National General Holdings Corp.

Income Taxes

The Company files a consolidated Federal income tax return. The Reciprocal Exchanges are not included in the Company’s consolidated tax return as the Company does not have an ownership interest in the Reciprocal Exchanges, and they are not a part of the consolidated tax sharing agreement among the Company and its subsidiaries.

Federal income tax expense consisted of the following:



	Year Ended December 31,
	2017									2016									2015
	NGHC			Reciprocal Exchanges			Total			NGHC			Reciprocal Exchanges			Total			NGHC			Reciprocal Exchanges			Total
Current expense (benefit)
Federal	$	13,876		$	2,840		$	16,716		$	61,893		$	857		$	62,750		$	52,238		$	(1,059	)	$	51,179
Foreign	2,057			—			2,057			5,119			—			5,119			—			—			—
Total current tax expense (benefit)	$	15,933		$	2,840		$	18,773		$	67,012		$	857		$	67,869		$	52,238		$	(1,059	)	$	51,179
Deferred tax expense (benefit)
Federal	$	59,304		$	(8,485	)	$	50,819		$	(4,195	)	$	(10,648	)	$	(14,843	)	$	(3,019	)	$	(4,890	)	$	(7,909	)
Foreign	(8,319		)	—			(8,319		)	(19,028		)	—			(19,028		)	(27,094		)	—			(27,094		)
Total deferred tax expense (benefit)	$	50,985		$	(8,485	)	$	42,500		$	(23,223	)	$	(10,648	)	$	(33,871	)	$	(30,113	)	$	(4,890	)	$	(35,003	)
Provision (benefit) for income taxes	$	66,918		$	(5,645	)	$	61,273		$	43,789		$	(9,791	)	$	33,998		$	22,125		$	(5,949	)	$	16,176

The domestic and foreign components of income before taxes and earnings of equity method investments are as follows:



	Year Ended December 31,
	2017									2016						2015
	NGHC			Reciprocal Exchanges			Total			NGHC		Reciprocal Exchanges		Total		NGHC			Reciprocal Exchanges		Total
Domestic	$	230,628		$	(9,282	)	$	221,346		$	185,771	$	10,764	$	196,535	$	225,272		$	7,944	$	233,216
Foreign	(49,070		)	—			(49,070		)	18,236		—		18,236		(69,370		)	—		(69,370		)
Income (loss)	$	181,558		$	(9,282	)	$	172,276		$	204,007	$	10,764	$	214,771	$	155,902		$	7,944	$	163,846

The Tax Cuts and Jobs Act was enacted on December 22, 2017 (the “TCJA”). The TCJA reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, creates new taxes on certain foreign sourced earnings, and revises the tax treatment of certain items for property and casualty insurers. As of December 31, 2017, the Company has not completed the accounting for the tax effects of enactment of the TCJA; however, under the SEC guidance, Staff Accounting Bulletin No. 118 (“SAB 118”), in certain cases, as described below, the Company has made a reasonable estimate of the effects on the existing deferred tax balances. For the items for which the Company was able to determine a reasonable estimate, the Company recognized a provisional expense (benefit) of $25,783 for NGHC and $(5,194) for the Reciprocal Exchanges. These amounts are primarily related to the restatement of deferred taxes from 35% to the newly enacted 2018 rate of 21%, and are included as a component of income tax expense from continuing operations. In all cases, the Company will continue to make and refine calculations as additional analysis is completed.

Deferred income taxes are recognized for the future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The tax effects of temporary differences that give rise to the net deferred tax liability are presented below based upon the 2018 enacted rate of 21%.

The tax effects of temporary differences that give rise to the net deferred tax asset or liability are presented below:



	December 31,
	2017								2016
	NGHC		Reciprocal Exchanges			Total			NGHC		Reciprocal Exchanges			Total
Deferred tax assets:
Accrued expenses	$	8,195	$	5,249		$	13,444		$	36,518	$	13,216		$	49,734
Unearned premiums and other revenue	60,298		4,279			64,577			104,955		6,659			111,614
Bad debt	3,887		33			3,920			6,228		366			6,594
Depreciation	3,878		53			3,931			6,083		—			6,083
Contingent commissions	690		—			690			12,547		—			12,547
Loss reserve discount	10,509		953			11,462			11,782		1,396			13,178
Net operating loss carryforwards	13,607		3,905			17,512			22,833		5,655			28,488
Capital loss carryforwards	4,037		190			4,227			2,401		—			2,401
Special estimated tax payments	1,244		—			1,244			2,072		—			2,072
Impairments	783		—			783			16,313		—			16,313
Goodwill	—		—			—			1,701		—			1,701
Foreign translation	2,076		—			2,076			1,249		—			1,249
Stock-based compensation	3,396		—			3,396			4,171		—			4,171
Other	23,847		1,062			24,909			20,488		611			21,099
Gross deferred tax assets	136,447		15,724			152,171			249,341		27,903			277,244
Less: Valuation allowance	—		(5,410		)	(5,410		)	—		(7,135		)	(7,135		)
Total deferred tax assets	136,447		10,314			146,761			249,341		20,768			270,109
Deferred tax liabilities:
Deferred acquisition costs	43,311		4,376			47,687			65,943		10,555			76,498
Investments	503		—			503			—		353			353
Intangible assets	46,103		914			47,017			91,336		3,748			95,084
Loss reserve discount earnout	3,649		313			3,962			—		—			—
Goodwill	1,893		—			1,893			—		—			—
Premises and equipment	2,040		—			2,040			4,520		—			4,520
Statutory equalization reserves	—		—			—			8,319		—			8,319
Unrealized capital gains	—		91			91			7,438		1,865			9,303
Surplus note interest	—		13,003			13,003			—		22,575			22,575
Other	274		—			274			433		767			1,200
Gross deferred tax liabilities	97,773		18,697			116,470			177,989		39,863			217,852
Deferred tax asset	$	38,674	$	—		$	38,674		$	71,352	$	—		$	71,352
Deferred tax liability	$	—	$	(8,383	)	$	(8,383	)	$	—	$	(19,095	)	$	(19,095	)

Excluding the Reciprocal Exchanges, there were no deferred tax asset valuation allowances at December 31, 2017 and 2016. In assessing the reliability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

For the Reciprocal Exchanges, the Company had a partial valuation allowance against the net deferred tax assets as of December 31, 2017 and 2016, respectively, and no tax benefit from consolidated pre-tax losses generated for the years ended December 31, 2017 and 2016, was recognized. For the year ended December 31, 2017, for the New Jersey Skylands Insurance Association consolidated group (“NJSIA”), negative evidence in the form of a multi-year history of net operating losses for tax purposes plus expected break-even or minimal taxable income in future years supported the determination that the realized net deferred tax asset should be fully reserved. For NJSIA, at December 31, 2017, in considering the need for the full valuation allowance, the Company concluded that retaining a deferred tax liability of $954 associated with the indefinite long-lived surplus note intangibles was appropriate considering this liability cannot be used to offset the Company’s net deferred tax asset when determining the amount of valuation allowance required.

Under the Tax Cut and Jobs Act, undistributed Post-1986 earnings and profits (“E&P”) previously deferred from U.S. income taxes are subject to a one-time transition tax. Based on an initial review, the Company cannot reasonably estimate its one-time transitional tax liability at December 31, 2017. As provided under SAB 118, the Company will disclose an estimate in a period where it can reasonably calculate its post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amount held in cash or other specified assets. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the transition tax, or any additional outside basis difference inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities (i.e., basis difference in excess of that subject to the one-time transition tax) is not practicable.

Excluding the Reciprocal Exchanges, the Company had net operating carryforwards of $64,795, $65,237 and $9,453 available for tax purposes for the years ended December 31, 2017, 2016 and 2015, respectively. The net operating loss carryforwards expire between December 31, 2029 and December 31, 2036.

Total income tax expense is different from the amount determined by multiplying earnings before income taxes by the statutory Federal tax rate of 35%. The reasons for such differences are as follows:



	Year Ended December 31, 2017
	NGHC			Reciprocal Exchanges			Total			Tax Rate
Income (loss) before provision for income taxes and earnings of equity method investments	$	181,558		$	(9,282	)	$	172,276
Tax rate	35		%	35		%	35		%
Computed “expected” tax expense	$	63,545		$	(3,249	)	$	60,296		35.00	%
Tax effects resulting from:
Tax-exempt interest	(2,634		)	(110		)	(2,744		)	(1.59	)
Exempt foreign income	(4,940		)	—			(4,940		)	(2.87	)
Equity method income	(3,078		)	—			(3,078		)	(1.79	)
Goodwill impairment	1,709			—			1,709			0.99
Statutory equalization reserves	(8,319		)	—			(8,319		)	(4.83	)
Change in valuation allowance	—			1,255			1,255			0.73
Deferred tax impairment due to 2017 tax reform	25,783			(5,194		)	20,589			11.95
Other permanent items	(5,148		)	1,653			(3,495		)	(2.03	)
Provision (benefit) for income taxes	$	66,918		$	(5,645	)	$	61,273		35.56	%



	Year Ended December 31, 2016
	NGHC			Reciprocal Exchanges			Total			Tax Rate
Income before provision for income taxes and earnings of equity method investments	$	204,007		$	10,764		$	214,771
Tax rate	35		%	35		%	35		%
Computed “expected” tax expense	$	71,402		$	3,767		$	75,169		35.00	%
Tax effects resulting from:
Tax-exempt interest	(3,212		)	(149		)	(3,361		)	(1.56	)
Exempt foreign income	(13,416		)	—			(13,416		)	(6.25	)
Equity method income	5,460			—			5,460			2.54
Goodwill impairment	1,023			—			1,023			0.48
Statutory equalization reserves	(5,898		)	—			(5,898		)	(2.75	)
State tax	4,824			—			4,824			2.25
Change in valuation allowance	—			(13,403		)	(13,403		)	(6.24	)
Bargain purchase gain	(8,508		)	—			(8,508		)	(3.96	)
Other permanent items	(7,886		)	(6		)	(7,892		)	(3.68	)
Provision (benefit) for income taxes	$	43,789		$	(9,791	)	$	33,998		15.83	%



	Year Ended December 31, 2015
	NGHC			Reciprocal Exchanges			Total			Tax Rate
Income before provision for income taxes and earnings of equity method investments	$	155,902		$	7,944		$	163,846
Tax rate	35		%	35		%	35		%
Computed “expected” tax expense	$	54,566		$	2,780		$	57,346		35.00	%
Tax effects resulting from:
Tax-exempt interest	(1,354		)	(165		)	(1,519		)	(0.93	)
Exempt foreign income	(11,393		)	—			(11,393		)	(6.95	)
Equity method income	1,206			—			1,206			0.74
Goodwill impairment	6,113			—			6,113			3.73
Statutory equalization reserves	(27,094		)	—			(27,094		)	(16.54	)
State tax	1,754			—			1,754			1.07
Change in valuation allowance	—			(4,025		)	(4,025		)	(2.46	)
Other permanent items	(1,673		)	(4,539		)	(6,212		)	(3.79	)
Provision (benefit) for income taxes	$	22,125		$	(5,949	)	$	16,176		9.87	%

As permitted by ASC 740, “Income Taxes,” the Company recognizes interest and penalties, if any, related to unrecognized tax benefits in its income tax provision. The Company does not have any unrecognized tax benefits and, therefore, has not recorded any unrecognized tax benefits, or any related interest and penalties, as of December 31, 2017 and 2016. No interest or penalties have been recorded by the Company for the years ended December 31, 2017, 2016 and 2015. The Company does not anticipate any significant changes to its total unrecognized tax benefits in the next 12 months.

All tax liabilities are payable to the Internal Revenue Service (“IRS”) and various state and local taxing agencies. The Company’s subsidiaries are currently under audit by the IRS for the year ended December 31, 2014, and open to years thereafter for federal tax purposes. For state and local tax purposes, the Company is open to audit for tax years ended December 31, 2013 forward, depending on jurisdiction.