid losses and loss adjustment expenses (“LAE”) are less than the actuarially determined amounts, we increase the expense in the current period. Conversely, when our estimated liabilities for unpaid losses and LAE are greater than the actuarially determined amounts, we decrease the expense in the current period.

We are focusing our marketing efforts on continuing to expand our distribution network while maintaining our commitment to long-term relationships. We market our products and services throughout Florida and in other states by establishing relationships with additional independent agents and general agents. There can be no assurance, however, that we will be able to obtain the required regulatory approvals to offer additional insurance products or expand into other states.

FNU acts as FNIC’s exclusive managing general agent in Florida and is also licensed as a managing general agent in the States of Alabama, Georgia, Louisiana, Nevada, South Carolina and Texas. FNU has contracted with several unaffiliated insurance companies to sell commercial general liability, workers compensation, personal umbrella, inland marine and other various lines of insurance through FNU’s existing network of agents.

FNU earns commissions and fees for providing policy administration, marketing, accounting and analytical services, and for participating in the negotiation of reinsurance contracts. FNU earns a $25 per policy fee, and traditionally a 6% commission fee from its affiliate, FNIC. During the fourth quarter of 2010, FNU, pursuant to the Consent Order as discussed above, reduced its fee to earn amounts varying between 2% and 4%. A formal agreement reflecting this fee modification was executed during January 2011.

We internally process claims made by our insureds through our wholly owned claims adjusting company, FNA. Our agents have no authority to settle claims or otherwise exercise control over the claims process. Furthermore, we believe that the retention of independent adjusters, in addition to the employment of salaried claims personnel, results in reduced ultimate loss payments, lower LAE and improved customer service for our claimants and policyholders. We also employ an in-house Litigation Manager to cost effectively manage claims-related litigation and to monitor our claims handling practices for efficiency and regulatory compliance.

During the three months ended June 30, 2014, the Florida OIR approved an application to allow the claims administration operations of FNA to be assumed by FNU. Under the amended managing general agency agreement between FNU and FNIC, FNU will provide the same claims administration services under the same fee structure. The combination of these services in FNU had no affect on consolidated net income.

Insure-Link, Inc. (“Insure-Link”) serves as an independent insurance agency. The insurance agency markets direct to the public to provide a variety of insurance products and services to individual clients, as well as business clients, by offering a full line of insurance products including, but not limited to,  homeowners’, flood, personal and commercial automobile, commercial general liability and workers’ compensation insurance through their agency appointments with over forty different carriers.

(2) Basis of Presentation

The accompanying unaudited condensed consolidated financial statements for the Company and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America referred to as Generally Accepted Accounting Principles (“GAAP”) for interim financial information, and the Securities and Exchange Commission (“SEC”) rules for interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position as of September 30, 2014 and the results of operations and cash flows for the periods presented.
 
- 10 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The results of operations for the interim periods presented are not necessarily indicative of the results of operations to be expected for any subsequent interim period or for the fiscal year ending December 31, 2014. The accompanying unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2013 included in the Company’s Form 10-K, which was filed with the SEC on March 17, 2014.

In preparing the interim unaudited condensed consolidated financial statements, management was required to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the periods being reported upon. Certain of the estimates result from judgments that can be subjective and complex and consequently actual results may differ from these estimates.

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of loss and LAE, ceded reinsurance balances payable, the recoverability of Deferred Policy Acquisition Costs (“DPAC”), the determination of federal income taxes, and the net realizable value of reinsurance recoverables. Although considerable variability is inherent in these estimates, management believes that the amounts provided are reasonable. These estimates are continually reviewed and adjusted as necessary. Such adjustments are reflected in current operations.

All significant intercompany balances and transactions have been eliminated. No material reclassifications have been made to the prior-period balances to conform to the current-period presentation.

(3) Summary of Significant Accounting Policies and Practices

(A)  Critical Accounting Policies

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with management’s evaluation of the determination of (i) liability for unpaid losses and LAE, (ii) the amount and recoverability of amortization of DPAC, and (iii) estimates for our reserves with respect to finance contracts, premiums receivable and deferred income taxes. Various assumptions and other factors underlie the determination of these significant estimates, which are described in greater detail in Footnote 2 of the Company’s audited consolidated financial statements for the fiscal year ended December 31, 2013, which we included in the Company’s Annual Report on Form 10-K which was filed with the SEC on March 17, 2014.

We believe that there were no significant changes in those critical accounting policies and estimates during the nine months ended September 30, 2014. Senior management has reviewed the development and selection of our critical accounting policies and estimates and their disclosure in this Form 10-Q with the Audit Committee of our Board of Directors.

The process of determining significant estimates is fact-specific and takes into account factors such as historical experience, current and expected economic conditions, and in the case of unpaid losses and LAE, an actuarial valuation. Management regularly reevaluates these significant factors and makes adjustments where facts and circumstances dictate. In selecting the best estimate, we utilize various actuarial methodologies. Each of these methodologies is designed to forecast the number of claims we will be called upon to pay and the amounts we will pay on average to settle those claims. In arriving at our best estimate, our actuaries consider the likely predictive value of the various loss development methodologies employed in light of underwriting practices, premium rate changes and claim settlement practices that may have occurred, and weigh the credibility of each methodology. Our actuarial methodologies take into account various factors, including, but not limited to, paid losses, liability estimates for reported losses, paid allocated LAE, salvage and other recoveries received, reported claim counts, open claim counts and counts for claims closed with and without payment for loss.
 
- 11 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Accounting for loss contingencies pursuant to Financial Accounting Standards Board (“FASB”) issued guidance involves the existence of a condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future event(s) occur or fail to occur. Additionally, accounting for a loss contingency requires management to assess each event as probable, reasonably possible or remote. Probable is defined as the future event or events are likely to occur. Reasonably possible is defined as the chance of the future event or events occurring is more than remote but less than probable, while remote is defined as the chance of the future event or events occurring is slight. An estimated loss in connection with a loss contingency shall be recorded by a charge to current operations if both of the following conditions are met: First, the amount can be reasonably estimated, and second, the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements. It is implicit in this condition that it is probable that one or more future events will occur confirming the fact of the loss or incurrence of a liability.

We are required to review the contractual terms of all our reinsurance purchases to ensure compliance with FASB issued guidance. The guidance establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits. The guidance also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums.

FASB issued guidance addresses accounting and reporting for (a) investments in equity securities that have readily determinable fair values and (b) all investments in debt securities. We account for our investment securities consistent with FASB issued guidance that requires our securities to be classified into one of three categories: (i) held-to-maturity, (ii) trading securities or (iii) available-for-sale.

Investments classified as held-to-maturity include debt securities wherein the Company’s intent and ability are to hold the investment until maturity and are carried at amortized cost without consideration to unrealized gains or losses. Investments classified as trading securities include debt and equity securities bought and held primarily for sale in the near term and are carried at fair value with unrealized holding gains and losses included in current period operations. Investments classified as available-for-sale include debt and equity securities that are not classified as held-to-maturity or as trading security investments and are carried at fair value with unrealized holding gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, namely “Other Comprehensive Income.”

Premiums and discounts are amortized or accreted, respectively, over the life of the related debt security as an adjustment to yield using a method that approximates the effective interest method. Dividends and interest income are recognized when earned. Realized gains and losses are included in earnings and are derived using the specific-identification method for determining the cost of securities sold.

Financial instruments, which potentially expose us to concentrations of credit risk, consist primarily of investments, premiums receivable, amounts due from reinsurers on paid and unpaid losses and finance contracts. We have not experienced significant losses related to premiums receivable from individual policyholders or groups of policyholders in a particular industry or geographic area. We believe no credit risk beyond the amounts provided for collection losses is inherent in our premiums receivable or finance contracts. In order to reduce credit risk for amounts due from reinsurers, we seek to do business with financially sound reinsurance companies and regularly review the financial strength of all reinsurers used. Additionally, our credit risk in connection with our reinsurers is mitigated by the establishment of irrevocable clean letters of credit in favor of FNIC.

The fair value of our investments is estimated based on prices published by financial services or quotations received from securities dealers and is reflective of the interest rate environment that existed as of the close of business on September 30, 2014 and December 31, 2013. Changes in interest rates subsequent to September 30, 2014 and December 31, 2013 may affect the fair value of our investments.
 
- 12 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The carrying amounts for the following financial instrument categories approximate their fair values at September 30, 2014 and December 31, 2013 because of their short-term nature: cash and short-term investments, premiums receivable, finance contracts, due from reinsurers, revolving credit outstanding, bank overdraft, accounts payable and accrued expenses.

(B) Impact of New Accounting Pronouncements

In June 2014, the FASB issued Accounting Standard Update (“ASU”) No. 2014-12: Compensation – Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period, a consensus of the FASB Emerging Issues Task Force.  The amendments in this ASU apply to all reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period.  That is the case when an employee is eligible to retire or otherwise terminate employment before the end of the period in which a performance target (for example, an initial public offering or a profitability target) could be achieved and still be eligible to vest in the award if and when the performance target is achieved.  The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition.  Current U.S. GAAP does not contain explicit guidance on whether to treat a performance target that could be achieved after the requisite service period as a performance condition that affects vesting or as a nonvesting condition that affects the grant-date fair value of an award.  The amendments in this ASU provide explicit guidance for those awards.    The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015, and, earlier adoption is permitted.  The adoption of the amendments in this ASU will not have a material impact on our financial position, results of operations or cash flows.

In July 2013, the FASB issued Accounting Standard Update (“ASU”) No. 2013-11: Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.  Topic 740, Income Taxes, does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists, and there is diversity in practice in the presentation of unrecognized tax benefit in those instances.  The objective of the amendments in this ASU is to eliminate that diversity in practice.  The ASU applies to all entities that have unrecognized tax benefits when a net operating loss carry forward, a similar tax loss, or a tax credit carryforward exists at the operating date. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013 and early adoption is permitted.  The amendments in this ASU should be applied prospectively to all unrecognized tax benefits that exist at the effective date and   retrospective application is permitted.  The adoption of the amendments in this ASU did not have a material impact on our financial condition, results of operations or cash flows.

In February 2013, the FASB issued ASU No. 2013-02: Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.  The objective of this ASU is to improve the reporting of reclassifications out of accumulated other comprehensive income.  The amendments require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety in net income.  For other amounts that are not required to be reclassified to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts.  The amendments in the ASU do not change the current requirements for reporting net income or other comprehensive income in financial statements.  The ASU is effective prospectively for reporting periods beginning after December 15, 2012.  The adoption of these amendments did not have a material impact on our financial condition, results of operations or cash flows.
 
- 13 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

In January 2013, the FASB issued ASU No. 2013-01: Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. The objective of this ASU is to clarify the scope of offsetting disclosures and to address implementation issues with ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.  The amendments clarify that the scope of ASU 2011-11 applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions.  An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods.  An entity should provide the required disclosures retrospectively for all comparative periods.  The adoption of these amendments did not have a material impact on our financial condition, results of operations or cash flows.

In July 2012, the FASB issued ASU No. 2012-02: Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. The objective of the amendments in this ASU is to reduce the cost and complexity of performing an impairment test for indefinite-lived intangible assets by simplifying how an entity tests those assets for impairment and to improve consistency in impairment testing guidance among long-lived asset categories.  The amendments permit an entity first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30.  The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.   Upon adoption, these amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012; early adoption is permitted.  The adoption of these amendments did not have a material impact on our financial condition, results of operations or cash flows.

In June 2011, the FASB issued ASU No. 2011-05: Comprehensive Income (Topic 220):  Presentation of Comprehensive Income. The guidance in this ASU is intended to increase the prominence of items reported in other comprehensive income in the financial statements by presenting the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The guidance in this ASU does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. Upon adoption, this update is to be applied retrospectively and is effective during interim and annual periods beginning after December 15, 2011.  Early adoption is permitted. The adoption of this ASU did not have a material impact on our financial condition, results of operations or cash flows.

In December 2011, the FASB issued ASU No. 2011-12:  Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  The guidance defers certain provisions contained in ASU No. 2011-05 requiring the requirement to present components of reclassifications of other comprehensive income on the face of the income statement or in the notes to the financial statements. However, this deferral does not impact the other requirements contained in the new standard on comprehensive income as described above. This ASU is effective during interim and annual periods beginning after December 15, 2011.  The adoption of this ASU did not have a material impact on our financial condition, results of operations or cash flows.
 
- 14 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

In September 2011, the FASB issued ASU No. 2011-08: Intangibles – Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which amends ASC Topic 350, Intangibles – Goodwill and Other. The guidance in this ASU permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in ASC Topic 350. Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The adoption of this ASU did not have a material impact on our financial condition, results of operations or cash flows.

In December 2011, the FASB issued ASU No. 2011-11: Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, which requires new disclosure requirements mandating that entities disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement similar to a master netting arrangement. In addition, the standard requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. This ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU did not have a material impact on our financial condition, results of operations or cash flows.

Other recent accounting pronouncements issued by FASB, the American Institute of Certified Public Accountants (“AICPA”), and the SEC did not or are not believed by management to have a material impact on the Company’s present or future financial statements.

(C) Stock Options

Pursuant to FASB issued guidance, compensation cost recognized during the nine months ended September 30, 2014 includes compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the guidance.
 
(D) Earnings per Share

Basic earnings per share (“Basic EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the period presented. Diluted earnings per share (“Diluted EPS”) is computed by dividing net income by the weighted average number of shares of common stock and common stock equivalents outstanding during the period presented.

(E) Reclassifications

No material reclassification of the 2013 financial statements was necessary to conform to the 2014 presentation.

(4) Commitments and Contingencies

Management has a responsibility to continually measure and monitor its commitments and its contingencies. The nature of the Company’s commitments and contingencies can be grouped into three major categories: insured claim activity, assessment related activities and operational matters.

(A) Insured Claim Activity

We are involved in claims and legal actions arising in the ordinary course of business. The amount of liability for these claims and lawsuits is uncertain. Revisions to our estimates are based on our analysis of subsequent information that we receive regarding various factors, including: (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages; and (iv) trends in general economic conditions, including the effects of inflation. Management revises its estimates based on the results of its analysis. This process assumes that experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for estimating the ultimate settlement of all claims. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of the reserves, because the eventual redundancy or deficiency is affected by multiple factors. In the opinion of management, the ultimate disposition of these matters may have a material adverse effect on our consolidated financial position, results of operations, or liquidity.
 
- 15 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The Company’s subsidiaries are, from time to time, named as defendants in various lawsuits incidental to their insurance operations. Legal actions relating to claims made in the ordinary course of seeking indemnification for a loss covered by the insurance policy are considered by the Company in establishing losses and LAE reserves.

The Company also faces, in the ordinary course of business, lawsuits that seek damages beyond policy limits. The Company continually evaluates potential liabilities and reserves for litigation of these types using the criteria established by FASB issued guidance. Under this guidance, reserves for a loss are recorded if the likelihood of occurrence is probable and the amount can be reasonably estimated. If a loss, while not probable, is judged to be reasonably possible, management will make an estimate of a possible range of loss or state that an estimate cannot be made. Management considers each legal action using this guidance and records reserves for losses as warranted.

(B) Assessment Related Activity

We operate in a regulatory environment where certain entities and organizations have the authority to require us to participate in assessments. Currently these entities and organizations include, but are not limited to, Florida Insurance Guaranty Association (“FIGA”), Citizens Property Insurance Corporation (“Citizens”), Florida Hurricane Catastrophe Fund (“FHCF”) and Florida Joint Underwriters Insurance Association (“JUA”). As a direct premium writer in the state of Florida, we are required to participate in certain insurer solvency associations under Florida Statutes Section 631.57(3) (a), administered by FIGA.

FNIC is also required to participate in an insurance apportionment plan under Florida Statutes Section 627.351, which is referred to as a JUA Plan. The JUA Plan provides for the equitable apportionment of any profits realized, or losses and expenses incurred, among participating automobile insurers. In the event of an underwriting deficit incurred by the JUA Plan which is not recovered through the policyholders in the JUA Plan, such deficit shall be recovered from the companies participating in the JUA Plan in the proportion that the net direct written premiums of each such member during the preceding calendar year bear to the aggregate net direct premiums written in this state by all members of the JUA Plan. FNIC was assessed approximately $27,000 by the JUA Plan during 2014 and nothing during 2013. Future assessments by this association are undeterminable at this time.

(C) Operational Matters

The Company files federal income tax returns as well as multiple state and local tax returns. The Company’s consolidated federal and state income tax returns for 2010 - 2013 are open for review by the Internal Revenue Service (“IRS”) and the various state taxing authorities. The Company’s 2011 federal tax return was reviewed by the IRS and a “no change” report was issued indicating that the IRS is in agreement with the tax positions presented on the 2011 return. The 2013 federal and state income tax returns were timely filed by the extended filing deadline of September 15, 2014.  The Company does not have any known uncertain tax positions and all tax positions are evaluated in accordance with FIN 48.  Any change to or resolution of tax reserves could be material to the Company’s results of operations for any period, but is not expected to be material to the Company’s financial position.

The Company has recorded a net deferred tax liability of $2.0 million as of September 30, 2014 and a net deferred tax asset of $1.0 million as of December 31, 2013, respectively.

The calculation of current and deferred income taxes presents management’s assessment of the amount of current and future taxes to be paid. The calculation of deferred tax assets and liabilities is in accordance with ASC 740. These assets and liabilities may be impacted if new information not previously available is considered in future analysis and calculations. Because of the unpredictability and complexity of these future uncertainties the ultimate resolution of the tax payment may be an amount that is materially different from the current estimate of the tax liabilities. As of September 30, 2014 the Company has recorded a net deferred tax liability of $2.0 million. The primary reasons for the shift from a deferred tax asset to a deferred tax liability include the tax impact of the appreciation in the market value of the available-for-sale securities, the resolution of an accrued legal settlement, and the decrease in the unearned premium balance related to the ceding of 30% of policies under a homeowners quota share reinsurance agreement.  Any change in circumstances leading to a change in the tax liability would be recorded in the period that the change in circumstances occurs.
 
- 16 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Our executive offices are located at 14050 N.W. 14th Street, Suite 180, Sunrise, Florida 33323 in an 18,500 square foot office facility. Our original lease for this office space was scheduled to expire in May 2017. During March 2014, we extended our lease term to expire in August 2019 and expanded the leased premises to include an additional 13,642 square feet. All of our operations are consolidated within these facilities. We believe that the facilities are well maintained, in substantial compliance with environmental laws and regulations, and adequately covered by insurance. We also believe that these leased facilities are not unique and could be replaced, if necessary, at the end of the lease term.

The expected future payments in connection with this lease are as follows.

Fiscal Year
 
Payments
 
   
(Dollars in Thousands)
 
2014
   
171
 
2015
   
694
 
2016
   
708
 
2017
   
722
 
2018
   
736
 
2019
   
499
 
Total
 
$
3,530
 
 
The Company is not currently involved in any material legal actions arising from the ordinary course of business that are not related to the insured claims activity.

(5) Investments

FASB issued guidance addresses accounting and reporting for (a) investments in equity securities that have readily determinable fair values and (b) all investments in debt securities. We account for our investment securities consistent with FASB issued guidance that requires our securities to be classified into one of three categories: (i) held-to-maturity, (ii) trading securities or (iii) available-for-sale.

Investments classified as held-to-maturity include debt securities wherein the Company’s intent and ability are to hold the investment until maturity and are carried at amortized cost without consideration to unrealized gains or losses. Investments classified as trading securities include debt and equity securities bought and held primarily for sale in the near term and are carried at fair value with unrealized holding gains and losses included in current period operations. Investments classified as available-for-sale include debt and equity securities that are not classified as held-to-maturity or as trading security investments and are carried at fair value with unrealized holding gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, namely “Other Comprehensive Income.”

Total investments increased $98.5 million, or 44.6%, to $319.2 million as of September 30, 2014, compared with $220.7 million as of December 31, 2013. The change is due primarily to our homeowners’ gross written premium, which increased by $99.5 million, or 63.6%, to $255.9 million for the nine months ended September 30, 2014, compared with $156.4 million for the nine months ended September 30, 2013. The increased homeowners’ gross written premium generated additional cash available for investment, of which approximately $59.0 million was transferred to the investment accounts during the nine months ended September 30, 2014.

The debt and equity securities that are available-for-sale and carried at fair value represent 98% and 97% of total investments as of September 30, 2014 and December 31, 2013, respectively.

We did not hold any trading investment securities during the nine months ended September 30, 2014.
 
- 17 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The FASB issued guidance also addresses the determination as to when an investment is considered impaired, whether that impairment is other-than temporary, and the measurement of an impairment loss. The Company’s policy for the valuation of temporarily impaired securities is to determine impairment based on the analysis of the following factors.

· rating downgrade or other credit event (eg., failure to pay interest when due);

· length of time and the extent to which the fair value has been less than amortized cost;

· financial condition and near term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment;

· prospects for the issuer’s industry segment;

· intent and ability of the Company to retain the investment for a period of time sufficient to allow for anticipated recovery in market value;

· historical volatility of the fair value of the security.

Pursuant to FASB issued guidance, the Company records the unrealized losses, net of estimated income taxes that are associated with that part of our portfolio classified as available-for-sale through the shareholders' equity account titled “Other Comprehensive Income”. Management periodically reviews the individual investments that comprise our portfolio in order to determine whether a decline in fair value below our cost either is other-than temporarily or permanently impaired. Factors used in such consideration include, but are not limited to, the extent and length of time over which the market value has been less than cost, the financial condition and near-term prospects of the issuer and our ability and intent to keep the investment for a period sufficient to allow for an anticipated recovery in market value.

In reaching a conclusion that a security is either other-than-temporarily or permanently impaired we consider such factors as the timeliness and completeness of expected dividends, principal and interest payments, ratings from nationally recognized statistical rating organizations such as Standard and Poor’s (“S&P”) and Moody’s Investors Service, Inc. (“Moody’s”), as well as information released via the general media channels. During the nine months ended September 30, 2014 and 2013, respectively, in connection with the process, we have not charged operations with investment losses.

As of September 30, 2014 and December 31, 2013, respectively, all of our securities are in good standing and not impaired as defined by FASB issued guidance.

As of September 30, 2014 and December 31, 2013, our investments consisted primarily of corporate bonds held in various industries, municipal bonds and United States government bonds. As of September 30, 2014, 79% of our debt portfolio was in diverse industries and 21% was in United States government bonds. As of September 30, 2014, approximately 87% of our equity holdings were in equities related to diverse industries and 13% were in mutual funds. As of December 31, 2013, 83% of our debt portfolio was in diverse industries and 17% was in United States government bonds. As of December 31, 2013, approximately 91% of our equity holdings were in equities related to diverse industries and 9% were in mutual funds.

As of September 30, 2014 and December 31, 2013, we have classified $7.4 million and $7.2 million, respectively, of our bond portfolio as held-to-maturity. We classify bonds as held-to-maturity to support securitization of credit requirements.

During the nine months ended September 30, 2014, we did not re-classify any of our bond portfolio between available-for-sale and held-to-maturity. During the nine months ended September 30, 2013, we re-classified $0.1 million of our bond portfolio between available-for-sale and held-to-maturity.
 
- 18 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

(A) Debt and Equity Securities

The following table summarizes, by type, our investments as of September 30, 2014 and December 31, 2013.

   
September 30, 2014
   
December 31, 2013
 
   
Carrying
Amount
   
Percent
of Total
   
Carrying
Amount
   
Percent
of Total
 
   
(Dollars in Thousands)
 
Debt securities, at market:
               
United States government obligations and authorities
 
$
55,643
     
17.43
%
 
$
27,209
     
12.33
%
Obligations of states and political subdivisions
   
91,641
     
28.71
%
   
52,064
     
23.59
%
Corporate
   
117,150
     
36.70
%
   
91,941
     
41.66
%
International
   
10,953
     
3.43
%
   
3,698
     
1.68
%
     
275,387
     
86.27
%
   
174,912
     
79.26
%
Debt securities, at amortized cost:
                               
United States government obligations and authorities
   
4,433
     
1.39
%
   
4,630
     
2.10
%
Corporate
   
2,673
     
0.84
%
   
2,475
     
1.12
%
International
   
246
     
0.08
%
   
109
     
0.05
%
     
7,352
     
2.31
%
   
7,214
     
3.27
%
Total debt securities
   
282,739
     
88.58
%
   
182,126
     
82.53
%
                                 
Equity securities, at market:
   
36,463
     
11.42
%
   
38,584
     
17.47
%
Total investments
 
$
319,202
     
100.00
%
 
$
220,710
     
100.00
%
 
The following table shows the realized gains (losses) for debt and equity securities for the three months ended September 30, 2014 and 2013.

   
Three Months Ended September 30,
 
   
2014
   
2013
 
   
Gains
(Losses)
   
Fair Value
at Sale
   
Gains
(Losses)
   
Fair Value
at Sale
 
   
(Dollars in Thousands)
 
                 
Debt securities
 
$
241
   
$
16,413
   
$
202
   
$
6,183
 
Equity securities
   
453
     
1,642
     
1,274
     
5,619
 
Total realized gains
   
694
     
18,055
     
1,476
     
11,802
 
                                 
Debt securities
   
(20
)
   
1,627
     
(421
)
   
14,462
 
Equity securities
   
(15
)
   
118
     
(275
)
   
1,471
 
Total realized losses
   
(35
)
   
1,745
     
(696
)
   
15,933
 
                                 
Net realized gains on investments
 
$
659
   
$
19,800
   
$
780
   
$
27,735
 

Net realized investment gains totaled $0.7 million for the three months ended September 30, 2014, compared with $0.8 million during the three months ended September 30, 2013. During the three months ended September 30, 2014, the investment committee directed new invested dollars to the fixed income portfolio.
 
- 19 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The following table shows the realized gains (losses) for debt and equity securities for the nine months ended September 30, 2014 and 2013.

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
Gains
(Losses)
   
Fair Value
at Sale
   
Gains
(Losses)
   
Fair Value
at Sale
 
   
(Dollars in Thousands)
 
                 
Debt securities
 
$
533
   
$
38,657
   
$
1,595
   
$
36,918
 
Equity securities
   
4,013
     
12,595
     
2,437
     
10,063
 
Total realized gains
   
4,546
     
51,252
     
4,032
     
46,981
 
                                 
Debt securities
   
(118
)
   
8,333
     
(922
)
   
37,493
 
Equity securities
   
(381
)
   
1,639
     
(630
)
   
3,049
 
Total realized losses
   
(499
)
   
9,972
     
(1,552
)
   
40,542
 
                                 
Net realized gains on investments
 
$
4,047
   
$
61,224
   
$
2,480
   
$
87,523
 
 
Net realized investment gains totaled $4.0 million for the nine months ended September 30, 2014, compared with $2.5 million during the nine months ended September 30, 2013. During the nine months ended September 30, 2014, the investment committee decided to increase the fixed income asset allocation by directing new invested dollars and reducing our exposure to equities.
 
- 20 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

A summary of the amortized cost, estimated fair value and gross unrealized gains and losses of debt and equity securities at September 30, 2014 and December 31, 2013 is as follows.

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
 
   
(Dollars in Thousands)
 
September 30, 2014
               
Debt Securities  - Available-For-Sale:
               
United States government obligations and authorities
 
$
55,371
   
$
469
   
$
197
   
$
55,643
 
Obligations of states and political subdivisions
   
90,597
     
1,091
     
47
     
91,641
 
Corporate
   
115,833
     
1,613
     
296
     
117,150
 
International
   
10,909
     
57
     
13
     
10,953
 
   
$
272,710
   
$
3,230
   
$
553
   
$
275,387
 
                                 
Debt Securities  - Held-To-Maturity:
                               
United States government obligations and authorities
 
$
4,433
   
$
31
   
$
243
   
$
4,221
 
Corporate
   
2,673
     
33
     
2
     
2,704
 
International
   
246
     
1
     
1
     
246
 
   
$
7,352
   
$
65
   
$
246
   
$
7,171
 
                                 
Equity securities - common stocks
 
$
29,220
   
$
7,886
   
$
643
   
$
36,463
 
                                 
December 31, 2013
                               
Debt Securities  - Available-For-Sale:
                               
United States government obligations and authorities
 
$
27,422
   
$
186
   
$
399
   
$
27,209
 
Obligations of states and political subdivisions
   
51,883
     
303
     
122
     
52,064
 
Corporate
   
91,475
     
1,233
     
767
     
91,941
 
International
   
3,731
     
5
     
38
     
3,698
 
   
$
174,511
   
$
1,727
   
$
1,326
   
$
174,912
 
                                 
Debt Securities  - Held-To-Maturity:
                               
United States government obligations and authorities
 
$
4,630
   
$
32
   
$
326
   
$
4,336
 
Corporate
   
2,475
     
22
     
17
     
2,480
 
International
   
109
     
-
     
1
     
108
 
   
$
7,214
   
$
54
   
$
344
   
$
6,924
 
                                 
Equity securities - common stocks
 
$
29,423
   
$
9,436
   
$
275
   
$
38,584
 
 
- 21 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The table below reflects our unrealized investment losses by investment class, aged for length of time in a continuous unrealized loss position as of September 30, 2014.

   
Unrealized Losses
   
Less than 12 months
   
12 months or longer
 
   
(Dollars in Thousands)
 
Debt securities:
           
United States government obligations and authorities
 
$
197
   
$
89
   
$
108
 
Obligations of states and political subdivisions
   
47
     
39
     
8
 
Corporate
   
296
     
188
     
108
 
International
   
13
     
13
     
-
 
     
553
     
329
     
224
 
Equity securities:
                       
Common stocks
   
643
     
614
     
29
 
                         
Total debt and equity securities
 
$
1,196
   
$
943
   
$
253
 
 
The table below reflects our unrealized investment losses by investment class, aged for length of time in a continuous unrealized loss position as of December 31, 2013.

   
Unrealized Losses
   
Less than 12 months
   
12 months or longer
 
   
(Dollars in Thousands)
 
Debt securities:
           
United States government obligations and authorities
 
$
399
   
$
391
   
$
8
 
Obligations of states and political subdivisions
   
122
     
122
     
-
 
Corporate
   
767
     
761
     
6
 
International
   
38
     
38
     
-
 
     
1,326
     
1,312
     
14
 
Equity securities:
                       
Common stocks
   
275
     
148
     
127
 
                         
Total debt and equity securities
 
$
1,601
   
$
1,460
   
$
141
 
 
Below is a summary of debt securities at September 30, 2014 and December 31, 2013, by contractual or expected maturity periods. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
September 30, 2014
   
December 31, 2013
 
   
Amortized
Cost
   
Estimated
Fair Value
   
Amortized
Cost
   
Estimated
Fair Value
 
   
(Dollars in Thousands)
 
                 
Due in one year or less
 
$
13,702
   
$
13,734
   
$
5,161
   
$
5,181
 
Due after one through five years
   
176,615
     
177,950
     
113,027
     
113,561
 
Due after five through ten years
   
89,719
     
90,841
     
62,656
     
62,220
 
Due after ten years
   
26
     
33
     
881
     
874
 
                                 
Total
 
$
280,062
   
$
282,558
   
$
181,725
   
$
181,836
 
 
- 22 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

United States Treasury notes with a book value of $61,727 and $2,220,344, maturing in 2016 and 2022, respectively, were on deposit with the Florida OIR as of September 30, 2014, as required by law for FNIC, and are included with other investments held until maturity.

United States Treasury notes with a book value of $62,490 and $2,193,814, maturing in 2016 and 2022, respectively, were on deposit with the Florida OIR as of December 31, 2013, as required by law for FNIC, and are included with other investments held until maturity.

The table below sets forth investment results for the three months ended September 30, 2014 and 2013.

   
Three Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in Thousands)
 
         
Interest on debt securities
 
$
1,328
   
$
691
 
Dividends on equity securities
   
121
     
108
 
Interest on cash and cash equivalents
   
1
     
1
 
                 
Total investment income
 
$
1,450
   
$
800
 
                 
Net realized gains
 
$
659
   
$
780
 

Proceeds from sales, pay downs and maturities of debt securities and proceeds from sales of equity securities during the three months ended September 30, 2014 and 2013, were approximately $21.8 million and $28.7 million, respectively.

The table below sets forth investment results for the nine months ended September 30, 2014 and 2013.

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in Thousands)
 
         
Interest on debt securities
 
$
3,432
   
$
2,059
 
Dividends on equity securities
   
324
     
320
 
Interest on cash and cash equivalents
   
2
     
3
 
                 
Total investment income
 
$
3,758
   
$
2,382
 
                 
Net realized gains
 
$
4,047
   
$
2,480
 

Proceeds from sales, pay downs and maturities of debt securities and proceeds from sales of equity securities during the nine months ended September 30, 2014 and 2013, were approximately $65.9 million and $93.1 million, respectively.
 
- 23 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The table below sets forth a summary of net realized investment gains (losses) during the three months ended September 30, 2014 and 2013.

   
Three Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in Thousands)
 
Net realized gains (losses)
       
Debt securities
 
$
221
   
$
(219
)
Equity securities
   
438
     
999
 
                 
Total
 
$
659
   
$
780
 
 
The table below sets forth a summary of net realized investment gains during the nine months ended September 30, 2014 and 2013.

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in Thousands)
 
Net realized gains
       
Debt securities
 
$
415
   
$
673
 
Equity securities
   
3,632
     
1,807
 
                 
Total
 
$
4,047
   
$
2,480
 
 
The table below sets forth a summary of net unrealized investment gains as of September 30, 2014 and December 31, 2013.

   
Unrealized Gains
 
   
September 30, 2014
   
December 31, 2013
 
   
(Dollars in Thousands)
 
Net unrealized gains
       
Debt securities
 
$
2,677
   
$
401
 
Equity securities
   
7,243
     
9,161
 
                 
Total
 
$
9,920
   
$
9,562
 
 
(6) Fair Value Disclosure

In April 2009, the FASB issued accounting guidance that if an entity determines that either the volume and/or level of activity for an investment security has significantly decreased (from normal conditions for that investment security) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. This guidance was effective for interim and annual periods ending after June 15, 2009, with early adoption permitted. This guidance was applied prospectively. The adoption of this guidance did not have an impact on our financial condition, results of operations or cash flows.

In October 2008, the FASB issued accounting guidance to clarify the application of GAAP in determining fair value of financial instruments in a market that is not active. The guidance was effective upon issuance, including prior periods for which financial statements had not been issued. Our adoption of this guidance did not have a material effect on our financial position, results of operations or cash flows.
 
- 24 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

In September 2006, FASB issued accounting guidance that defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants on the measurement date. This guidance also establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance also categorizes assets and liabilities at fair value into one of three different levels depending on the observation of the inputs employed in the measurement, as follows.

Level 1 — inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market provides the most reliable fair value measurement because it is directly observable to the market.

Level 2 — inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs are observable for an asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 — inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Securities available-for-sale:  The fair value of securities available-for-sale is determined by obtaining quoted prices on nationally recognized security exchanges.

Assets measured at fair value on a recurring basis as of September 30, 2014, presented in accordance with this guidance, are as follows.

   
As of September 30, 2014
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
   
(Dollars in Thousands)
 
Debt securities:
               
United States government obligations and authorities
 
$
-
   
$
55,643
   
$
-
   
$
55,643
 
Obligations of states and political subdivisions
   
-
     
91,641
     
-
     
91,641
 
Corporate
   
-
     
117,150
     
-
     
117,150
 
International
   
-
     
10,953
     
-
     
10,953
 
     
-
     
275,387
     
-
     
275,387
 
                                 
Equity securities:
                               
Common stocks
   
36,463
     
-
     
-
     
36,463
 
     
36,463
     
-
     
-
     
36,463
 
                                 
Total debt and equity securities
 
$
36,463
   
$
275,387
   
$
-
   
$
311,850
 
 
- 25 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Assets measured at fair value on a recurring basis as of December 31, 2013, presented in accordance with this guidance, are as follows.

   
As of December 31, 2013
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
   
(Dollars in Thousands)
 
Debt securities:
               
United States government obligations and authorities
 
$
-
   
$
27,209
   
$
-
   
$
27,209
 
Obligations of states and political subdivisions
   
-
     
52,064
     
-
     
52,064
 
Corporate
   
-
     
91,941
     
-
     
91,941
 
International
   
-
     
3,698
     
-
     
3,698
 
     
-
     
174,912
     
-
     
174,912
 
                                 
Equity securities:
                               
Common stocks
   
38,584
     
-
     
-
     
38,584
 
     
38,584
     
-
     
-
     
38,584
 
                                 
Total debt and equity securities
 
$
38,584
   
$
174,912
   
$
-
   
$
213,496
 
 
(7) Reinsurance Agreements

Financing risk generally involves a combination of risk retention and risk transfer techniques. “Retention”, similar to a deductible, involves financing losses by funds internally generated. “Transfer” involves the existence of a contractual arrangement designed to shift financial responsibility to another party in exchange for premium. Secondary to the primary risk-transfer agreements, we use reinsurance agreements to transfer a portion of the risks insured under our policies to other companies through the purchase of reinsurance. We utilize reinsurance to reduce exposure to catastrophic and non-catastrophic risks and to help manage the cost of capital. Reinsurance techniques are designed to lessen earnings volatility, improve shareholder return, and to support the required statutory surplus requirements. We also use reinsurance to realize an arbitrage of premium rates, benefit from the availability of our reinsurers’ expertise, and benefit from the management of a profitable portfolio of insureds by way of enhanced analytical capacities. Our primary property line that is subject to catastrophic reinsurance is Homeowners’ Multiple Peril. FNIC cedes these risks to domestic and foreign reinsurance participants from Bermuda and Europe as well as to the FHCF.

Quota share reinsurance is a pro rata agreement among the primary insurer and one or more reinsurers where each party shares a fixed and predetermined percentage of the program’s premiums and losses. Excess of loss risk transfer agreements involve the transfer of premium in exchange for reimbursement for claims, if they occur, as a result of specific events such as  severe catastrophic weather. For quota share and excess of loss reinsurance, coverage is generally afforded based on meeting predetermined risk characteristics. In contrast, facultative reinsurance is negotiated between the primary insurer and the reinsurer(s) on a case-by-case basis with no obligation on either part to cede or assume share in the risk.

Our reinsurance structures are maintained to protect our insurance subsidiary against the severity of losses on individual claims or unusually serious occurrences in which the frequency and or the severity of claims produce an aggregate extraordinary loss from catastrophic events. In addition to reinsurance agreements, we also from time to time enter into retro-cessionary reinsurance agreements; each designed to shift financial responsibility based on predefined conditions.
 
- 26 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Although reinsurance does not discharge us from our primary obligation to pay for losses insured under the policies we issue, reinsurance does make the assuming reinsurer liable to the insurance subsidiary for the reinsured portion of the risk. A credit risk exposure exists with respect to ceded losses to the extent that any reinsurer is unable or unwilling to meet the obligations assumed under the reinsurance contracts. The collectability of reinsurance is subject to the solvency of the reinsurers, interpretation of contract language and other factors. A reinsurer's insolvency or inability to make payments under the terms of a reinsurance contract could have a material adverse effect on our results of operations and financial condition. Our reinsurance structure has significant risks, including the fact that the FHCF may not be able to raise sufficient money to pay its claims or impair its ability to pay its claims in a timely manner. This could result in significant financial, legal and operational challenges to all property and casualty companies associated with FHCF, including our company.
 
The availability and costs associated with the acquisition of reinsurance will vary year to year. These fluctuations, which can be significant, are not subject to our control and may limit our ability to purchase adequate coverage. For example, FHCF continues to restrict its reinsurance capacity and is expected to continue constricting capacity for future seasons. This gradual restriction is requiring us to replace that capacity with private market reinsurance. Our reinsurance program is subject to approval by the Florida OIR and review by Demotech, Inc. (“Demotech”). The recovery of increased reinsurance costs through rate action is not immediate and cannot be presumed and is subject to Florida OIR approval.
 
For the 2014–2015 hurricane season, the excess of loss and FHCF treaties insured the property lines for approximately $1.49 billion of aggregate catastrophic losses and LAE with a maximum single event coverage totaling approximately $1.00 billion, with the Company retaining the first $7.0 million in Florida and $3.0 million in Louisiana for losses and LAE from each event. Florida risks represent 98.5%, or $1.46 billion of the $1.49 billion of total aggregate catastrophic losses and LAE. The reinsurance program includes coverage purchased from the private market, which affords optional reinstatement premium protection that provides coverage beyond the first event, along with any remaining coverage from the FHCF. The FHCF only affords coverage for losses sustained in Florida. Coverage afforded by the FHCF totals approximately $546.3 million, or 37.4% of Florida’s $1.46 billion of aggregate catastrophic losses and LAE. The FHCF affords coverage for the entire season, subject to maximum payouts, without regard to any particular insurable event.
 
The estimated cost to the Company for the excess of loss reinsurance products for the 2014–2015 hurricane season, inclusive of approximately $41.0 million payable to the FHCF and the prepaid automatic premium reinstatement protection, is approximately $117.4 million.
 
Included in this year’s program is a 30% quota share reinsurance treaty for the Company’s in-force new and renewal homeowners’ insurance program in the State of Florida. This two-year quota share reinsurance treaty provides 30% of $200 million of aggregate catastrophe coverage per year with maximum single event coverage of 30% of $100 million per year. The approximate cost of this quota share is projected to be $6.7 million per year, net of ceding commissions, and it is included in the $117.4 million amount referenced above. The quota share treaty contains commutation provisions for the Company to share profits based on loss experience during the term of the treaty.
 
The 30% quota share reinsurance treaty described above contains profit sharing provisions that will adjust over its two-year term depending on the Company’s loss experience from catastrophic and non-catastrophic events during the term. The frequency and severity of catastrophic events, coupled with non-catastrophic loss experience, will determine the ultimate profit share, if any. In accordance with GAAP, the Company will initially recognize an asset and liability and the resultant net income or loss. For example, deferred quota-share profit sharing totaled $12.3 million as of September 30, 2014. The deferred quota-share profit sharing was originally recorded at $14.0 million at the program’s July 1, 2014 inception and will continue to amortize over the life of the program. Subsequently, the Company will adjust the value of the asset and liability based on information available at the time of valuation. Upward and downward adjustments to the asset’s value will affect the Company’s results of operations by increasing or decreasing net income in the period of the adjustment.
 
- 27 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The 2014-2015 private reinsurance companies and their respective A.M. Best Company (“A.M. Best”) and S&P ratings are listed in the table as follows.

Reinsurer
A.M. Best Rating
 
 
S&P Rating
           
 
UNITED STATES
         
 
American Agricultural Insurance Company
 
A-
     
NR
American Standard Insurance Company of Wisconsin
 
A
     
NR
AIG (National Union Fire Insurance Company of Pittsburgh, PA)
 
A
     
A+
Everest Reinsurance Company
 
A+
     
A+
Odyssey Reinsurance Company
 
A
     
A-
QBE Reinsurance Corporation
 
A
     
A+
RLI Insurance Company
 
A+
     
A+
Transatlantic Reinsurance Company
 
A
     
A+
           
 
BERMUDA
         
 
ACE Tempest Reinsurance Limited
 
A++
     
AA-
Allied World Assurance Company, Limited
 
A
     
A
Arch Reinsurance Limited
 
A+
     
A+
Argo Reinsurance Limited
 
A
     
NR
Ariel Reinsurance Bermuda Ltd for and on Behalf of Ariel Syndicate 1910 (ARE)
 
A-
     
A+
Aspen Bermuda Limited
 
A
     
A
AXIS Specialty Limited
 
A+
     
A+
BGS Services (Bermuda) Limited/Lloyds Syndicate 2987
 
A
     
A+
DaVinci Reinsurance Ltd
 
A
     
AA-
Endurance Specialty Insurance Limited
 
A
     
A
Hamilton Re, Limited
 
A-
     
NR
Hiscox Insurance Company (Bermuda) Limited
 
A
     
NR
Partner Reinsurance Company Limited
 
A+
     
A+
Platinum Underwriters Bermuda Limited
 
A
     
A-
Renaissance Reinsurance, Limited
 
A+
     
AA-
Securis Re III Limited Bermuda
 
NR
*
 
**
NR
Securis Re IV Limited Bermuda
 
NR
*
 
**
NR
Tokio Millennium Re AG, Bermuda Branch
 
A++
     
AA-
XL RE Limited
 
A
     
A+
           
 
UNITED KINGDOM
         
 
A.F. Beazley Syndicate No. 623 (AFB)
 
A
     
A+
A.F. Beazley Syndicate No. 2623 (AFB)
 
A
     
A+
Amlin Syndicate No. 2001 (AML)
 
A
     
A+
Antares Syndicate No. 1274 (AUL)
 
A
     
A+
Ariel Syndicate No. 1910 (ARE)
 
A
     
A+
ARK Syndicate No. 4020 (ARK)
 
A
     
A+
Ascot Syndicate No. 1414 (ASC)
 
A
     
A+
Barbican Syndication No. 1955 (BAR)
 
A
     
A+
Canopius Syndicate No. 958 (CNP)
 
A
     
A+
Canopius Syndicate No. 4444 (CNP)
 
A
     
A+
Cathederal Syndicate No. 2010 (MMX)
 
A
     
A+
Chaucer Syndicate No. 1084 (CSL)
 
A
     
A+
Dale Underwriting Syndicate No. 1729 (DUW)
 
A
     
A+
Faraday Syndicate No. 435 (FDY)
 
A
     
A+
Hiscox Syndicate No. 0033 (HIS)
 
A
     
A+
Kiln Syndicate No. 510 (KLN)
 
A
     
A+
Liberty Syndicates Services Limited, Paris for and on behalf of Lloyd's Syndicate No. 4472 (LIB)
 
A
     
A+
MAP Underwriting Syndicate No. 2791 (MAP)
 
A
     
A+
MAP Underwriting Syndicate No. 2791 (Parallel) (MAP)
 
A
     
A+
Novae Syndicate No. 2007 (NVA)
 
A
     
A+
S.J.O, Catlin & Others No. 2003 (SJC)
 
A
     
A+
           
 
EUROPE
         
 
Amlin AG, Switzerland, Bermuda Branch
 
A
     
A
Hannover Rueck SE (obo Pillar Capital Management)
 
NR
*
 
**
NR
Lansforsakringar Sak Forsakringsaktiebolag (publ)
 
NR
     
A
SCOR Global P&C SE, Paris, Zurich Branch
 
A
     
A
           
 
ASIA
         
 
China Reinsurance (Group) Corporation
 
A
     
NR
Qatar Reinsurance Company LLC
 
A
     
A
 
* Reinstatement Premium Protection Program Participants
 
** Participant will fund a trust agreement for their exposure with cash and U.S. Government obligations of American institutions at fair market value.
 
 
- 28 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

For the 2013–2014 hurricane season, the excess of loss and FHCF treaties insured the property lines for approximately $562.7 million of aggregate catastrophic losses and LAE with a maximum single event coverage totaling approximately $420.4 million, with the Company retaining the first $7.0 million of losses and LAE for each event. The reinsurance program includes coverage purchased from the private market, which affords optional reinstatement premium protection that provides coverage beyond the first event, along with any remaining coverage from the FHCF. Coverage afforded by the FHCF totals approximately $278.1 million, or 49.4% of the $562.7 million of aggregate catastrophic losses and LAE. The FHCF affords coverage for the entire season, subject to maximum payouts, without regard to any particular insurable event.

The estimated cost to the Company for the excess of loss reinsurance products for the 2013-2014 hurricane season, inclusive of approximately $21.7 million payable to the FHCF and the prepaid automatic premium reinstatement protection, is approximately $67.9 million.
 
- 29 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

The 2013-2014 private reinsurance companies and their respective A.M. Best and S&P ratings are listed in the table as follows.

Reinsurer
A.M. Best Rating
 
 
S&P Rating
           
 
           
 
UNITED STATES
         
 
American Agricultural Insurance Company
 
A-
     
NR
Everest Reinsurance Company
 
A+
     
A+
Houston Casualty Company, UK Branch
 
A
     
A+
Odyssey Reinsurance Company
 
A
     
A-
           
 
BERMUDA
         
 
ACE Tempest Reinsurance Limited
 
A+
     
AA-
Allied World Assurance Company Limited, Bermuda
 
A
     
A
Arch Reinsurance Limited
 
A+
     
A+
Argo Reinsurance Limited
 
A
     
NR
Ariel Reinsurance Bermuda Ltd for and on Behalf of Ariel Syndicate 1910 (ARE)
 
A-
     
NR
DaVinci Reinsurance Ltd
 
A
     
A+
Endurance Specialty Insurance Limited
 
A
     
A
JC Re Ltd. (aka Pillar Capital and fka Juniperus & Actua Re Ltd.)
 
NR
*
 
**
NR
Partner Reinsurance Company Limited
 
A+
     
A+
Platinum Underwriters Bermuda Limited
 
A
     
A-
Renaissance Reinsurance Ltd
 
A+
     
AA-
S.A.C. Re, Ltd.
 
A-
     
NR
XL Re Limited
 
A
     
A
           
 
UNITED KINGDOM
         
 
A.F. Beazley Syndicate No. 623 (AFB)
 
A
     
A+
A.F. Beazley Syndicate No. 2623 (AFB)
 
A
     
A+
Amlin Syndicate No. 2001 (AML)
 
A
     
A+
Ariel Syndicate No. 1910 (ARE)
 
A
     
A+
ARK Syndicate No. 3902 (NOA)
 
A
     
A+
Ascot Syndicate No. 1414 (ASC)
 
A
     
A+
Barbican Syndication No. 1955 (BAR)
 
A
     
A+
Canopius Syndicate No. 958 (CNP)
 
A
     
A+
Canopius Syndicate No. 4444 (CNP)
 
A
     
A+
Cathederal Syndicate No. 2010 (MMX)
 
A
     
A+
Kiln Syndicate No. 510 (KLN)
 
A
     
A+
Liberty Syndicates Services Limited, Paris for and on behalf of Lloyd's Syndicate  No. 4472 (LIB)
 
NR
     
A+
MAP Underwriting Syndicate No. 2791 (MAP)
 
A
     
A+
MAP Underwriting Syndicate No. 2791 (Parallel) (MAP)
 
A
     
A+
Novae Syndicate No. 2007 (NVA)
 
A
     
A+
Pembroke Syndicate No. 4000 (PEM)
 
A
     
A+
Tokio Marine Kiln Syndicate No. 1880 (TMK)
 
A
     
A+
           
 
EUROPE
         
 
Amlin Bermuda (Branch of Amlin AG)
 
A
     
A
SCOR Global P&C SE
 
A
     
A
 
* Reinstatement Premium Protection Program Participants
 
** Participant will fund a trust agreement for their exposure with cash and U.S. Government obligations of American institutions at fair market value.
 
- 30 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Annually, the cost and amounts of reinsurance are based on management's analysis of FNIC's exposure to catastrophic risk as of June 30 and estimated to September 30. Our data is then subjected to actual exposure level analysis as of September 30. This analysis of our exposure level in relation to the total exposures to the FHCF and excess of loss treaties may produce changes in limits and reinsurance premiums as a result of the reconciliation of estimated to actual exposure level. The September 30, 2014 change to total insured value was an increase of $5.4 billion or 8.2% and the change to reinsurance premiums are not yet available. The September 30, 2013 change to total insured value  was an increase of $8.7 billion or 25.3% and the change to reinsurance premiums was an increase of $8.3 million or 13.3%.These adjustments are amortized over the remaining underlying policy term.

To date, we have made no claims asserted against our reinsurers in connection with the 2014–2015 and 2013–2014 excess of loss and FHCF treaties.

The quota share retrocessionaire reinsurance agreements require FNIC to securitize credit, regulatory and business risk. Fully funded trust agreements totaled $4.8 million and $4.9 million as of September 30, 2014 and December 31, 2013.

We are selective in choosing reinsurers and consider numerous factors, the most important of which are the financial stability of the reinsurer, their history of responding to claims and their overall reputation. In an effort to minimize our exposure to the insolvency of a reinsurer, we evaluate the acceptability and review the financial condition of the reinsurer at least annually.

(8) Unpaid losses and LAE

The liability for unpaid losses and LAE is determined on an individual-case basis for all incidents reported. The liability also includes amounts for unallocated expenses, anticipated future claim development and Incurred but Not Yet Reported (“IBNR”).

Activity in the liability for unpaid losses and LAE is summarized as follows.

   
Period Ending
 
   
September 30, 2014
   
December 31, 2013
 
   
(Dollars in Thousands)
 
         
Balance at January 1
 
$
61,016
   
$
49,908
 
Less reinsurance recoverables
   
(2,742
)
   
(3,503
)
Net balance at January 1
 
$
58,274
   
$
46,405
 
                 
Incurred related to
               
Current year
 
$
56,818
   
$
56,209
 
Prior years
   
3,658
     
201
 
Total incurred
 
$
60,476
   
$
56,410
 
                 
Paid related to
               
Current year
 
$
24,153
   
$
22,695
 
Prior years
   
30,723
     
21,846
 
Total paid
 
$
54,876
   
$
44,541
 
                 
Net balance at period end
 
$
63,874
   
$
58,274
 
Plus reinsurance recoverables
   
9,235
     
2,742
 
Balance as of period end
 
$
73,109
   
$
61,016
 
 
- 31 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

Based upon consultations with our independent actuarial consultants, we believe that the liability for unpaid losses and LAE is adequate to cover all claims and related expenses that may arise from incidents reported.

Our review of the liability for losses and LAE includes a re-evaluation of the adequacy of reserve levels for prior year’s claims. We increased the liability for losses and LAE for claims occurring in prior years by $3.7 million during the nine months ended September 30, 2014. This development is attributable to adverse decisions on matters beyond the insurance company policy limits. These matters are resolved and further development is unlikely. We increased the liability for losses and LAE for claims occurring in prior years by $0.2 million during the year ended December 31, 2013.

We continue to revise our estimates of the ultimate financial impact of claims made resulting from past storms. The revisions to our estimates are based on our analysis of subsequent information that we receive regarding various factors, including: (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages, and (iv) trends in general economic conditions, including the effects of inflation.

(9) Stock Compensation Plans

We implemented a stock option plan in 1998 (the “1998 Plan”), which expired in September 2008. Under this plan, we were authorized to grant options to purchase up to 900,000 common shares, and as of September 30, 2014 and December 31, 2013, we had outstanding exercisable options to purchase zero and 3,000 shares, respectively.

We implemented a stock option plan in 2002 (the “2002 Plan”), which expired in April 2012.  Under this plan, we were authorized to grant options to purchase up to 1,800,000 common shares, and as of September 30, 2014 and December 31, 2013, we had outstanding exercisable options to purchase 250,303 and 523,521 shares, respectively.

In April 2012, our Board of Directors adopted, and in September 2012 our shareholders approved, the Company’s 2012 Stock Incentive Plan (the “2012 Plan”). The 2012 Plan permits the issuance of up to 1,000,000 shares of our common stock, subject to adjustment as provided for in the 2012 Plan, in connection with the grant of a variety of equity incentive awards, such as incentive stock options, non-qualified stock options, stock appreciation rights, dividend equivalent rights, restricted stock, restricted stock units, and performance shares. Officers, directors and executive, managerial, administrative and professional employees of the Company and its subsidiaries are eligible to participate in the 2012 Plan. Awards may be granted singly, in combination, or in tandem. The 2012 Plan was amended and restated in March 2013 to clarify the plan administrator’s authority to permit the vesting of unvested restricted shares in the event of the death of the grantee. The 2012 Plan will expire on April 5, 2022.

On March 4, 2013, a total of 100,000 restricted shares from the 2012 Plan were granted pursuant to the vesting requirements and other terms and conditions set forth in restricted stock agreements. Of the total, 25,000 shares were granted to the Company's Chief Executive Officer and President and 15,000 shares were granted to the Company's Chief Financial Officer. An aggregate of 20,000 shares were granted to the Company's directors and the remaining 40,000 shares were granted to other employees of the Company.

On August 5, 2013, a total of 150,000 restricted shares from the 2012 Plan were granted pursuant to the vesting requirements and other terms and conditions set forth in restricted stock agreements. Of the total, 100,000 shares were granted to the Company's Chief Executive Officer and President and 50,000 shares were granted to the Company's Chief Financial Officer.

On March 4, 2014, a total of 88,648 restricted shares from the 2012 Plan were granted pursuant to the vesting requirements and other terms and conditions set forth in restricted stock agreements. Of the total, 43,997 shares were granted to the Company's Chief Executive Officer and President and 16,341 shares were granted to the Company's Chief Financial Officer. An aggregate of 15,710 shares were granted to the Company's directors and the remaining 12,600 shares were granted to other employees of the Company.
 
- 32 -

Federated National Holding Company
Notes to Condensed Consolidated Financial Statements

On September 9, 2014, a total of 130,000 restricted shares from the 2012 Plan were granted pursuant to the vesting requirements and other terms and conditions set forth in restricted stock agreements. Of the total, 45,000 shares were granted to the Company's Chief Executive Officer and President and 15,000 shares were granted to the Company's Chief Financial Officer. An aggregate of 50,000 shares were granted to the Company's directors and the remaining 20,000 shares were granted to other employees of the Company.

FASB issued guidance requires that when valuing an employee stock option under the Black-Scholes option pricing model, the fair value be based on the option’s expected term and expected volatility rather than the contractual term. The estimate of the fair value on the grant date should reflect the assumptions marketplace participants now use on the date of the measurement (i.e. grant date). During 2011, management changed the expected term in the Black –Scholes option pricing model from four years to two years for new options granted.  Management believes that share price volatility over the last two years is more indicative of future share price volatility. The change has had an immaterial impact on the financial statements.

Activity in our stock option and incentive plans for the period from January 1, 2012 to September 30, 2014 is as follows.

   
1998 Plan
   
2002 Plan
   
2012 Plan
 
   
Number of
Shares
   
Weighted
Average
Option
Exercise Price
   
Number of
Shares
   
Weighted
Average
Option
Exercise Price
   
Number of
Shares
   
Fair Market
Value at Grant
 
Outstanding at January 1, 2012
   
89,750
   
$
12.83
     
624,700
   
$
6.15
     
-
   
$
-
 
Granted
   
-
   
$
-
     
181,500
   
$
4.40
     
-
   
$
-
 
Exercised
   
-
   
$
-
     
(33,104
)
 
$
3.86
     
-
   
$
-
 
Cancelled
   
(11,250
)
 
$
13.54
     
(70,499
)
 
$
12.45
     
-
   
$
-
 
Outstanding at January 1, 2013
   
78,500
   
$
12.73
     
702,597
   
$
5.17
     
-
   
$
-
 
Granted
   
-
   
$
-
     
-
   
$
-
     
250,000
   
$
8.23
 
Exercised
   
(500
)
 
$
8.67
     
(165,577
)
 
$
7.15
     
-
   
$
-
 
Cancelled
   
(75,000
)
 
$
12.92
     
(13,499
)
 
$
5.41
     
(500
)
 
$
5.54
 
Outstanding at January 1, 2014
   
3,000
   
$
8.67
     
523,521
   
$
4.54
     
249,500
   
$
8.24
 
Granted
   
-
   
$
-
     
-
   
$
-
     
218,648
   
$
21.66
 
Exercised
   
(3,000
)
 
$
8.67
     
(268,984
)
 
$
5.31
     
(68,988
)
 
$
18.67
 
Cancelled
   
-
   
$
-
     
(4,234
)
 
$
3.50
     
(846
)
 
$
7.73
 
Outstanding at September 30, 2014
   
-
   
$
-
     
250,303
   
$
3.73
     
398,314
   
$
13.80
 
 
Options outstanding as of September 30, 2014 are exercisable as follows.

   
1998 Plan
   
2002 Plan
 
Options Exercisable at:
 
Number of
Shares
   
Weighted
Average
Option
Exercise Price
   
Number of
Shares
   
Weighted
Average
Option
Exercise Price
 
                 
September 30, 2014
   
-
   
$
-