1. ORGANIZATION, CONSOLIDATION AND BASIS OF PREPARATION

Organization

Federated National Holding Company (“FNHC,” the “Company,” “we,” “us,” or "our") is an insurance holding company that controls substantially all aspects of the insurance underwriting, distribution and claims processes through our subsidiaries and contractual relationships with independent agents and general agents. We, through our wholly owned subsidiaries, are authorized to underwrite, and/or place homeowners multi-peril (“homeowners”), personal automobile, commercial general liability, federal flood and other lines of insurance in Florida and other states. We market, distribute and service our own and third-party insurers’ products and other services through a network of independent and general agents.

Federated National Insurance Company (“FNIC”), one of our wholly owned insurance subsidiaries, is licensed as an admitted carrier, to write specific lines of insurance by the state’s insurance departments, in Florida, Louisiana, Texas, Georgia, South Carolina and Alabama. Monarch National Insurance Company (“MNIC”), our other insurance subsidiary, is licensed as an admitted carrier in Florida. Admitted carriers are bound by rate and form regulations, and are strictly regulated to protect policyholders from a variety of illegal and unethical practices. Admitted carriers are also required to financially contribute to the state guarantee fund used to pay for losses if an insurance carrier becomes insolvent or unable to pay loss amounts due to their policyholders.

Monarch National Insurance Company

The Company organized MNIC to obtain its certificate of authority to write homeowners property and casualty insurance in Florida from the Florida Office of Insurance Regulation (the “Florida OIR”). The Company’s joint venture partners are Crosswinds Investor Monarch LP (“Crosswinds Investor”), a wholly-owned subsidiary of Crosswinds Holdings Inc. (“Crosswinds Holdings”), a private equity firm and asset manager, and Transatlantic Reinsurance Company (“TransRe”), an international property and casualty reinsurance company. The Company and Crosswinds Investor each invested $14.0 million for a 42.4% membership interest in Monarch Delaware Holdings LLC ("Monarch Delaware") (each holding 50.0% of the voting interests in Monarch Delaware). TransRe invested $5.0 million for a 15.2% non-voting membership interest in Monarch Delaware and advanced an additional $5.0 million in debt evidenced by a six-year promissory note bearing an annual interest rate of 6% and payable by Monarch National Holding Company (“Monarch Holding”).

On November 27, 2017, the Company entered into a purchase and sale agreement with Crosswinds Investor and TransRe, whereby the Company agreed to purchase Crosswinds Investor’s 42.4% Class A membership interest and 50.0% voting interest for $12.3 million, and TransRe’s 15.2% non-voting membership interest in Monarch Delaware for $4.4 million.

Also pursuant to the purchase and sale agreement, Crosswinds AUM LLC (“Crosswinds AUM”), a subsidiary of Crosswinds Holdings, will continue to serve as a consultant to FNHC for a quarterly fee of $75,000 through December 31, 2018, and each of a subsidiary of Crosswinds Holdings and TransRe have a right of first refusal through December 31, 2018, to participate in FNIC’s catastrophe excess of loss reinsurance program, at market rates and terms, up to a placement of $10.0 million in reinsurance limit in the aggregate from Crosswinds Holdings and to a placement of $10.0 million in reinsurance limit in excess of its placement on FNIC’s current catastrophe excess of loss reinsurance program from TransRe.

On February 21, 2018, FNIC closed on the transaction contemplated by the purchase and sale agreement with Crosswinds Investor and TransRe. Refer to Note 17. Subsequent Events, in these notes to consolidated financial statements, for additional information regarding the transaction.

Material Distribution Relationships

Ivantage Select Agency, Inc.

The Company is a party to an insurance agency master agreement with Ivantage Select Agency, Inc. (“ISA”), an affiliate of Allstate Insurance Company (“Allstate”), pursuant to which the Company has been authorized by ISA to appoint Allstate agents to offer the Company’s homeowners and commercial general liability insurance products to consumers in Florida. As a percentage of the total homeowners premiums we underwrote, 23.8%, 24.1% and 25.4%, were from Allstate’s network of Florida agents, for the years ended December 31, 2017, 2016 and 2015, respectively.

SageSure Insurance Managers, LLC

The Company is a party to a managing general underwriting agreement with SageSure Insurance Managers, LLC (“SageSure”) to facilitate growth in our FNIC homeowners business outside of Florida. As a percentage of the total homeowners premiums, 10.2%,6.9% and 5.0% respectively, of the Company’s premiums were underwritten by SageSure, for the years ended December 31, 2017, 2016, and 2015 respectively.

Basis of Presentation and Principles of Consolidation

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”). The consolidated financial statements include the accounts of FNHC and its wholly-owned subsidiaries and all entities in which the Company has a controlling financial interest and any variable interest entity (“VIE”) of which the Company is the primary beneficiary. The Company’s management believes the consolidated financial statements reflect all material adjustments, including normal recurring adjustments, necessary to fairly state the financial position, results of operations and cash flows of the Company for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation.

The Company identifies a VIE as an entity that does not have sufficient equity to finance its own activities without additional financial support or where the equity investors lack certain characteristics of a controlling financial interest. The Company assesses its contractual, ownership or other interests in a VIE to determine if the Company’s interest participates in the variability the VIE was designed to absorb and pass onto variable interest holders. The Company performs an ongoing qualitative assessment of its variable interests in a VIE to determine whether the Company has a controlling financial interest and would therefore be considered the primary beneficiary of the VIE. If the Company determines it is the primary beneficiary of a VIE, the Company consolidates the assets and liabilities of the VIE in its consolidated financial statements.

In connection with the investment in Monarch Delaware, the Company has determined that the Company possesses the power to direct the activities of the VIE that most significantly impact its economic performance and the Company is the primary beneficiary of the VIE. As such, the Company consolidates Monarch Delaware in its consolidated financial statements. Refer to Note 14. Variable Interest Entity, in these notes to consolidated financial statements, for additional information regarding the VIE.

Revisions of Previously Issued Financial Statements

In connection with the preparation, review and audit of the Company’s consolidated financial statements required to be included in this Annual Report on Form 10-K (“Annual Report") for the year ended December 31, 2017, management identified certain errors in the Company’s historical financial statements, resulting in a conclusion that certain corrections need to be made to the Company’s previously audited consolidated financial statements for the fiscal years 2016 and 2015 as well as the previous unaudited consolidated financial statements for the first three quarters of fiscal year 2017.

The Company believes that these errors are not material to any of the Company’s previously-issued financial statements based on an analysis of quantitative and qualitative factors in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) Nos. 99 and 108. However, correcting the errors in 2017 would be material to the Company’s consolidated financial statements for the year ended December 31, 2017. Accordingly, the Company has concluded that an amendment of previously-filed periodic reports is not required. Rather, the Company made revisions to the historical periods in the Company’s Annual Report for the fiscal year ended December 31, 2017, and to the historical periods that will be presented in the Company's prospective filings.

The revisions to correct the errors primarily relate to: (1) up-front recognition of direct written policy fees across all our lines of business and fee income generated through the Company’s personal automobile business, (2) the over-amortization of deferred acquisition costs and (3) the accounting for certain limits in our automobile reinsurance agreements, related to ceded premiums and other items. The Company has also included certain other adjustments that have been corrected.

The nature and description of each of these adjustments is as follows:

•

Direct written policy fees and other fee income: The Company re-evaluated the accounting treatment for up-front recognition of direct written policy fees across all lines of business and fee income generated through the Company’s personal automobile business. As a result of the re-evaluation, the Company concluded that the direct written policy fees and fee income should be recognized over the life of the underlying policies, net of cancellations, and not be recognized up-front. Additionally, with this change, the timing of revenue recognition of direct written policy fees and fee income will be consistent with the timing of recognition of the related insurance costs, including commissions and other acquisition related expenses. This correction resulted in an after-tax net loss impact of $0.7 million and $1.4 million for the years ended December 31, 2016 and 2015, respectively.

•

Deferred acquisition costs: The Company corrected an error in the calculation of deferred acquisition costs related to the over-amortization of the costs, resulting in an overstatement of expenses. Consistent with above, the timing of expense recognition will be consistent with the timing of the recognition of the related premiums and policy fees and the underlying policy term. This correction resulted in an impact to commissions and other underwriting expenses for all periods presented. This correction resulted in an after-tax net income impact of $0.5 million and $0.7 million for the years ended December 31, 2016 and 2015, respectively.

•

Automobile reinsurance agreements: The Company corrected errors on the accounting for certain terms in its reinsurance coverage related to the automobile line of business. This correction was related to limits on the amount of premiums that could be ceded and other terms. The primary impact of the correction resulted in a lower inception-to-date quota share percentage on the reinsurance treaties impacted, which resulted in an overstatement of ceded premiums earned, ceded loss and LAE and ceded commissions. This correction resulted in an after-tax net loss impact of $0.4 million for the year ended December 31, 2016.

•

Income taxes: The Company corrected errors in its tax provision related to tax deductions on executive compensation, which resulted in an after-tax net loss of $0.4 million and $0.2 million for the years ended December 31, 2016 and 2015, respectively. Additionally, a portion of the revisions includes a $2.2 million deferred tax adjustment which is part of the retained earnings beginning balance adjustment, as the item related to periods in 2014 and prior. This error was previously recorded as an out-of-period adjustment and disclosed in the 2016 financial statements.

•

Income statement reclassifications: As previously disclosed and reclassified in the Company’s Quarterly Report on Form 10-Q (“Quarterly Report”) for the period ended June 30, 2017, the Company re-assessed the income statement classification of ceded commission income and salaries and wages from our claims department. As a result, the Company adjusted ceded commission from other income to commissions and other underwriting expenses and salaries and wages from the Company’s claims department from commissions and other underwriting expenses to loss and LAE. Refer to the Company’s Quarterly Report for the period ended June 30, 2017, for more detailed information.

•

Homeowners quota share agreements: As previously disclosed and corrected in the Company’s Quarterly Report for the period ended September 30, 2015, the Company re-evaluated the accounting treatment for quota share reinsurance contracts with retrospective rating provisions and other adjustments. As part of these revisions, the Company recorded these adjustments in the appropriate period. These adjustments resulted in an impact to revenue, loss and LAE, commissions and other underwriting expenses and general and administrative expenses, which had an after-tax net loss impact of $0.8 million for the year ended December 31, 2015.

The following table includes the effects of the adjustments on the retained earnings beginning balance as of January 1, 2015, which represents the cumulative impact of the revisions to periods prior to 2015.



	As of January 1, 2015
	As Reported		Adjustments			As Adjusted

Retained earnings	$	57,423	$	(3,018	)	$	54,405

The following tables summarize the impact of the revisions to the Company’s previously reported consolidated balance sheet as of December 31, 2016, and the Company’s previously reported consolidated statements of operations for the years ended December 31, 2016 and 2015.



	December 31, 2016
	As Reported		Adjustments			As Adjusted
ASSETS	(In thousands, except share and per share data)
Investments:
Debt securities, available-for-sale, at fair value (amortized cost of $376,644)	$	374,756	$	—		$	374,756
Debt securities, held-to-maturity, at amortized cost	5,551		—			5,551
Equity securities, available-for-sale, at fair value (cost of $24,163)	29,375		—			29,375
Total investments (including $28,704 related to the VIE)	409,682		—			409,682

Cash and cash equivalents (including $15,668 related to the VIE)	74,593		—			74,593
Prepaid reinsurance premiums	156,932		—			156,932
Premiums receivable, net of allowance of $55 (including 1,584 related to the VIE)	54,854		—			54,854
Reinsurance recoverable, net	48,530		(667		)	47,863
Deferred acquisition costs	38,962		2,930			41,892
Income taxes receivable	13,871		—			13,871
Property and equipment, net	4,194		—			4,194
Other assets (including $371 related to the VIE)	11,509		—			11,509
TOTAL ASSETS	$	813,127	$	2,263		$	815,390

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Loss and loss adjustment expense reserves	$	158,110	$	—		$	158,110
Unearned premiums	294,022		—			294,022
Reinsurance payable	79,154		—			79,154
Long-term debt	4,909		—			4,909
Deferred revenue	—		6,834			6,834
Deferred tax liabilities, net	1,433		(1,180		)	253
Other liabilities	37,643		—			37,643
Total liabilities	575,271		5,654			580,925
SHAREHOLDERS’ EQUITY:
Preferred stock, $0.01 par value: 1,000,000 shares authorized	—		—			—
Common stock, $0.01 par value: 25,000,000 shares authorized; 13,473,120 shares issued and outstanding	134		—			134
Additional paid-in capital	136,779		—			136,779
Accumulated other comprehensive income	1,941		—			1,941
Retained earnings	80,275		(3,391		)	76,884
Total shareholders’ equity attributable to Federated National Holding Company shareholders	219,129		(3,391		)	215,738
Non-controlling interest	18,727		—			18,727
Total shareholders’ equity	237,856		(3,391		)	234,465
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	813,127	$	2,263		$	815,390



	Year Ended December 31,
	2016								2015
	As Reported			Adjustments			As Adjusted		As Reported			Adjustments			As Adjusted
Revenue:	(In thousands, except share and per share data)
Net premiums earned	$	259,872		$	1,497		$	261,369	$	210,020		$	3,000		$	213,020
Net investment income	9,063			—			9,063		7,226			—			7,226
Net realized investment gains	3,045			—			3,045		3,616			—			3,616
Direct written policy fees	17,730			(1,111		)	16,619		11,248			(1,508		)	9,740
Other income (loss)	26,674			(9,245		)	17,429		17,783			(7,914		)	9,869
Total revenue	316,384			(8,859		)	307,525		249,893			(6,422		)	243,471

Costs and expenses:
Losses and loss adjustment expenses	187,341			10,469			197,810		104,353			8,357			112,710
Commissions and other underwriting expenses	108,776			(18,398		)	90,378		64,868			(12,006		)	52,862
General and administrative expenses	17,186			—			17,186		15,223			(525		)	14,698
Interest expense	348			—			348		256			—			256
Total costs and expenses	313,651			(7,929		)	305,722		184,700			(4,174		)	180,526

Income before income taxes	2,733			(930		)	1,803		65,193			(2,248		)	62,945
Income taxes	2,683			(2,141		)	542		24,753			(664		)	24,089
Net income	50			1,211			1,261		40,440			(1,584		)	38,856
Net income (loss) attributable to non-controlling interest	246			—			246		(445		)	—			(445		)
Net (loss) income attributable to Federated National
Holding Company shareholders	$	(196	)	$	1,211		$	1,015	$	40,885		$	(1,584	)	$	39,301

Net (loss) income per share attributable to Federated
National Holding Company shareholders:
Basic	$	(0.01	)	$	0.08		$	0.07	$	2.98		$	(0.12	)	$	2.86
Diluted	$	(0.01	)	$	0.08		$	0.07	$	2.92		$	(0.11	)	$	2.81

Weighted average number of shares of common stock
outstanding:
Basic	13,758			—			13,758		13,729			—			13,729
Diluted	13,758			164			13,922		13,997			—			13,997

Dividends declared per share of common stock	$	0.27		$	—		$	0.27	$	0.18		$	—		$	0.18

For the impacts of the revisions to the Company’s previously reported consolidated statements of operations for each of the quarterly periods ended March 31, 2017 to September 30, 2017, the six months ended June 30, 2017, and the nine months ended September 30, 2017, refer to Note 16. Quarterly Results of Operations (Unaudited), in these notes to the consolidated financial statements.

Certain prior period line items in the consolidated statements of comprehensive income, consolidated statements of changes in shareholders’ equity and consolidated statements of cash flows, were affected by the revisions of previously issued financial statements. All of the changes in the consolidated statements of cash flows were included in cash flows from operating activities and all of the changes in the consolidated statements of comprehensive income were isolated to the net income line, which has been addressed through the preceding disclosures.