Unpaid Losses and Loss Adjustment Expenses

The Company establishes reserves for unpaid losses and loss adjustment expenses ("LAE") which represent the estimated ultimate cost of all losses incurred that were both reported and unreported (i.e., incurred but not yet reported losses; or “IBNR”) and LAE incurred that remain unpaid at the balance sheet date. The Company’s reserving process takes into account known facts and interpretations of circumstances and factors including the Company’s experience with similar cases, actual claims paid, historical trends involving claim payment patterns and pending levels of unpaid claims, loss management programs, product mix and contractual terms, changes in law and regulation, judicial decisions, and economic conditions. In the normal course of business, the Company may also supplement its claims processes by utilizing third party adjusters, appraisers, engineers, inspectors, and other professionals and information sources to assess and settle catastrophe and non-catastrophe related claims. The effects of inflation are implicitly considered in the reserving process.

Reserves are estimates of unpaid portions of losses that have occurred, including IBNR losses; therefore the establishment of appropriate reserves is an inherently uncertain and complex process. The ultimate cost of losses may vary materially from recorded amounts, which are based on management’s best estimates. The highest degree of uncertainty is associated with reserves for losses incurred in the current reporting period as it contains the greatest proportion of losses that have not been reported or settled. The Company regularly updates its reserve estimates as new information becomes available and as events unfold that may affect the resolution of unsettled claims. Changes in reserve estimates, which may be material, are reported in the results of operations in the period such changes are determined to be needed and recorded.

Management believes that the reserve for losses and LAE, net of reinsurance recoverables, is appropriately established in the aggregate and adequate to cover the ultimate net cost of reported and unreported claims arising from losses which had occurred by the date of the consolidated financial statements based on available facts and in accordance with applicable laws and regulations.

The table below provides the changes in the reserves for losses and LAE, net of reinsurance recoverables, for the periods indicated as follows (dollars in thousands):



	Three Months Ended March 31,
	2018			2017
Gross reserves - beginning of period	$	87,896		$	54,651
Less: reinsurance recoverables on unpaid losses	20,066			6,658
Net reserves - beginning of period	67,830			47,993

Add: incurred losses and LAE, net of reinsurance:
Current period	13,344			12,654
Prior period	(16		)	3,079
Total net incurred losses and LAE	13,328			15,733

Deduct: loss and LAE payments, net of reinsurance:
Current period	1,588			1,903
Prior period	12,711			8,813
Total net loss and LAE payments	14,299			10,716

Net reserves - end of period	66,859			53,010
Plus: reinsurance recoverables on unpaid losses	20,063			9,125
Less: deferred gain on ADC	(1,431		)	—
Gross reserves - end of period	$	85,491		$	62,135

On September 28, 2017, the Company entered into an adverse development cover reinsurance agreement (the "ADC") to cover loss development of up to $17.5 million in excess of stated reserves as of June 30, 2017. The ADC provides up to $17.5 million of reinsurance for adverse net loss reserve development for accident years 2005 through 2016. The ADC attaches when net losses exceed $1.4 million of the $36.6 million carried reserves at June 30, 2017, and extends to $19.5 million in coverage up to $57.5 million. The Company retains a 10% co-participation for any development in excess of the retention.

The Company accounts for the agreement as retroactive reinsurance. For the quarter ended March 31, 2018, the Company recorded $1.7 million of net adverse loss development covered under this agreement, which increased the retroactive reinsurance recoverable to $8.9 million, leaving $8.6 million of coverage remaining on the ADC. The Company recorded the retroactive reinsurance recoverable in excess of the consideration as a deferred gain that is amortized to earnings using the interest method over the estimated claims settlement period. As of March 31, 2018, the deferred gain of $1.4 million, net of amortization, is included in Other Liabilities on the consolidated balance sheets.

The Company’s incurred losses during the three months ended March 31, 2018, included favorable prior-year reserve development of $16,000. Excluding the effect of the ADC, the commercial lines of business reported $104,000 of favorable prior-year development offset by $366,000 of unfavorable development from the personal lines of business of which $266,000 was attributable to additional 2017 losses from Hurricane Harvey. The ADC had a favorable impact of $278,000 on prior year reserve development.

The Company’s incurred losses during the three months ended March 31, 2017, included prior-year adverse reserve development of $3.1 million. For the three months ended March 31, 2017, there was adverse development of $1.6 million from the commercial property line, $1.3 million from the commercial liability line of business, $325,000 from the Florida homeowners line, and $201,000 from the personal auto line of business. The adverse development was offset by $456,000 of favorable development in other lines of business for the same period.