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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2004 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: 000-32057 American Physicians Capital, Inc.(Exact name of registrant as specified in its charter) Michigan
(State or other jurisdiction of
incorporation or organization)
    
    38-3543910
(IRS employer
identification number)
 1301 North Hagadorn Road, East Lansing, Michigan 48823
(Address of principal executive offices)(Zip Code) Registrants telephone number, including area code: (517) 351-1150 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 þ          NO o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act) YES þ          NO o The number of shares outstanding of the registrants common stock, no par value
per share, as of July 31, 2004 was 8,518,757. 1




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TABLE OF CONTENTS  
 PART I. FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (Unaudited)Condensed Consolidated Balance Sheets
    
    
    3Condensed Consolidated Statements of Income
    
    
    4Condensed Consolidated Statements of Comprehensive Income
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    37Item 4.
    
    Controls and Procedures
    
    
    39PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    40Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    40Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    40Signatures
    
    
    42Exhibit Index
    
    
    43302 Certification of Chief Executive Officer302 Certification of Chief Financial Officer906 Certification of Chief Executive Officer and Chief Financial Officer
 2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS AMERICAN PHYSICIANS
CAPITAL, INC. AND SUBSIDIARIES 
 Condensed Consolidated
Balance Sheets
 June 30,
    
    December 31,2004
    
    2003(Unaudited)(In thousands, except share data)AssetsInvestments:Fixed maturities, at fair value
    
    $
    670,796
    
    
    $
    694,633Equity securities, at fair value
    
    
    12,609
    
    
    
    7,545Other investments
    
    
    26,039
    
    
    
    29,776Total investments
    
    
    709,444
    
    
    
    731,954Cash and cash equivalents
    
    
    140,087
    
    
    
    102,051Premiums receivable
    
    
    47,070
    
    
    
    65,362Reinsurance recoverable
    
    
    94,228
    
    
    
    103,652Federal income tax recoverable
    
    
    1,881
    
    
    
    973Property and equipment, net of accumulated depreciation
    
    
    13,711
    
    
    
    16,490Intangible assets
    
    
    1,082
    
    
    
    1,539Other assets
    
    
    35,382
    
    
    
    41,025Total assets
    
    $
    1,042,885
    
    
    $
    1,063,046LiabilitiesUnpaid losses and loss adjustment expenses
    
    $
    682,398
    
    
    $
    673,605Unearned premiums
    
    
    84,952
    
    
    
    103,806Note payable, officer
    
    
    
    
    
    
    6,000Long-term debt
    
    
    30,928
    
    
    
    30,928Other liabilities
    
    
    49,344
    
    
    
    44,698Total liabilities
    
    
    847,622
    
    
    
    859,037Commitments and Contingencies (Note 6)Minority Interest in Consolidated Subsidiary
    
    
    2,174
    
    
    
    2,201Shareholders EquityCommon stock, no par value, 50,000,000 shares
authorized: 8,501,927 and 8,445,807 shares outstanding
at June 30, 2004 and December 31, 2003, respectively
    
    
    
    
    
    
    Additional paid-in-capital
    
    
    86,049
    
    
    
    85,137Retained earnings
    
    
    96,324
    
    
    
    87,352Unearned stock compensation
    
    
    (602
    )
    
    
    (288
    )Accumulated other comprehensive income:Net unrealized appreciation on investments,
net of deferred federal income taxes
    
    
    11,318
    
    
    
    29,607Total shareholders equity
    
    
    193,089
    
    
    
    201,808Total liabilities and shareholders equity
    
    $
    1,042,885
    
    
    $
    1,063,046
 The accompanying notes are an integral part of the condensed consolidated financial statements. 3




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES 
 Condensed Consolidated
Statements of Income (Unaudited)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share data)Net premiums written
    
    $
    38,048
    
    
    $
    44,994
    
    
    $
    86,081
    
    
    $
    99,831Change in net unearned premiums
    
    
    13,079
    
    
    
    9,502
    
    
    
    19,123
    
    
    
    13,101Net premiums earned
    
    
    51,127
    
    
    
    54,496
    
    
    
    105,204
    
    
    
    112,932Investment income
    
    
    12,291
    
    
    
    10,424
    
    
    
    25,504
    
    
    
    20,809Net realized (losses) gains
    
    
    (71
    )
    
    
    1,151
    
    
    
    1,565
    
    
    
    1,148Other income
    
    
    229
    
    
    
    196
    
    
    
    406
    
    
    
    357Total revenues and other income
    
    
    63,576
    
    
    
    66,267
    
    
    
    132,679
    
    
    
    135,246Losses and loss adjustment expenses
    
    
    45,087
    
    
    
    51,030
    
    
    
    94,927
    
    
    
    107,012Underwriting expenses
    
    
    11,883
    
    
    
    11,820
    
    
    
    24,148
    
    
    
    25,107Investment expenses
    
    
    812
    
    
    
    598
    
    
    
    1,545
    
    
    
    1,149Interest expense
    
    
    400
    
    
    
    278
    
    
    
    801
    
    
    
    373Amortization expense
    
    
    274
    
    
    
    95
    
    
    
    548
    
    
    
    139General and administrative expenses
    
    
    1,518
    
    
    
    743
    
    
    
    2,206
    
    
    
    1,278Other expenses
    
    
    26
    
    
    
    
    
    
    
    147
    
    
    
    Total expenses
    
    
    60,000
    
    
    
    64,564
    
    
    
    124,322
    
    
    
    135,058Income before federal income taxes and
minority interest
    
    
    3,576
    
    
    
    1,703
    
    
    
    8,357
    
    
    
    188Federal income tax (benefit) expense
    
    
    479
    
    
    
    596
    
    
    
    (600
    )
    
    
    66Income before minority interest
    
    
    3,097
    
    
    
    1,107
    
    
    
    8,957
    
    
    
    122Minority interest in net loss of consolidated subsidiary
    
    
    1
    
    
    
    
    
    
    
    15
    
    
    
    Net income
    
    $
    3,098
    
    
    $
    1,107
    
    
    $
    8,972
    
    
    $
    122Net income  per common shareBasic
    
    $
    0.37
    
    
    $
    0.13
    
    
    $
    1.07
    
    
    $
    0.01Diluted
    
    $
    0.36
    
    
    $
    0.12
    
    
    $
    1.05
    
    
    $
    0.01
 The accompanying notes are an integral part of the condensed consolidated financial statements. 4




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESCondensed Consolidated Statements of Comprehensive Income (Unaudited) 
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Net income
    
    $
    3,098
    
    
    $
    1,107
    
    
    $
    8,972
    
    
    $
    122Other comprehensive (loss) income:Unrealized (depreciation) appreciation on investment securities
arising during the period, net of deferred federal income tax
(benefit) expense of $(6,620) and $(4,774), respectively, in
2004 and $4,389 and $5,086, respectively, in 2003
    
    
    (12,294
    )
    
    
    8,152
    
    
    
    (8,866
    )
    
    
    9,447Intra-period tax allocation of the effect of unrealized
depreciation on the deferred tax valuation allowance
    
    
    (6,406
    )
    
    
    
    
    
    
    (6,406
    )
    
    
    Reclassification adjustment for realized gains on
investment securities included in net income, net of income
tax expense of $1,003 and $1,625, respectively, in
2004 and $403 in 2003
    
    
    (1,862
    )
    
    
    (748
    )
    
    
    (3,017
    )
    
    
    (748
    )Other comprehensive (loss) income
    
    
    (20,562
    )
    
    
    7,404
    
    
    
    (18,289
    )
    
    
    8,699Comprehensive (loss) income
    
    $
    (17,464
    )
    
    $
    8,511
    
    
    $
    (9,317
    )
    
    $
    8,821
 The accompanying notes are an integral part of the condensed consolidated financial statements. 5




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES 
 Condensed Consolidated
Statements of Cash Flows (Unaudited)
 Six Months EndedJune 30,2004
    
    2003(In thousands)Cash flows from operating activitiesNet income
    
    $
    8,972
    
    
    $
    122Adjustments to reconcile net income to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    4,278
    
    
    
    2,537Net realized gains
    
    
    (1,565
    )
    
    
    (1,148
    )Change in fair value of derivatives instruments
    
    
    (293
    )
    
    
    (400
    )Change in deferred federal income taxes
    
    
    
    
    
    
    1,050Minority interest in net loss of consolidated subsidiary
    
    
    15
    
    
    
    Change in unpaid loss and loss adjustment expenses
    
    
    8,793
    
    
    
    (5,006
    )Change in unearned premiums
    
    
    (18,854
    )
    
    
    (14,678
    )Changes in other assets and liabilities
    
    
    37,097
    
    
    
    7,195Net cash provided by (used in) operating activities
    
    
    38,443
    
    
    
    (10,328
    )Cash flows from investing activitiesPurchasesAvailable-for-sale  fixed maturities
    
    
    (155,134
    )
    
    
    (46,667
    )Available-for-sale  equity securities
    
    
    (26,586
    )
    
    
    (1,426
    )Physicians Insurance Company, net of cash acquired
    
    
    
    
    
    
    2,550Leasehold improvements
    
    
    
    
    
    
    (361
    )Property and equipment
    
    
    (728
    )
    
    
    (1,400
    )Sales and maturitiesAvailable-for-sale  fixed maturities
    
    
    163,816
    
    
    
    87,480Available-for-sale  equity securities
    
    
    21,563
    
    
    
    Real estate
    
    
    2,255
    
    
    
    Property and equipment
    
    
    11
    
    
    
    3Net cash provided by investing activities
    
    
    5,197
    
    
    
    40,179Cash flows from financing activitiesPrincipal payment on note payable
    
    
    (6,000
    )
    
    
    (1,000
    )Issuance of long-term debt
    
    
    
    
    
    
    30,928Proceeds from stock options exercised
    
    
    396
    
    
    
    68Net cash (used in) provided by financing activities
    
    
    (5,604
    )
    
    
    29,996Net increase in cash and cash equivalents
    
    
    38,036
    
    
    
    59,847Cash and cash equivalents, beginning of period
    
    
    102,051
    
    
    
    151,825Cash and cash equivalents, end of period
    
    $
    140,087
    
    
    $
    211,672
 Supplemental disclosures of cash flow information The Company purchased 49% of the outstanding common stock of Physicians Insurance Company
in March 2003 for $2,450,000. Cash acquired in connection with the purchase was $5,000,000. The accompanying notes are an integral part of the condensed consolidated financial statements. 6




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited) 1. Basis of Presentation The accompanying unaudited Condensed Consolidated Financial Statements
include the accounts of American Physicians Capital, Inc. (APCapital), and
its wholly owned subsidiaries, Insurance Corporation of America (ICA),
APSpecialty Insurance Corporation (APS), APConsulting LLC, APDirect Sales,
LLC, Alpha Advisors, Inc., APIndemnity (Bermuda) Ltd., APManagement Ltd. and
American Physicians Assurance Corporation (American Physicians). In
accordance with the guidance given in Financial Accounting Standards Board
(FASB) Interpretation No. 46 (FIN No. 46), the accounts of two wholly owned
subsidiary trusts used to issue mandatorily redeemable trust preferred
securities have been included on the equity method in the accompanying
unaudited Condensed Consolidated Financial Statements, and the accounts of
Physicians Insurance Company (PIC) have been included in the accompanying
unaudited Condensed Consolidated Financial Statements. APCapital and its
consolidated subsidiaries are sometimes referred to herein as the Company.
See Note 2 for further discussion regarding the impact of FIN No. 46. All
significant intercompany accounts and transactions are eliminated in
consolidation. Certain 2003 amounts have been restated for the inclusion of PIC, which
was not initially consolidated until the fourth quarter of 2003. The Company is principally engaged in the business of providing medical
professional liability insurance throughout the United States with a
concentration of writings in the Midwest, and is currently in the process of
exiting its workers compensation and health insurance lines of business. The accompanying unaudited Condensed Consolidated Financial Statements of
the Company have been prepared in conformity with accounting principles
generally accepted in the United States of America (GAAP) and with the
instructions for Form 10-Q and Rule 10-01 of Regulation S-X as they apply to
interim financial information. Accordingly, they do not include all of the
information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal
recurring adjustments) considered necessary for a fair presentation have been
included. The operating results for the three-month and six-month periods ended
June 30, 2004 are not necessarily indicative of the results to be expected for
the year ending December 31, 2004. The accompanying unaudited Condensed
Consolidated Financial Statements should be read with the annual consolidated
financial statements and notes contained in the Companys Annual Report on Form
10-K for the year ended December 31, 2003. The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates. 7




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)
 (Continued) 1. Basis of Presentation (continued) The most significant estimates that are susceptible to significant change
in the near-term relate to the determination of the losses and loss adjustment
expense reserves, investments, income taxes, reinsurance, the reserve for
extended reporting period claims and deferred policy acquisition costs.
Although considerable variability is inherent in these estimates, management
believes that the current estimates are reasonable in all material respects.
The estimates are reviewed regularly and adjusted as necessary. Such
adjustments are reflected in current operations. Stock-based Compensation The Company uses the intrinsic value-based method to account for all
stock-based employee compensation plans and has adopted the disclosure
alternative of Statement of Financial Accounting Standard (SFAS) No. 123
Accounting for Stock-Based Compensation, as amended by SFAS No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosure. In
accordance with SFAS No. 123, as amended by SFAS No. 148, the Company is
required to disclose the pro forma effects on operating results as if the
Company had elected the fair value approach to account for its stock-based
employee compensation plans. If compensation had been determined based on the fair value at the grant
date, consistent with the provisions of SFAS No. 123, our net income (loss) and
net income (loss) per share would have been as follows for the three and six
months ended June 30, 2004 and 2003: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share data)Net income, as reported
    
    $
    3,098
    
    
    $
    1,107
    
    
    $
    8,972
    
    
    $
    122Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effects
    
    
    66
    
    
    
    75
    
    
    
    131
    
    
    
    150Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards granted since 2000,
net of related tax effects
    
    
    (225
    )
    
    
    (349
    )
    
    
    (459
    )
    
    
    (698
    )Pro forma net income (loss)
    
    $
    2,939
    
    
    $
    833
    
    
    $
    8,644
    
    
    $
    (426
    )Basic income (loss) per shareAs reported
    
    $
    0.37
    
    
    $
    0.13
    
    
    $
    1.07
    
    
    $
    0.01Pro forma
    
    $
    0.35
    
    
    $
    0.10
    
    
    $
    1.03
    
    
    $
    (0.05
    )Diluted income (loss) per shareAs reported
    
    $
    0.36
    
    
    $
    0.12
    
    
    $
    1.05
    
    
    $
    0.01Pro forma
    
    $
    0.34
    
    
    $
    0.09
    
    
    $
    1.01
    
    
    $
    (0.05
    )
 8




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 1. Basis of Presentation (continued) Stock-based Compensation (continued) Such pro forma disclosures may not be representative of future
compensation costs as options may vest over several years and additional grants
may be made. In March 2004, there were 100,000 options granted with an exercise price
of $21.54. At June 30, 2004, there were 887,800 options outstanding with a
weighted average exercise price of $18.63. In addition, on January 14, 2004,
the Company issued 30,000 shares of restricted stock to certain employees with
a fair market value at the date of grant of $17.20 per share. Derivative Financial Instruments During the second quarter of 2003, the Company purchased interest-only
certificates that may not allow for the recovery of substantially all of its
investment. These certificates pay a variable rate of interest that is
inversely related to the London Interbank Offered Rate (LIBOR). The Company
has determined that these certificates contain an embedded
derivative instrument as defined by SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities. All interest-only certificates with an inverse floating rate of interest
are carried on the balance sheet at fair value as a fixed maturity security.
These certificates are not linked to specific assets or liabilities on the
balance sheet or to a forecasted transaction and, therefore, do not qualify for
hedge accounting. In addition, the Company does not feel that it can reliably
identify and separately measure the embedded derivative instrument.
Accordingly, any changes in the fair value of the entire interest-only
certificates, based on quoted market prices, are recorded in current period
earnings as a component of investment income. At June 30, 2004, the Company had such certificates with a fair value of
approximately $6.7 million. The fair value of these certificates increased
approximately $85,000 and $293,000, respectively, during the three-month and
six-month periods ended June 30, 2004 and $400,000 during the three months and
six months ended June 30, 2003. The Company uses these certificates as a part of its overall interest rate
risk-management strategy related to its investment portfolio. 9




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 2. Effects of New Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (FASB) issued
FIN No. 46, which was revised in December 2003 by FASB FIN No. 46R. These
interpretations address consolidation by business enterprises of variable
interest entities and are effective during the first interim or annual period
ending after December 15, 2003. The Company has evaluated certain investments,
as required by FIN No. 46, and has determined that its investments in
subsidiary trusts used to issue mandatorily redeemable trust preferred
securities should not be consolidated. Accordingly, the Company has not
consolidated the trusts in the accompanying unaudited Condensed Consolidated
Financial Statements. Also, during 2003, the Company invested $2,450,000 for
49% of the outstanding common stock of PIC, a start-up insurance company in the
state of Florida. The Company has evaluated its investment in PIC, and based
on the guidance given in FIN No. 46, has determined that PIC should be
consolidated because, among other factors, the Company financed a portion of
the other investors capital contribution at PICs inception. The amount
financed was repaid in full prior to December 31, 2003. Minority interest in
the accompanying Unaudited Condensed Consolidated Statements of Income and
Condensed Consolidated Balance Sheets represents the remaining 51% of the net
loss and shareholders equity of PIC. PIC was formed in March of 2003 with the intent of writing as much medical
professional liability insurance as PICs capital and surplus levels could
reasonably support. At June 30, 2004, PICs total assets were approximately
$11.2 million and direct premiums written by PIC were approximately $3.3
million and $0 for the six months ended June 30, 2004 and 2003, respectively.
The Company has no future obligations with respect to its investment in PIC,
nor do creditors of PIC have any recourse to the general credit of the Company.
Accordingly, the maximum exposure to loss as a result of the Companys
involvement with PIC, is approximately $2.6 million, which represents the
initial pro-rata equity contribution of $2,450,000 plus the remaining
unamortized balance of an intangible asset of $145,000 related to a covenant
not to compete. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity
(SFAS No. 150). This statement, which is effective for interim periods
beginning after June 15, 2003, establishes standards for how certain financial
instruments with characteristics of both liabilities and equity are classified
in a Companys balance sheet. The adoption of SFAS No. 150 did not have any
effect on the Companys reported results of operations or financial condition. 10




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 3. Income Per Share Net income per common share is computed by dividing net income by the
weighted average number of shares of common stock and common stock equivalents
(e.g., stock options and stock awards) outstanding, calculated on a daily
basis. Basic weighted average shares outstanding for the three and six months
ended June 30, 2004 were 8,426,955 and 8,419,094, respectively, and 8,599,392
and 8,596,995, respectively for the three and six months ended June 30, 2003.
Diluted weighted average shares outstanding for the three and six months ended
June 30, 2004 were 8,584,733 and 8,534,018, respectively, and 8,972,313 and
8,909,701, respectively, for the three and six months ended June 30, 2003. The following table sets forth the computation of basic and diluted net
income per common share: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share data)Numerator for basic and diluted income per
common share:Net income
    
    $
    3,098
    
    
    $
    1,107
    
    
    $
    8,972
    
    
    $
    122Denominator:Denominator for basic income per common
share  weighted average shares outstanding
    
    
    8,427
    
    
    
    8,599
    
    
    
    8,419
    
    
    
    8,597Effect of dilutive stock options and awards
    
    
    158
    
    
    
    373
    
    
    
    115
    
    
    
    313Denominator for diluted income per common
share  adjusted weighted average shares
outstanding
    
    
    8,585
    
    
    
    8,972
    
    
    
    8,534
    
    
    
    8,910Net income per common share  basic
    
    $
    0.37
    
    
    $
    0.13
    
    
    $
    1.07
    
    
    $
    0.01Net income per common share  diluted
    
    $
    0.36
    
    
    $
    0.12
    
    
    $
    1.05
    
    
    $
    0.01
 4. Segment Information The Company is organized and operates principally in the property and
casualty insurance industry and has three reportable segments  medical
professional liability, other insurance lines, and corporate and other in 2004.
Prior to 2004, the Company had five reportable segments  medical professional
liability, workers compensation, health, and personal and commercial insurance
lines, as well as a corporate and other segment. As the Company has
implemented its exit from the workers compensation and health insurance lines,
and exited the personal and commercial lines in 2001, managements emphasis on
these lines, as well as their financial significance has decreased.
Accordingly, these three previously separately 11




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 4. Segment Information (continued) reported segments have been aggregated into the other insurance lines segment
reported in 2004. Reported 2003 amounts have been reclassified to conform to
the current year presentation. The accounting policies of the segments are consistent with those
described in the Notes to the Consolidated Financial Statements included in the
Companys most recent Annual Report on Form 10-K. Expense allocations are
based primarily on loss and loss adjustment expenses by line of business and
certain other estimates for underwriting expenses. Investment income,
investment expense, amortization expense and interest expense are allocated to
the segments based on that segments ownership percentage of the assets or
liabilities underlying the income or expense. General and administrative
expenses are attributed exclusively to the holding company and are included in
corporate and other. The following tables show total assets and income (loss) before income
taxes and minority interests for each of the Companys reportable segments: Medical
    
    Other
    
    CorporateProfessional
    
    Insurance
    
    and
    
    IntersegmentLiability
    
    Lines
    
    Other
    
    Eliminations
    
    Consolidated(In thousands)Total assets:June 30, 2004
    
    $
    967,860
    
    
    $
    91,755
    
    
    $
    226,888
    
    
    $
    (243,618
    )
    
    $
    1,042,885December 31, 2003
    
    $
    909,372
    
    
    $
    123,064
    
    
    $
    234,326
    
    
    $
    (203,716
    )
    
    $
    1,063,046
 For the Three Months Ended June 30, 2004Medical
    
    Other
    
    CorporateProfessional
    
    Insurance
    
    and
    
    IntersegmentLiability
    
    Lines
    
    Other
    
    Eliminations
    
    Consolidated(In thousands)Revenues:Net premiums earned
    
    $
    43,559
    
    
    $
    7,568
    
    
    $
    
    
    
    $
    
    
    
    $
    51,127Investment income
    
    
    11,243
    
    
    
    1,041
    
    
    
    7
    
    
    
    
    
    
    
    12,291Other revenue items
    
    
    84
    
    
    
    (35
    )
    
    
    255
    
    
    
    (146
    )
    
    
    158Total revenues
    
    
    54,886
    
    
    
    8,574
    
    
    
    262
    
    
    
    (146
    )
    
    
    63,576Expenses:Loss and loss adjustment expenses
    
    
    36,281
    
    
    
    8,806
    
    
    
    
    
    
    
    
    
    
    
    45,087Underwriting expenses
    
    
    8,981
    
    
    
    2,902
    
    
    
    
    
    
    
    
    
    
    
    11,883General and administrative expenses
    
    
    
    
    
    
    
    
    
    
    1,518
    
    
    
    
    
    
    
    1,518Other expense items
    
    
    835
    
    
    
    104
    
    
    
    719
    
    
    
    (146
    )
    
    
    1,512Total expenses
    
    
    46,097
    
    
    
    11,812
    
    
    
    2,237
    
    
    
    (146
    )
    
    
    60,000Income (loss) before income taxes and
minority interest
    
    $
    8,789
    
    
    $
    (3,238
    )
    
    $
    (1,975
    )
    
    $
    
    
    
    $
    3,576
 12




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 4. Segment Information (continued) For the Three Months Ended June 30, 2003Medical
    
    Other
    
    CorporateProfessional
    
    Insurance
    
    and
    
    IntersegmentLiability
    
    Lines
    
    Other
    
    Eliminations
    
    Consolidated(In thousands)Revenues:Net premiums earned
    
    $
    38,375
    
    
    $
    16,121
    
    
    $
    
    
    
    $
    
    
    
    $
    54,496Investment income
    
    
    8,612
    
    
    
    1,720
    
    
    
    92
    
    
    
    
    
    
    
    10,424Other revenue items
    
    
    997
    
    
    
    242
    
    
    
    258
    
    
    
    (150
    )
    
    
    1,347Total revenues
    
    
    47,984
    
    
    
    18,083
    
    
    
    350
    
    
    
    (150
    )
    
    
    66,267Expenses:Loss and loss adjustment expenses
    
    
    37,483
    
    
    
    13,547
    
    
    
    
    
    
    
    
    
    
    
    51,030Underwriting expenses
    
    
    7,076
    
    
    
    4,744
    
    
    
    
    
    
    
    
    
    
    
    11,820General and administrative expenses
    
    
    
    
    
    
    
    
    
    
    743
    
    
    
    
    
    
    
    743Other expense items
    
    
    590
    
    
    
    142
    
    
    
    389
    
    
    
    (150
    )
    
    
    971Total expenses
    
    
    45,149
    
    
    
    18,433
    
    
    
    1,132
    
    
    
    (150
    )
    
    
    64,564Income (loss) before income taxes and
minority interest
    
    $
    2,835
    
    
    $
    (350
    )
    
    $
    (782
    )
    
    $
    
    
    
    $
    1,703
 For the Six Months Ended June 30, 2004Medical
    
    Other
    
    CorporateProfessional
    
    Insurance
    
    and
    
    IntersegmentLiability
    
    Lines
    
    Other
    
    Eliminations
    
    Consolidated(In thousands)Revenues:Net premiums earned
    
    $
    86,015
    
    
    $
    19,189
    
    
    $
    
    
    
    $
    
    
    
    $
    105,204Investment income
    
    
    22,857
    
    
    
    2,617
    
    
    
    30
    
    
    
    
    
    
    
    25,504Other revenue items
    
    
    1,645
    
    
    
    161
    
    
    
    454
    
    
    
    (289
    )
    
    
    1,971Total revenues
    
    
    110,517
    
    
    
    21,967
    
    
    
    484
    
    
    
    (289
    )
    
    
    132,679Expenses:Loss and loss adjustment expenses
    
    
    74,966
    
    
    
    19,961
    
    
    
    
    
    
    
    
    
    
    
    94,927Underwriting expenses
    
    
    18,155
    
    
    
    5,993
    
    
    
    
    
    
    
    
    
    
    
    24,148General and administrative expenses
    
    
    
    
    
    
    
    
    
    
    2,206
    
    
    
    
    
    
    
    2,206Other expense items
    
    
    1,625
    
    
    
    330
    
    
    
    1,375
    
    
    
    (289
    )
    
    
    3,041Total expenses
    
    
    94,746
    
    
    
    26,284
    
    
    
    3,581
    
    
    
    (289
    )
    
    
    124,322Income (loss) before income taxes and
minority interest
    
    $
    15,771
    
    
    $
    (4,317
    )
    
    $
    (3,097
    )
    
    $
    
    
    
    $
    8,357
 13




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 4. Segment Information (continued) For the Six Months Ended June 30, 2003Medical
    
    Other
    
    CorporateProfessional
    
    Insurance
    
    and
    
    IntersegmentLiability
    
    Lines
    
    Other
    
    Eliminations
    
    Consolidated(In thousands)Revenues:Net premiums earned
    
    $
    77,860
    
    
    $
    35,072
    
    
    $
    
    
    
    $
    
    
    
    $
    112,932Investment income
    
    
    17,436
    
    
    
    3,213
    
    
    
    160
    
    
    
    
    
    
    
    20,809Other revenue items
    
    
    1,108
    
    
    
    241
    
    
    
    455
    
    
    
    (299
    )
    
    
    1,505Total revenues
    
    
    96,404
    
    
    
    38,526
    
    
    
    615
    
    
    
    (299
    )
    
    
    135,246Expenses:Loss and loss adjustment expenses
    
    
    78,669
    
    
    
    28,343
    
    
    
    
    
    
    
    
    
    
    
    107,012Underwriting expenses
    
    
    14,892
    
    
    
    10,215
    
    
    
    
    
    
    
    
    
    
    
    25,107General and administrative expenses
    
    
    
    
    
    
    
    
    
    
    1,278
    
    
    
    
    
    
    
    1,278Other expense items
    
    
    1,186
    
    
    
    253
    
    
    
    521
    
    
    
    (299
    )
    
    
    1,661Total expenses
    
    
    94,747
    
    
    
    38,811
    
    
    
    1,799
    
    
    
    (299
    )
    
    
    135,058Income (loss) before income taxes and
minority interest
    
    $
    1,657
    
    
    $
    (285
    )
    
    $
    (1,184
    )
    
    $
    
    
    
    $
    188
 In late 2003, management announced its intention to exit both the workers
compensation and health insurance lines of business, both of which are included
above in other insurance lines. The Company began non-renewing workers
compensation policies in early 2004 and began non-renewing health policies
effective July 1, 2004. 5. Investments The composition of the investment portfolio, including unrealized gains
and losses at June 30, 2004 and December 31, 2003 was as follows: June 30, 2004Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost/Cost
    
    Gains
    
    Losses
    
    Fair Value(In thousands)Available-for-saleU.S. government obligations
    
    $
    103,225
    
    
    $
    1,394
    
    
    $
    (19
    )
    
    $
    104,600States and political subdivisions
    
    
    30,635
    
    
    
    1,890
    
    
    
    
    
    
    
    32,525Corporate securities
    
    
    346,848
    
    
    
    22,668
    
    
    
    (222
    )
    
    
    369,294Mortgage-backed securities
    
    
    145,447
    
    
    
    2,870
    
    
    
    (1,158
    )
    
    
    147,159Other debt securities
    
    
    16,676
    
    
    
    542
    
    
    
    
    
    
    
    17,218Fixed maturities
    
    
    642,831
    
    
    
    29,364
    
    
    
    (1,399
    )
    
    
    670,796Equity securities
    
    
    12,589
    
    
    
    624
    
    
    
    (604
    )
    
    
    12,609Total available-for-sale
    
    $
    655,420
    
    
    $
    29,988
    
    
    $
    (2,003
    )
    
    $
    683,405
 14




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 5. Investments (continued) December 31, 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost/Cost
    
    Gains
    
    Losses
    
    Fair Value(In thousands)Available-for-saleU.S. government obligations
    
    $
    54,168
    
    
    $
    1,927
    
    
    $
    (4
    )
    
    $
    56,091States and political subdivisions
    
    
    32,932
    
    
    
    1,404
    
    
    
    (18
    )
    
    
    34,318Corporate securities
    
    
    475,866
    
    
    
    37,896
    
    
    
    (75
    )
    
    
    513,687Mortgage-backed securities
    
    
    60,440
    
    
    
    2,546
    
    
    
    (557
    )
    
    
    62,429Other debt securities
    
    
    25,706
    
    
    
    2,402
    
    
    
    
    
    
    
    28,108Fixed maturities
    
    
    649,112
    
    
    
    46,175
    
    
    
    (654
    )
    
    
    694,633Equity securities
    
    
    7,085
    
    
    
    567
    
    
    
    (107
    )
    
    
    7,545Total available-for-sale
    
    $
    656,197
    
    
    $
    46,742
    
    
    $
    (761
    )
    
    $
    702,178
 Unrealized gains at June 30, 2004 and December 31, 2003 include $725,000
and $432,000, respectively, of gains that relate to securities that contain an
embedded derivative instrument. These gains have been included in investment
income for the period in accordance with SFAS No. 133. See Note 1 for further
discussion of these securities and the embedded derivative instruments. 6. Commitments and Contingencies On both December 30, 2003 and February 20, 2004, separate putative
shareholder class action complaints were filed in United States District Court
for the Western District of Michigan against the Company, its former President
and Chief Executive Officer, and its Chief Financial Officer. The complaints
allege violations of federal securities laws for certain disclosures made by
the Company between February 13, 2003 and November 6, 2003, regarding its
operating results and the adequacy of its reserves, and each seeks monetary
damages in an unspecified amount. The Company denies the allegations and
intends to vigorously defend the lawsuits. On March 23, 2004, the Court
dismissed the first case and entered an Order approving a lead plaintiff in the
second case. A consolidated amended complaint was filed by the lead plaintiff
on May 7, 2004. On June 28, 2004, the Company and the individual defendants
filed a motion to dismiss the complaint. While management believes that
meritorious defenses to the allegations exist, the ultimate disposition of this
litigation could have a material adverse impact on the Companys financial
position, liquidity and results of operations. 15




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 7. Related Party Transactions On January 2, 2004, the $6.0 million obligation to the Companys former
President and Chief Executive Officer (CEO) was repaid in its entirety in
connection with his retirement. At December 31, 2003, the Company had a $286,000 non-interest bearing note
receivable from SCW Agency Group, Inc. (SCW), an insurance agency that is
principally owned by the Companys former President and CEO. At December 31,
2003, the Company had established an allowance in the amount of $286,000
related to the note receivable. As part of a new master agency agreement
between American Physicians, a wholly owned subsidiary of APCapital, and SCW,
which was effective January 1, 2004, this note receivable was forgiven in
exchange for certain more favorable contract terms. Accordingly, the note
receivable and the allowance were written off during 2004, which did not result
in a charge to income. 8. Restructuring Charges In the fourth quarter of 2003, the Company began to exit its workers
compensation and health lines of business. In connection with the exit of
these lines, the Company expects to incur a total of approximately $1.1 million
of restructuring charges for one-time employee termination benefits and
employee stay bonuses. During the three and six months ended June 30, 2004,
$26,000 and $147,000, respectively, of additional restructuring costs were
incurred, bringing the total amount incurred through June 30, 2004, to
$955,000. The costs are included on the accompanying unaudited Condensed
Consolidated Statements of Income in the other expenses line item. The activity in the liability for restructuring charges for the six months
ended June 30, 2004 was as follows (in thousands): 2004Balance, January 1
    
    $
    727Employee separations
    
    
    147Payments
    
    
    (523
    )Balance, June 30
    
    $
    351
 Certain employees related to the workers compensation line of business
have been retained to manage the run-off of this line through June 30, 2005.
The employee separation costs related to these individuals will be recognized
prospectively over the future service period. At June 30, 2004, total future
employee separation costs are estimated to be approximately $150,000. 16




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 9. Income Taxes The provision for income taxes for the three and six months ended June 30,
2004 and 2003 consists of: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Current (benefit) expense
    
    $
    (600
    )
    
    $
    326
    
    
    $
    (600
    )
    
    $
    (984
    )Deferred expense
    
    
    1,242
    
    
    
    270
    
    
    
    2,788
    
    
    
    1,050Deferred tax valuation allowance
    
    
    (163
    )
    
    
    
    
    
    
    (2,788
    )
    
    
    Total expense (benefit)
    
    $
    479
    
    
    $
    596
    
    
    $
    (600
    )
    
    $
    66
 Income taxes incurred do not bear the usual relationship to income before
federal income taxes for the three and six months ended June 30, 2004 and 2003
due to the following: Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(In thousands)Income before federal income
taxes and minority interest
    
    $
    3,576
    
    
    
    
    
    
    $
    1,703
    
    
    
    
    
    
    $
    8,357
    
    
    
    
    
    
    $
    188Tax at statutory rate
    
    $
    1,252
    
    
    
    35.0
    %
    
    $
    596
    
    
    
    35.0
    %
    
    $
    2,925
    
    
    
    35.0
    %
    
    $
    66
    
    
    
    35.0
    %Tax effect of:Tax exempt interest
    
    
    (90
    )
    
    
    -2.5
    %
    
    
    (117
    )
    
    
    -6.9
    %
    
    
    (197
    )
    
    
    -2.4
    %
    
    
    (248
    )
    
    
    -131.9
    %Cushion adjustment
    
    
    (600
    )
    
    
    -16.8
    %
    
    
    85
    
    
    
    5.0
    %
    
    
    (600
    )
    
    
    -7.2
    %
    
    
    191
    
    
    
    101.6
    %Other items, net
    
    
    80
    
    
    
    2.2
    %
    
    
    32
    
    
    
    1.9
    %
    
    
    60
    
    
    
    0.7
    %
    
    
    57
    
    
    
    30.3
    %Valuation allowance
    
    
    (163
    )
    
    
    -4.5
    %
    
    
    
    
    
    
    0.0
    %
    
    
    (2,788
    )
    
    
    -33.3
    %
    
    
    
    
    
    
    0.0
    %Total expense (benefit)
    
    $
    479
    
    
    
    13.4
    %
    
    $
    596
    
    
    
    35.0
    %
    
    $
    (600
    )
    
    
    -7.2
    %
    
    $
    66
    
    
    
    35.0
    %
 Deferred federal income tax assets and liabilities are recognized for the
estimated future tax consequences attributable to the differences between
financial statement carrying amounts of existing assets and liabilities, and
their respective tax bases. The Company has reviewed its deferred federal
income tax assets for recoverability based on the availability of future
taxable income when the deductible temporary differences are expected to
reverse, and has determined, based on its recent loss experience, that
sufficient taxable income may not exist in the periods of reversal.
Accordingly, the Company has recorded a deferred tax asset valuation allowance
for the entire net deferred tax asset. As the Companys deferred tax assets
and liabilities change, the valuation allowance also changes. Any change in
the valuation allowance related to the tax effect of items that are included in
continuing operations is recorded as federal income tax expense (benefit) from
continuing operations in the period of change. In periods of reported net
income,
the change in the deferred tax valuation allowance that pertains to items
that are not related to continuing operations, such as unrealized appreciation
or depreciation on investment securities, is reported as a component of that
measure of income to which those items pertain. Accordingly, the Company has
recorded the effect of the change in the valuation allowance related to
unrealized appreciation or depreciation on investment securities as a component
of other 17




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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIESNotes to Condensed Consolidated Financial Statements (Unaudited)  (Continued) 9. Income Taxes (continued) comprehensive income in the second quarter of 2004. This effectively reverses
the federal income tax benefit recorded during the three months ended March 31,
2004. Once the Company has re-established a pattern of profitability, the
deferred tax asset valuation allowance may be reduced upon evaluation of the
availability of future taxable income. The federal income tax benefit recorded for the six months ended June 30,
2004 represents the reversal of tax cushion that we had been maintaining in
connection with an amended return filed for tax year 2000. Although the
Company has not yet received the refund related to the 2000 amended return,
dialogue with the Internal Revenue Service has indicated that the refund is
being processed as requested, and the cushion is therefore no longer needed. At June 30, 2004 and December 31, 2003, the components of the net deferred
federal income tax asset were as follows: June 30,
    
    December 31,2004
    
    2003(In thousands)Deferred tax assets arising fromLosses and loss adjustment expenses
    
    $
    30,330
    
    
    $
    29,385Net operating loss carryforwards
    
    
    14,142
    
    
    
    15,658Unearned and audit premiums
    
    
    6,516
    
    
    
    7,732Minimum tax credits
    
    
    8,242
    
    
    
    8,242Realized losses on investments
    
    
    1,871
    
    
    
    4,257Goodwill
    
    
    4,668
    
    
    
    4,827Other
    
    
    3,424
    
    
    
    2,604Total deferred tax assets
    
    
    69,193
    
    
    
    72,705Deferred tax liabilities arising fromDeferred policy acquisition costs
    
    
    2,801
    
    
    
    3,656Net unrealized gains on securities
    
    
    9,536
    
    
    
    15,942Other
    
    
    2,352
    
    
    
    2,435Total deferred tax liabilities
    
    
    14,689
    
    
    
    22,033Net deferred tax asset before valuation allowance
    
    
    54,504
    
    
    
    50,672Valuation allowance
    
    
    (54,504
    )
    
    
    (50,672
    )Net deferred tax asset
    
    $
    
    
    
    $
    
 18




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9. Income Taxes (continued) At June 30, 2004, the Company had the following net operating loss
carryforwards: Annual
    
    Year ofAmount
    
    Limitation
    
    Expiration(in thousands)New Mexico Physicians Mutual Liability Company merger (2)
    
    $
    3,421
    
    
    $
    575
    
    
    
    2010State Mutual Insurance Company merger (2)
    
    $
    2,376
    
    
    $
    340
    
    
    
    20122003 net operating loss (1)
    
    $
    34,394
    
    
    
    N/A
    
    
    
    2018
   (1)
    
    There are no limitations on the annual use of net operating losses related to the year
ended December 31, 2003.(2)
    
    American Physicians merged with New Mexico Physicians Mutual Liability Company and
State Mutual Insurance Company in 1997. In addition to the net operating loss carryforwards above, at June 30,
2004, the Company had approximately $8.2 million of alternative minimum tax
credits, which can be carried forward indefinitely. 10. Reinsurance The Company commuted its ceded reinsurance treaties with Gerling Global
Reinsurance Corporation (Gerling) in May 2004. The Company recognized the
$13.5 million received from Gerling as reduction of losses and loss adjustment
expenses paid (thereby reducing losses and loss adjustment expenses incurred)
in the current year. The Company also reduced its reinsurance recoverable from
Gerling (thereby increasing losses and loss adjustment expenses incurred) to
recognize the effect of releasing Gerling from its obligations under the
treaties. The net effect of the commutation was an increase in losses and loss
adjustment expenses of $4.4 million, partially offset by an $837,000 increase
in net premiums earned. 19




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with
the unaudited Condensed Consolidated Financial Statements and the Notes thereto
included elsewhere in this report and our Annual Report on Form 10-K for the
year ended December 31, 2003, particularly Item 7  Managements Discussion
and Analysis of Financial Condition and Results of Operations in the Annual
Report. The following discussion of our financial condition and results of
operations contains certain forward-looking statements related to our
anticipated future financial condition and operating results and our current
business plans. When we use words such as will, should, likely,
believe, expect, anticipate, estimate or similar expressions, we are
making forward-looking statements. These forward-looking statements represent
our outlook only as of the date of this report. We claim the protection of the safe harbor for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995 for all of
our forward-looking statements. While we believe that our forward-looking
statements are reasonable, you should not place undue reliance on any such
forward-looking statements, which speak only as of the date made. Because
these forward-looking statements are based on estimates and assumptions that
are subject to significant business, economic and competitive uncertainties,
many of which are beyond our control or are subject to change, actual results
could be materially different. Factors that might cause such a difference
include the following:  
    
    The assumptions and methodologies used in estimating and establishing
the reserve for unpaid losses and loss adjustment expenses are
continually reviewed and any adjustments are reflected as income or
expense in the period in which the adjustment is made. Historically,
such estimates have not exceeded plus or minus 8% of our recorded net
reserves as of the beginning of the period, but can materially and
adversely affect our results of operations when an adjustment is made.
Due to the current volatility of losses in the medical professional
liability industry, adjustments have occurred in each of the last
several years.  
    
    A deterioration in the current accident year experience could result
in a portion or all of our deferred policy acquisition costs not being
recoverable, which would result in a charge to income.  
    
    Our exit from various markets and lines of business, including without
limitation our exit from the workers compensation, health and
personal and commercial lines of business, as well as various
geographic markets, could result in future charges to income due to
unforeseen costs or the need for unanticipated reserve enhancements.  
    
    An adverse outcome in the putative shareholder class action lawsuit against us
may result in a charge to income that could have a material adverse
effect on our financial condition, liquidity and results of
operations. 20




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##### Table of Contents




    
    Substantial jury awards against our insureds could impose liability on
us exceeding our policy limits or the funds we have reserved for the
payment of claims.
    
    If the marketplace puts pressure on pricing increases, we may not be
able to obtain expected rate increases.
    
    If competitive or other conditions change, our revenues may decrease
or our expenses may increase.
    
    If we experience substantial changes in claims frequency or severity
patterns, our profitability may decline.
    
    We may be unable to collect the full amount of reinsurance recoverable
from PMA Reinsurance Corporation if their cash flow or surplus levels
are inadequate to make claim payments, which could result in a future
charge to income.
    
    If reinsurance rates rise significantly or reinsurance becomes
unavailable or reinsurers are unable to pay our claims, our results of
operations and financial condition may be adversely affected.
    
    The concentration of our business in Michigan, Illinois and Ohio
leaves us vulnerable to various factors specific to those states.
    
    If our current relationship with medical associations and physicians
does not continue, our ability to market our products and compete
successfully may be harmed.
    
    An interruption or change in our relationship with SCW Agency Group,
an insurance sales agency, which is principally owned by our former
President and CEO, could reduce our insurance premiums and net income.
This agency accounts for substantially more of our medical
professional liability premiums written than any other agency.
    
    If any of the member companies in the various guaranty associations in
which we participate were to become insolvent, we could be assessed by
the relevant association in an amount that could materially affect our
financial condition or results of operations.
    
    We may not be able to obtain regulatory approval for rate increases,
which may negatively affect our profitability.
    
    If we fail to comply with insurance industry regulations, or if those
regulations become more burdensome to us, we may not be able to
operate profitably.
    
    A further reduction in our A.M. Best Company rating could make it more
difficult for us to sell our products.
    
    Changes in prevailing interest rates and other negative changes in
financial market conditions may reduce our revenues, cash flows or
assets, including the amount of unrealized gains on investments shown
on our balance sheet. 21




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##### Table of Contents




    
    Changes in current market conditions may adversely impact the property
value of real estate investments that we currently hold.
    
    A downturn in general economic conditions or significant increase in
inflation in the markets in which we compete could negatively affect
our profitability. Other factors not currently anticipated by management may also materially
and adversely affect the Companys financial position and results of
operations. The Company does not undertake, and expressly disclaims any
obligation, to update or alter its statements, whether as a result of new
information, future events or otherwise, except as required by applicable law. Overview of APCapitals Operations We are a leading provider of medical professional liability insurance.
Medical professional liability insurance coverage protects physicians and other
health providers from claims filed against them for alleged acts of medical
malpractice. In addition to medical professional liability insurance, we have
historically also offered workers compensation insurance and health insurance
products. However, in late 2003, we announced our intention to exit the
workers compensation and health insurance markets. We began non-renewing
workers compensation policies in the first quarter of 2004 and began
non-renewing health policies effective July 1, 2004. Significant Accounting Policies The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires us to
make estimates and assumptions that affect amounts reported in the accompanying
consolidated financial statements and related footnotes. These estimates and
assumptions are evaluated on an on-going basis based on historical
developments, market conditions, industry trends and other information we
believe to be reasonable under the circumstances. There can be no assurance
that actual results will conform to our estimates and assumptions, or that
reported results of operations will not be materially adversely affected by the
need to make accounting adjustments to reflect changes in these estimates and
assumptions from time to time. Adjustments related to changes in estimates are
reflected in the Companys earnings in the period those estimates changed. The policies relating to unpaid loss and loss adjustment expenses,
investments, income taxes, reinsurance, the reserve for extended reporting
period claims and deferred policy acquisition costs are those we believe to be
most sensitive to estimates and judgments. These policies are more fully
described in Item 7  Managements Discussion and Analysis of Financial
Condition and Results of Operations, Significant Accounting Policies of our
Annual Report on Form 10-K for the year ended December 31, 2003, and in Note 1
to our Consolidated Financial Statements contained in that report. There have
been no material changes to these policies during the most recent quarter. 22




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##### Table of Contents



Description of Ratios Analyzed In the analysis of our operating results that follows, we refer to various
financial ratios and other measures that management uses to analyze and compare
the underwriting results of our insurance operations. GAAP Ratios and Other GAAP Financial Measures We calculate loss ratio, underwriting expense ratio and combined ratio on
a GAAP basis. There have been no material changes to the calculation and use
of these ratios during the most recent quarter. The Company also calculates
underwriting gain (loss) on a GAAP basis. This measure equals the net premiums
earned less loss and loss adjustment expenses as well as underwriting expenses.
It is another measure used by management and insurance regulators to evaluate
the underwriting performance of our insurance operations. Accident Year Loss Ratio In addition to our reported GAAP loss ratios, we also report accident year
loss ratios. The accident year loss ratio excludes the effect of development
on prior year loss reserves. We believe this ratio is useful in evaluating our
current underwriting performance, as it focuses on the relationships between
current premiums earned and losses incurred related to the current year.
Considerable variability is inherent in the establishment of loss reserves
related to the current accident year. While management believes that its
estimate is reasonable, there can be no assurance that these loss reserves will
develop as expected. Our method of calculating accident year loss ratios may
differ from those used by other companies and, therefore, comparability may be
limited. 23




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##### Table of Contents



Results of
Operations  Three and Six Months Ended June 30, 2004 Compared to Three and Six Months Ended June 30, 2003 Consolidated Results of Operations The following table sets forth our results of operations for the
three-month and six-month periods ended June 30, 2004 and 2003, on a
consolidated basis. The discussion that follows should be read in connection
with the unaudited Condensed Consolidated Financial Statements, and Notes
thereto, included elsewhere in this report. For the Three Months Ended June 30,
    
    For the Six Months Ended June 30,Percentage
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percentage2004
    
    2003
    
    Change
    
    Change
    
    2004
    
    2003
    
    Change
    
    Change(dollars in thousands)Net premiums earned by insurance segment:Medical professional liability
    
    $
    43,559
    
    
    $
    38,375
    
    
    $
    5,184
    
    
    
    13.5
    %
    
    $
    86,015
    
    
    $
    77,860
    
    
    $
    8,155
    
    
    
    10.5
    %Other insurance lines
    
    
    7,568
    
    
    
    16,121
    
    
    
    (8,553
    )
    
    
    -53.1
    %
    
    
    19,189
    
    
    
    35,072
    
    
    
    (15,883
    )
    
    
    -45.3
    %Total net premiums earned
    
    
    51,127
    
    
    
    54,496
    
    
    
    (3,369
    )
    
    
    -6.2
    %
    
    
    105,204
    
    
    
    112,932
    
    
    
    (7,728
    )
    
    
    -6.8
    %Investment income
    
    
    12,291
    
    
    
    10,424
    
    
    
    1,867
    
    
    
    17.9
    %
    
    
    25,504
    
    
    
    20,809
    
    
    
    4,695
    
    
    
    22.6
    %Net realized gains (losses)
    
    
    (71
    )
    
    
    1,151
    
    
    
    (1,222
    )
    
    
    -106.2
    %
    
    
    1,565
    
    
    
    1,148
    
    
    
    417
    
    
    
    36.3
    %Other income
    
    
    229
    
    
    
    196
    
    
    
    33
    
    
    
    16.8
    %
    
    
    406
    
    
    
    357
    
    
    
    49
    
    
    
    13.7
    %Total revenues and other income
    
    
    63,576
    
    
    
    66,267
    
    
    
    (2,691
    )
    
    
    -4.1
    %
    
    
    132,679
    
    
    
    135,246
    
    
    
    (2,567
    )
    
    
    -1.9
    %Losses and loss adjustment expenses
    
    
    45,087
    
    
    
    51,030
    
    
    
    (5,943
    )
    
    
    -11.6
    %
    
    
    94,927
    
    
    
    107,012
    
    
    
    (12,085
    )
    
    
    -11.3
    %Underwriting expenses
    
    
    11,883
    
    
    
    11,820
    
    
    
    63
    
    
    
    0.5
    %
    
    
    24,148
    
    
    
    25,107
    
    
    
    (959
    )
    
    
    -3.8
    %Investment expenses
    
    
    812
    
    
    
    598
    
    
    
    214
    
    
    
    35.8
    %
    
    
    1,545
    
    
    
    1,149
    
    
    
    396
    
    
    
    34.5
    %Interest expense
    
    
    400
    
    
    
    278
    
    
    
    122
    
    
    
    43.9
    %
    
    
    801
    
    
    
    373
    
    
    
    428
    
    
    
    114.7
    %Amortization expense
    
    
    274
    
    
    
    95
    
    
    
    179
    
    
    
    188.4
    %
    
    
    548
    
    
    
    139
    
    
    
    409
    
    
    
    294.2
    %General and administrative expenses
    
    
    1,518
    
    
    
    743
    
    
    
    775
    
    
    
    104.3
    %
    
    
    2,206
    
    
    
    1,278
    
    
    
    928
    
    
    
    72.6
    %Other expense
    
    
    26
    
    
    
    
    
    
    
    26
    
    
    
    
    
    
    
    147
    
    
    
    
    
    
    
    147Total expenses
    
    
    60,000
    
    
    
    64,564
    
    
    
    (4,564
    )
    
    
    -7.1
    %
    
    
    124,322
    
    
    
    135,058
    
    
    
    (10,736
    )
    
    
    -7.9
    %Income before federal income taxes and
minority interest
    
    
    3,576
    
    
    
    1,703
    
    
    
    1,873
    
    
    
    110.0
    %
    
    
    8,357
    
    
    
    188
    
    
    
    8,169
    
    
    
    4345.2
    %Federal income tax expense (benefit)
    
    
    479
    
    
    
    596
    
    
    
    (117
    )
    
    
    -19.6
    %
    
    
    (600
    )
    
    
    66
    
    
    
    (666
    )
    
    
    -1009.1
    %Income before minority interest
    
    
    3,097
    
    
    
    1,107
    
    
    
    1,990
    
    
    
    179.8
    %
    
    
    8,957
    
    
    
    122
    
    
    
    8,835
    
    
    
    7241.8
    %Minority interest
    
    
    1
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    15
    
    
    
    
    
    
    
    15Net income
    
    $
    3,098
    
    
    $
    1,107
    
    
    $
    1,991
    
    
    
    179.9
    %
    
    $
    8,972
    
    
    $
    122
    
    
    $
    8,850
    
    
    
    7254.1
    %Loss ratio
    
    
    88.2
    %
    
    
    93.6
    %
    
    
    -5.4
    %
    
    
    
    
    
    
    90.2
    %
    
    
    94.8
    %
    
    
    -4.6
    %Underwriting ratio
    
    
    23.2
    %
    
    
    21.7
    %
    
    
    1.5
    %
    
    
    
    
    
    
    23.0
    %
    
    
    22.2
    %
    
    
    0.8
    %Combined ratio
    
    
    111.4
    %
    
    
    115.3
    %
    
    
    -3.9
    %
    
    
    
    
    
    
    113.2
    %
    
    
    117.0
    %
    
    
    -3.8
    %
 Net income for the three months and six months ended June 30, 2004 was
largely attributable to the improved underwriting performance (i.e.,
underwriting gain or loss) of our medical professional liability segment, which
is discussed more fully in the section regarding that segments results of
operations. In addition to the improved underwriting results of our medical
professional liability segment, which included a $3.3 million charge in the
second quarter of 2004 for the commutation of reinsurance treaties with Gerling Global
Reinsurance Corporation (Gerling), increases in investment income also
contributed to the increases in net income. Offsetting these positive factors
were increases in general and administrative expenses and a $2.5 million charge
related to the write-off of software in the second quarter of 2004. 24




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##### Table of Contents



The decreases in net premiums earned were primarily attributable to our
continued exit from the workers compensation and health insurance lines of
business, which we announced in the fourth quarter of 2003, partially offset by
premium rate increases on our medical professional liability line and an
$837,000 increase in net premiums earned related to the commutation of our
reinsurance treaties with Gerling. We anticipate that net premiums earned will
continue to remain at lower levels than in previous periods for the near future
as we complete our exit from these lines. However, we believe that rate
increases related to our medical professional liability line will eventually
offset the decrease in net premiums earned from the exit of our workers
compensation and health lines. Investment income for the three months ended June 30, 2004 was $12.3
million, an increase of $1.9 million from the same period in 2003. For the six
months ended June 30, 2004, investment income was $25.5 million, a $4.7 million
increase compared to the same period in 2003. The increases in investment income during 2004 were
the result of strong returns on our collateralized-mortgage obligations and
high-yield bond portfolios, one-time call premiums of $1.2 million, and a
decrease in the percentage of our investment portfolio that was allocated to
short-term investments. Overall, the yield on our investment portfolio
increased to 6.41% for the six months ended June 30, 2004 compared to 5.46% for
the six months ended June 30, 2003. Near the end of the first quarter of 2004 we began to liquidate our $50
million investment in high-yield bonds. As of June 30, 2004, the portfolio had
been sold for a pre-tax gain of $1.6 million, of which $460,000 was realized in
the second quarter. In addition, we liquidated the majority of our other
non-investment grade securities for a gain of $2.6 million. The liquidation of
our high-yield and other non-investment grade securities has reduced the
overall risk level associated with our investment portfolio, but is likely to
decrease future investment income as we reinvest in lower-risk, lower-yielding
securities. During the three months ended June 30, 2004, we purchased
approximately $140 million of U.S. Government Agency securities. These
securities will yield rates ranging from 5.8% to 6.3%. Offsetting the gains realized on the liquidation of our high-yield bonds
and other non-investment grade securities, during the three months ended June
30, 2004, was a $2.5 million charge for the write-off of capitalized software
costs associated with an information system project involving a computer system
to administer medical professional liability policies and claims. This
project, which began in the fall of 2002, was not producing the anticipated
results and therefore, management decided to discontinue the project. In an
effort to simplify the Companys investment portfolio, management has
accelerated its plans to divest its investment real estate properties. This
approach may result in the book value of these properties not being fully
realized in the event of a sale. Accordingly, we have recorded a $750,000
impairment charge related to these properties. The loss ratios for the three months and six months ended June 30, 2004
were 88.2% and 90.2%, respectively, which represent decreases of 5.4% and 4.6%
compared to the same periods of 2003. The improvement in the loss ratios was
primarily the result of underwriting changes and rate increases related to our
medical professional liability segment that have been implemented over the last
two years, as well as our continued exit from the workers compensation and
health lines of insurance. Partially offsetting these positive factors was a
$4.4 25




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##### Table of Contents



million increase in incurred losses from the commutation of our
reinsurance treaties with Gerling. In 2002, Gerling placed its U.S.
reinsurance operations into run-off, which resulted in
several A.M. Best Company rating downgrades for Gerling. While Gerling
continued to perform in accordance with the terms of our treaties, our
recoverables from Gerling represented a significant credit risk on our balance
sheet, with a net recoverable of $17.1 million. In exchange for releasing
Gerling from its obligations under the treaties, we received $13.5 million in
cash, or approximately 79% of the net recoverable amount. The increases in the underwriting expense ratio from 2003 to 2004 are
primarily attributable to severance costs incurred in connection with the
downsizing of non-operational support staff in our home office. In total, we
have eliminated approximately 20 positions with severances totaling
approximately $450,000 and $1.5 million during the three months and six months
ended June 30, 2004, respectively. These 20 positions represent annual salary
and employee benefit costs of approximately $1.4 million. In addition to
severance costs recorded in the first half of 2004, approximately $500,000 of
incremental professional service fees have been incurred during 2004 in
connection with documentation of the insurance company operations necessary to
comply with the recent Sarbanes-Oxley legislation, and other corporate
initiatives. While compliance with the provisions of Sarbanes-Oxley will be an
ongoing matter, we anticipate that costs incurred in 2004 will be more
significant than in subsequent years. The increases in investment expenses were primarily the result of
additional fees related to the management of our equity securities and
high-yield bond portfolio, as these investments were not acquired until late in
the second quarter of 2003. With the liquidation of our high-yield bond
portfolio, we expect to see a decrease in investment expenses in future
periods. However, these decreases should be at least partially offset as our equity
security portfolio grows. The increases in interest expense are related to the issuance of
approximately $30.9 million of long-term debt in connection with the issuance
of mandatorily redeemable trust preferred securities in May 2003. This
long-term debt and the transactions that gave rise to its issuance are more
fully described in Item 8  Notes to Consolidated Financial Statements
included in our Annual Report on Form 10-K for the year ended December 31,
2003. The increases in interest expense related to this long-term debt were
partially offset by the elimination of interest associated with an obligation
to the Companys former President and Chief Executive Officer. This obligation
was fully repaid in January 2004 in connection with his retirement. The increases in amortization expense were primarily related to an
intangible asset arising from a two-year covenant not to compete with the
Companys former CEO and President upon his retirement effective December 31,
2003. The increases in general and administrative expenses were primarily the
result of increased legal, audit and other professional fees incurred as a
result of the recent Sarbanes-Oxley legislation and the continued exploration
of strategic alternatives by the Board of Directors. The Board of Directors
completed its review of alternatives in late June 2004. As a result, we
anticipate that general and administrative costs in future periods will
decrease during the remainder of 2004 from levels experienced in the first six
months of 2004 but probably not to historical levels as the Company will
continue to incur costs associated with ongoing Sarbanes-Oxley compliance. 26




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##### Table of Contents



Other expenses represent the accrual of stay bonuses and termination
benefits associated with our exit from the workers compensation line of
business. The impact of employee separation costs related to the exit from our
workers compensation line of business is more fully described in Note 8 to the
unaudited Condensed Consolidated Financial Statements, included elsewhere in
this report. The effective tax rates for the three months and six months ended June 30,
2004 were 13.4% and (7.2%) compared to 35.0% for the three months and six
months ended June 30, 2003. In periods of reported net income, tax accounting
rules permit the recognition of the change in the deferred tax valuation
allowance that pertains to items that are not related to continuing operations,
such as unrealized appreciation or depreciation on investment securities, as a
component of that measure of income to which they pertain. In accordance with
this guidance, we have recorded the effect of the change in the valuation
allowance related to unrealized appreciation or depreciation on investment
securities as a component of other comprehensive income in the second quarter
of 2004. This effectively reverses the federal income tax benefit recorded
during the three months ended March 31, 2004. The federal income tax benefit
recorded for the six months ended June 30, 2004 represents the reversal of tax
cushion that we had been maintaining in connection with an amended return
filed for tax year 2000. Although we have not yet received the refund related
to the 2000 amended return, dialogue with the Internal Revenue Service has
indicated that the refund is being processed as requested, and the cushion is
therefore no longer needed. 27




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##### Table of Contents



Medical Professional Liability Results of Operations The following table sets forth the results of operations of our medical
professional liability insurance segment for the three months and six months
ended June 30, 2004 and 2003. Three Months Ended June 30,
    
    Six Months Ended June 30,Percentage
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percentage2004
    
    2003
    
    Change
    
    Change
    
    2004
    
    2003
    
    Change
    
    Change(dollars in thousands)Direct premiums written:Illinois
    
    $
    9,416
    
    
    $
    7,908
    
    
    $
    1,508
    
    
    
    19.1
    %
    
    $
    24,218
    
    
    $
    20,838
    
    
    $
    3,380
    
    
    
    16.2
    %Michigan
    
    
    13,962
    
    
    
    7,339
    
    
    
    6,623
    
    
    
    90.2
    %
    
    
    23,139
    
    
    
    15,781
    
    
    
    7,358
    
    
    
    46.6
    %Ohio
    
    
    7,879
    
    
    
    8,323
    
    
    
    (444
    )
    
    
    -5.3
    %
    
    
    18,285
    
    
    
    16,228
    
    
    
    2,057
    
    
    
    12.7
    %New Mexico
    
    
    4,195
    
    
    
    3,212
    
    
    
    983
    
    
    
    30.6
    %
    
    
    9,220
    
    
    
    7,025
    
    
    
    2,195
    
    
    
    31.2
    %Kentucky
    
    
    1,249
    
    
    
    1,798
    
    
    
    (549
    )
    
    
    -30.5
    %
    
    
    9,048
    
    
    
    10,013
    
    
    
    (965
    )
    
    
    -9.6
    %Florida  PIC
    
    
    2,046
    
    
    
    
    
    
    
    2,046
    
    
    
    
    
    
    
    3,308
    
    
    
    
    
    
    
    3,308Other
    
    
    371
    
    
    
    226
    
    
    
    145
    
    
    
    64.2
    %
    
    
    3,005
    
    
    
    1,993
    
    
    
    1,012
    
    
    
    50.8
    %Nevada
    
    
    1,167
    
    
    
    1,374
    
    
    
    (207
    )
    
    
    -15.1
    %
    
    
    2,441
    
    
    
    2,418
    
    
    
    23
    
    
    
    1.0
    %Florida
    
    
    148
    
    
    
    901
    
    
    
    (753
    )
    
    
    -83.6
    %
    
    
    393
    
    
    
    4,376
    
    
    
    (3,983
    )
    
    
    -91.0
    %Total
    
    $
    40,433
    
    
    $
    31,081
    
    
    $
    9,352
    
    
    
    30.1
    %
    
    $
    93,057
    
    
    $
    78,672
    
    
    $
    14,385
    
    
    
    18.3
    %Net premiums written
    
    $
    35,690
    
    
    $
    26,615
    
    
    $
    9,075
    
    
    
    34.1
    %
    
    $
    79,939
    
    
    $
    66,734
    
    
    $
    13,205
    
    
    
    19.8
    %Net premiums earned:Excluding Gerling
    
    $
    42,722
    
    
    $
    38,375
    
    
    $
    4,347
    
    
    
    11.3
    %
    
    $
    85,178
    
    
    $
    77,860
    
    
    $
    7,318
    
    
    
    9.4
    %Impact of Gerling commutation
    
    
    837
    
    
    
    
    
    
    
    837
    
    
    
    
    
    
    
    837
    
    
    
    
    
    
    
    837Total
    
    
    43,559
    
    
    
    38,375
    
    
    
    5,184
    
    
    
    13.5
    %
    
    
    86,015
    
    
    
    77,860
    
    
    
    8,155
    
    
    
    10.5
    %Incurred loss and loss
adjustment expenses:Current accident year losses
    
    
    36,578
    
    
    
    37,233
    
    
    
    (655
    )
    
    
    -1.8
    %
    
    
    75,676
    
    
    
    77,419
    
    
    
    (1,743
    )
    
    
    -2.3
    %Prior year losses  Gerling commutation
    
    
    4,139
    
    
    
    
    
    
    
    4,139
    
    
    
    
    
    
    
    4,139
    
    
    
    
    
    
    
    4,139Prior year losses, excluding Gerling
    
    
    (4,436
    )
    
    
    250
    
    
    
    (4,686
    )
    
    
    -1874.4
    %
    
    
    (4,849
    )
    
    
    1,250
    
    
    
    (6,099
    )
    
    
    -487.9
    %Total
    
    
    36,281
    
    
    
    37,483
    
    
    
    (1,202
    )
    
    
    -3.2
    %
    
    
    74,966
    
    
    
    78,669
    
    
    
    (3,703
    )
    
    
    -4.7
    %Underwriting expenses
    
    
    8,981
    
    
    
    7,076
    
    
    
    1,905
    
    
    
    26.9
    %
    
    
    18,155
    
    
    
    14,892
    
    
    
    3,263
    
    
    
    21.9
    %Underwriting loss
    
    $
    (1,703
    )
    
    $
    (6,184
    )
    
    $
    4,481
    
    
    
    72.5
    %
    
    $
    (7,106
    )
    
    $
    (15,701
    )
    
    $
    8,595
    
    
    
    54.7
    %Income before federal income taxes
and minority interest
    
    $
    8,789
    
    
    $
    2,835
    
    
    $
    5,954
    
    
    
    210.0
    %
    
    $
    15,771
    
    
    $
    1,657
    
    
    $
    14,114
    
    
    
    851.8
    %Loss ratio:Accident year
    
    
    84.0
    %
    
    
    97.0
    %
    
    
    -13.0
    %
    
    
    
    
    
    
    88.0
    %
    
    
    99.4
    %
    
    
    -11.4
    %Prior years
    
    
    -0.7
    %
    
    
    0.7
    %
    
    
    -1.4
    %
    
    
    
    
    
    
    -0.8
    %
    
    
    1.6
    %
    
    
    -2.4
    %Calendar year
    
    
    83.3
    %
    
    
    97.7
    %
    
    
    -14.4
    %
    
    
    
    
    
    
    87.2
    %
    
    
    101.0
    %
    
    
    -13.8
    %Underwriting expense ratio
    
    
    20.6
    %
    
    
    18.4
    %
    
    
    2.2
    %
    
    
    
    
    
    
    21.1
    %
    
    
    19.1
    %
    
    
    2.0
    %Combined ratio
    
    
    103.9
    %
    
    
    116.1
    %
    
    
    -12.2
    %
    
    
    
    
    
    
    108.3
    %
    
    
    120.1
    %
    
    
    -11.8
    %
 Direct premiums written increased primarily as a result of rate increases,
particularly in the states of Michigan, Illinois and Ohio. The Michigan and
Illinois rate increase took effect April 1, 2004. These increases were
partially offset by reduced physician counts in Kentucky and Ohio, where we
have discontinued writing occurrence-based policies and other high-risk
specialties, and Florida, which we began to exit in late 2002. At June 30,
2004, our insured physician count totaled approximately 10,000, down 4.1% from
December 31, 2003 and 6.1% from June 30, 2003. The majority of the
direct premiums written in the state of Florida were from our consolidated
subsidiary, Physicians Insurance Company (PIC). See Note 2 of the Notes to
unaudited Condensed Consolidated Financial Statements, included elsewhere in
this report, for further information regarding PIC. We are currently exploring
various options to divest our investment in PIC. We anticipate that direct
premiums written in this segment will continue to increase in the near-term, as
we implement additional rate increases. 28




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##### Table of Contents



Effective January 1, 2004, we modified a reinsurance arrangement so that
we retain a 30% participation in our primary medical professional liability
excess of loss contract, which reinsures the first $500,000 of a loss in excess
of $500,000. We anticipate that the retention of this additional risk will
result in an increase in net premiums written of approximately $10 million
during 2004. However, this increase is expected to be partially offset by an
increase in the overall cost of our reinsurance programs and an increase in net
incurred losses. As a result, we expect the impact of the modification on net
income to be immaterial. Net premiums earned did not increase as much as direct and net premiums
written as many of the rate increases taken in the later part of 2003 and early
2004 have not yet been fully earned. Net premiums earned for the three months
and six months ended June 30, 2004 include $837,000 related to the commutation
of reinsurance treaties with Gerling. Incurred loss and loss adjustment expenses decreased as a result of
decreases in net paid losses and lower reported claim counts. Net paid losses
for the three months and six months ended June 30, 2004 were $19.9 million and
$51.8 million, respectively, which represent decreases of $16.7 million and
$23.9 million compared to the same periods of 2003. Net paid losses during the
three months and six months ended June 30, 2004 were impacted by the
commutation of reinsurance treaties with Gerling, which reduced the amount
reported for both periods by $13.5 million. Claims reported to us during the
three months and six months ended June 30, 2004 numbered 459 and 984,
respectively, compared to 694 and 1,497, respectively, for the three months and
six months ended June 30, 2003. We believe that the decreases in our paid
losses and reported claim counts are the result of stricter underwriting
standards that we have worked to implement over the past few years. The
decrease in incurred loss and loss adjustment expenses combined with the
increase in net premiums earned resulted in a decrease of the loss ratio to
83.3% and 87.2% for the three months and six months ended June 30, 2004,
respectively, compared to 97.7% and 101.0%, respectively for the same periods
of 2003. The commutation of our reinsurance treaties with Gerling had the effect of
increasing medical professional liability losses incurred during the three
months and six months ended June 30, 2004 by approximately $4.1 million. The
losses covered under the Gerling treaties all related to prior accident years.
Without the impact of the Gerling commutation, we would have reported favorable
development on prior accident year losses of $4.4 million and $4.8 million for
the three and six months ended June 30, 2004. This favorable development is
the result of reported loss frequency developing more favorably than
anticipated at December 31, 2003, especially in our Michigan and Ohio markets. The increase in underwriting expenses is attributable to the payment of
severance costs relating to a reduction in headcount and an increase in
professional service costs relating to our initial internal controls audit
required by the Sarbanes Oxley Act and related SEC rules, as discussed under
 Consolidated Results of Operations. 29




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##### Table of Contents



Other Insurance Lines Results of Operations The following table sets forth the results of operations of our other
insurance lines segment for the three months and six months ended June 30, 2004
and 2003. The other insurance lines segment consists of the operations of our
workers compensation, health and personal and commercial lines of business. Three Months Ended June 30,
    
    Six Months Ended June 30,Percentage
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percentage2004
    
    2003
    
    Change
    
    Change
    
    2004
    
    2003
    
    Change
    
    Change(dollars in thousands)Direct premiums written:Workers compensation
    
    $
    (167
    )
    
    $
    12,943
    
    
    $
    (13,110
    )
    
    
    -101.3
    %
    
    $
    27
    
    
    $
    20,168
    
    
    $
    (20,141
    )
    
    
    -99.9
    %Health
    
    
    3,083
    
    
    
    5,740
    
    
    
    (2,657
    )
    
    
    -46.3
    %
    
    
    6,605
    
    
    
    12,582
    
    
    
    (5,977
    )
    
    
    -47.5
    %Total
    
    $
    2,916
    
    
    $
    18,683
    
    
    $
    (15,767
    )
    
    
    -84.4
    %
    
    $
    6,632
    
    
    $
    32,750
    
    
    $
    (26,118
    )
    
    
    -79.7
    %Net premiums written
    
    $
    2,358
    
    
    $
    18,379
    
    
    $
    (16,021
    )
    
    
    -87.2
    %
    
    $
    6,142
    
    
    $
    33,097
    
    
    $
    (26,955
    )
    
    
    -81.4
    %Net premiums earned
    
    $
    7,568
    
    
    $
    16,121
    
    
    $
    (8,553
    )
    
    
    -53.1
    %
    
    $
    19,189
    
    
    $
    35,072
    
    
    $
    (15,883
    )
    
    
    -45.3
    %Incurred loss and loss
adjustment expenses:Current accident year losses
    
    
    6,640
    
    
    
    13,754
    
    
    
    (7,114
    )
    
    
    -51.7
    %
    
    
    16,382
    
    
    
    29,660
    
    
    
    (13,278
    )
    
    
    -44.8
    %Prior year losses  Gerling commutation
    
    
    271
    
    
    
    
    
    
    
    271
    
    
    
    
    
    
    
    271
    
    
    
    
    
    
    
    271Prior year losses, excluding Gerling
    
    
    1,895
    
    
    
    (207
    )
    
    
    2,102
    
    
    
    1015.5
    %
    
    
    3,308
    
    
    
    (1,317
    )
    
    
    4,625
    
    
    
    351.2
    %Total
    
    
    8,806
    
    
    
    13,547
    
    
    
    (4,741
    )
    
    
    -35.0
    %
    
    
    19,961
    
    
    
    28,343
    
    
    
    (8,382
    )
    
    
    -29.6
    %Underwriting expenses
    
    
    2,902
    
    
    
    4,744
    
    
    
    (1,842
    )
    
    
    -38.8
    %
    
    
    5,993
    
    
    
    10,215
    
    
    
    (4,222
    )
    
    
    -41.3
    %Underwriting loss
    
    $
    (4,140
    )
    
    $
    (2,170
    )
    
    $
    (1,970
    )
    
    
    -90.8
    %
    
    $
    (6,765
    )
    
    $
    (3,486
    )
    
    $
    (3,279
    )
    
    
    -94.1
    %Income before federal income taxes
and minority interest
    
    $
    (3,238
    )
    
    $
    (350
    )
    
    $
    (2,888
    )
    
    
    -825.1
    %
    
    $
    (4,317
    )
    
    $
    (285
    )
    
    $
    (4,032
    )
    
    
    -1414.7
    %Loss ratio:Accident year
    
    
    87.7
    %
    
    
    85.3
    %
    
    
    2.4
    %
    
    
    
    
    
    
    85.4
    %
    
    
    84.6
    %
    
    
    0.8
    %Prior years
    
    
    28.6
    %
    
    
    -1.3
    %
    
    
    29.9
    %
    
    
    
    
    
    
    18.7
    %
    
    
    -3.8
    %
    
    
    22.5
    %Calendar year
    
    
    116.3
    %
    
    
    84.0
    %
    
    
    32.3
    %
    
    
    
    
    
    
    104.1
    %
    
    
    80.8
    %
    
    
    23.3
    %Underwriting expense ratio
    
    
    38.3
    %
    
    
    29.4
    %
    
    
    8.9
    %
    
    
    
    
    
    
    31.2
    %
    
    
    29.1
    %
    
    
    2.1
    %Combined ratio
    
    
    154.6
    %
    
    
    113.4
    %
    
    
    41.2
    %
    
    
    
    
    
    
    135.3
    %
    
    
    109.9
    %
    
    
    25.4
    %
 The decreases in direct premiums written were the result of our continued
exit from the workers compensation and health lines of business. In the first
quarter of 2004, we began the process of non-renewing all workers compensation
policies. In addition, as is often the case when a company announces its exit
from a certain line of business, a number of our policyholders with policies
currently in-force cancelled their coverage. Workers compensation direct
premiums written for the three months and six months ended June 30, 2004 were
$(167,000) and $27,000, respectively, which represent decreases of $13.1
million and $20.1 million, respectively, compared to the same period of 2003. Due to certain contractual obligations with a third-party who administers
a substantial portion of our health insurance business we were not able to
begin non-renewing health policies until July 1, 2004. However, during the
first six months of 2004, we implemented very strict underwriting and pricing
guidelines that resulted in a 35.0% reduction in the number of covered lives
since December 31, 2003 and a 49.9% reduction since June 30, 2003. Health
direct premiums written were $3.1 million and $6.6 million, respectively, for
the three months and six 30




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##### Table of Contents



months ended June 30, 2004. For the three months and
six months ended June 30, 2003, health direct premiums written were $5.7
million and $12.6 million, respectively. The decreases in net premiums written were relatively consistent with the
decreases in direct premiums written. Net premiums earned, however, did not
decrease as much as direct and net premiums written as premiums associated with
workers compensation policies written in 2003 continue to be earned in 2004.
As of June 30, 2004, there remained $3.4 million of net unearned premiums
related to our workers compensation line. We anticipate that the majority of
these premiums will be earned during the remainder of 2004. In addition, we
anticipate that direct and net premiums written as well as net premiums earned
related to our other insurance lines will continue to decrease as we continue
the process of non-renewing policies during our exit from these lines. Incurred loss and loss adjustment expenses decreased primarily as the
result of the decrease in exposure associated with the decrease in the number
of covered lives in our health line, and the number of policies in force for
workers compensation. Prior year workers compensation reserves developed
unfavorably during the quarter by $2.4 million and year-to-date by $3.8
million. The unfavorable development on prior accident years for both the
three months and six months ended June 30, 2004 includes $271,000 related to
the Gerling commutation. The unfavorable development on prior accident year
reserves for workers compensation is primarily the result of increasing
reserve estimates due to higher paid losses than those originally projected in
the estimation of the year-end 2003 reserves. The decrease in underwriting expenses is primarily the result of reduced
salary and employee benefit costs as a result of the departure of the workers
compensation management team in the last nine months of 2003. Also, as a
result of the decreased premium volume, there was a decrease in corporate and
shared services salary, employee benefit and other costs allocated to the other
insurance lines segment. As we continue our exit from these lines, these
underwriting expenses should continue to decrease. Corporate and Other Loss before federal income taxes and minority interests for this segment
was $2.0 million for the three months ended June 30, 2004 compared to a loss of
$782,000 for the three months ended June 30, 2003. For the six months ended
June 30, 2004, this segment incurred a loss before federal income taxes and
minority interest of $3.1 million compared to $1.2 million for the same period
of 2003. The increases in the loss were attributable to increases in general
and administrative expenses and interest expense, which are described more
fully in  Consolidated Results of Operations. 31




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##### Table of Contents



Liquidity and Capital Resources The primary sources of our liquidity, on both a short- and long-term
basis, are funds provided by insurance premiums collected, net investment
income, recoveries from reinsurers and proceeds from the maturity or sale of
invested assets. We also enter into financing transactions from time to time
to acquire additional capital, such as the issuance of trust preferred
securities and related 30 year debentures in May 2003, which resulted in the
incurrence of $30.9 million in long-term debt, as described in Note 9 of the
Notes to Consolidated Financial Statements included in our Annual Report on
Form 10-K for the year ended December 31, 2003. The primary uses of cash, on
both a short- and long-term basis, are losses, loss adjustment expenses,
operating expenses, the acquisition of invested assets and fixed assets,
reinsurance premiums, interest payments, taxes, and the repurchase of the
Companys stock. Our holding companys only material assets are the capital stock of
American Physicians and its other subsidiaries, and cash. APCapitals cash
flow consists primarily of dividends and other permissible payments from its
subsidiaries and investment earnings on funds held. The payment of dividends
to APCapital by its insurance subsidiaries is subject to limitations imposed by
applicable law. Currently, approximately $14.8 million of dividends could be
paid to APCapital without prior approval by the State of Michigan Office of
Financial and Insurance Services. APCapitals primary uses of cash, on both a
short- and long-term basis, include periodic interest payments, operating
expenses and the repayment of the debentures. In January 2004, APCapital made
a $25 million surplus contribution to its American Physicians subsidiary, and
in May 2004, APCapital contributed all of the outstanding common stock of
APSpecialty Insurance Corporation to American Physicians. The purpose of the
contributions was to increase American Physicians statutory capital and
surplus, which is a critical factor in the financial stability rating process
by insurance rating agencies such as A.M. Best. At June 30, 2004, APCapitals
cash and cash equivalent resources totaled approximately $1.9 million, which
will be held at the holding company for future debt service and other operating
costs. At June 30, 2004, we had no material planned expenditures for the
acquisition of assets, or other expenditures, other than expenses incurred in
the normal course of operations. The Board of Directors has authorized the Company to purchase shares of
its outstanding common stock from time to time, most recently in September
2003. There were no shares repurchased during the three or six months ended
June 30, 2004. The total number of shares purchased pursuant to these
authorizations as of June 30, 2004 was 3,197,070, at a total cost of
$60,382,000, or an average price per share of $18.89. The Companys repurchase
of any of its shares is subject to limitations that may be imposed by
applicable laws and regulations and the rules of the Nasdaq Stock Market. The
timing of the purchases and the number of shares to be bought at any one time
depend on market conditions and the Companys capital requirements. As of June
30, 2004, the Company has 418,369 shares of its September, 2003 stock
repurchase program remaining to be purchased. The Company does not anticipate
repurchasing any of its shares in the near future, as it plans to conserve
capital to support future premium growth. Our net cash flow provided by operations was $38.4 million for the six
months ended June 30, 2004, compared to $10.3 million used in operations for
the same period of 2003. The increase in cash flow from operations was
primarily the result of a $23.9 million decrease in paid 32




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##### Table of Contents



losses (including the $13.5
million received from Gerling) for the six
months ended June 30, 2004 compared to 2003, and a $16.9 million increase in
cash relating to pending security transactions. The increase in cash provided
was partially offset by an $11.0 million payment for ceded reinsurance premiums
in February 2004 related to our swing-rated reinsurance treaties. At June 30, 2004, the Company had $140.1 million of cash and cash
equivalents available and an investment portfolio of $709.4 million. The
portfolio includes $68.0 million of bonds maturing in the next year to meet
short-term cash flow needs. On a long-term basis, fixed income securities are
purchased on a basis intended to provide adequate cash flows from future
maturities to meet future policyholder obligations and ongoing cash needs to
fund operations. As of June 30, 2004, our fixed maturity portfolio included
$262.5 million of bonds that mature in the next one to five years and $77.0
million that mature in the next five to ten years. In addition, at June 30,
2004, we have $147.2 million of mortgage-backed securities that provide
periodic principal repayments. Based on historical trends, market conditions and our business plans, we
believe that our existing resources and sources of funds, including payments
from our insurance subsidiaries to our holding company, will be sufficient to
meet our short- and long-term liquidity needs. However, economic, market and
regulatory conditions may change, and there can be no assurance that our funds
will be sufficient to meet these liquidity needs. Financial Condition In evaluating our financial condition, two factors are the most critical.
First, the availability of adequate statutory capital and surplus to satisfy
state regulatory requirements and our current A.M. Best Company rating, and
second, the adequacy of our reserves for unpaid loss and loss adjustment
expenses. Statutory Capital and Surplus Our statutory capital and surplus (collectively referred to herein as
surplus) at June 30, 2004 was approximately $223.9 million, which resulted in
a net premiums written to surplus ratio of 0.93:1. Surplus at December 31,
2003 was approximately $150.3 million, yielding a net premiums written to
surplus ratio of 1.49:1. The decrease in our ratio of net premiums written to
surplus was primarily the result of the $25 million cash capital contribution,
and the contribution of APSpecialty Insurance Corporations common stock,
valued at approximately $20.5 million on a statutory basis, to American
Physicians, the improved underwriting results of the first two quarters of 2004
and the decrease in net premiums written as a result of our exit from the
workers compensation and health lines of business. The continued exit from
the workers compensation and health insurance lines of business in 2004 is
expected to provide additional surplus to support future medical professional
liability premiums. Reserves for Unpaid Losses and Loss Adjustment Expenses The adequacy of our reserves for unpaid loss and loss adjustment expenses
is another critical factor in evaluating our financial condition. 33




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##### Table of Contents



For the six months ended June 30, 2004, we recorded an increase in
ultimate loss estimates, net of reinsurance, for accident years 2003 and prior
of $2.9 million, or 0.5% of
$574.6 million of net loss and loss adjustment expense reserves as of December
31, 2003. Approximately $4.4 million of the unfavorable development on prior
year reserves was attributable to the commutation of our reinsurance treaties
with Gerling. This amount more than offset $1.5 million of favorable
development in prior year reserves during the first six months of 2004. This
favorable development was almost entirely attributable to our medical
professional liability segment, partially offset by $3.5 million (excluding the
effects of the Gerling commutation) of unfavorable development on our workers
compensation line of business. The adverse development for workers
compensation was the result of paid losses exceeding those originally projected
in the estimation of the December 31, 2003 reserves. Historical results have
shown that ultimate losses have varied from our initial estimates in a range of
plus or minus 8%. The following table shows net case reserves, net incurred but not reported
(IBNR) claims reserves, total net reserves, open claim counts, and average
net case reserve per open claim for our medical professional liability segment
at June 30, 2004 and December 31, 2003. Amounts included in the table exclude
the case and IBNR reserves of PIC. Although PIC is a consolidated entity, we
do not control or manage it and we are currently exploring various options to
divest our investment in PIC. PIC net case reserves were $517,000 and $82,000
at June 30, 2004 and December 31, 2003, respectively, while its net IBNR
reserves were $332,000 and $284,000, respectively, at the same dates. Net
    
    Net
    
    Total
    
    Number
    
    Average NetCase
    
    IBNR
    
    Net
    
    of Open
    
    Case ReserveReserves
    
    Reserves
    
    Reserves
    
    Claims
    
    Per Open Claim(In thousands, except claim counts)December 31, 2003
    
    $
    389,439
    
    
    $
    117,522
    
    
    $
    506,961
    
    
    
    4,447
    
    
    $
    87.6Change
    
    
    (373
    )
    
    
    23,056
    
    
    
    22,683
    
    
    
    (562
    )
    
    
    12.6June 30, 2004
    
    $
    389,066
    
    
    $
    140,578
    
    
    $
    529,644
    
    
    
    3,885
    
    
    $
    100.1
 Net IBNR reserves have increased approximately $23.1 million from December
31, 2003 in part due to the commutation of the Gerling reinsurance treaties,
which resulted in an increase of approximately $5.1 million. In addition, our
efforts to standardize our claims handling and processing across our various
regional offices resulted in a decrease in net case reserves and an increase in
net IBNR related to our New Mexico business of approximately $5 million. The
remaining $13 million increase in IBNR was the result of the favorable reported
loss development during the first six months of 2004 having a less significant
impact on the actuarial estimate of ultimate losses than it did on recorded
case reserves. Quarterly reported loss volatility can have a significant
impact on changes in IBNR because the reported loss development in a single
quarter, while directly impacting our net case reserves, does not always
represent enough data to significantly change the trends used by actuaries to
estimate ultimate losses that form the basis for our determination of total net
reserves. 34




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##### Table of Contents



Activity in the liability for unpaid loss and loss adjustment expenses by
insurance segment for the six months ended June 30, 2004 was as follows: Medical
    
    OtherProfessional
    
    InsuranceLiability
    
    Lines
    
    Consolidated(In thousands)Balance, December 31, 2003
    
    $
    598,329
    
    
    $
    75,276
    
    
    $
    673,605Less, reinsurance recoverables
    
    
    91,002
    
    
    
    7,956
    
    
    
    98,958Net reserves, December 31, 2003
    
    
    507,327
    
    
    
    67,320
    
    
    
    574,647Incurred related toCurrent year
    
    
    75,676
    
    
    
    16,382
    
    
    
    92,058Prior years
    
    
    (710
    )
    
    
    3,579
    
    
    
    2,869Total
    
    
    74,966
    
    
    
    19,961
    
    
    
    94,927Paid related toCurrent year
    
    
    1,065
    
    
    
    6,143
    
    
    
    7,208Prior years
    
    
    50,737
    
    
    
    19,713
    
    
    
    70,450Total
    
    
    51,802
    
    
    
    25,856
    
    
    
    77,658Net reserves, June 30, 2004
    
    
    530,491
    
    
    
    61,425
    
    
    
    591,916Plus, reinsurance recoverables
    
    
    85,946
    
    
    
    4,536
    
    
    
    90,482Balance, June 30, 2004
    
    $
    616,437
    
    
    
    65,961
    
    
    $
    682,398Development as a % of
December 31, 2003 net reserves
    
    
    -0.1
    %
    
    
    5.3
    %
    
    
    0.5
    %
 Other Significant Balance Sheet Items Our invested assets consist primarily of fixed maturity and equity
securities, which are carried in the unaudited Condensed Consolidated Balance
Sheets, included elsewhere in this report, at their estimated fair value,
investment real estate, and investment real estate limited partnerships. At
June 30, 2004, our investment portfolio included net unrealized gains of
approximately $27.2 million, a decrease of $18.3 million compared to December
31, 2003. Net unrealized gains are reported, net of tax, in the shareholders
equity section of the unaudited Condensed Consolidated Balance Sheets, included
elsewhere in this report, and represented approximately 5.9% and 14.7% of
consolidated shareholders equity at June 30, 2004 and December 31, 2003,
respectively. The decrease in unrealized gains was the result of an
approximately 100 basis point increase in interest rates in April of 2004.
Generally, the estimated fair value of our fixed maturity securities is
inversely related to current interest rates. Therefore, as interest rates rise
or fall, our net unrealized gains should change accordingly. See
Item 3  Quantitative and Qualitative Disclosure About Market Risk, for further
information regarding the potential impact of changes in prevailing interest
rates on the fair value of our fixed maturity portfolio. The cross-referenced
information is incorporated herein by reference. Premiums receivable decreased $18.3 million, or 28.0% to $47.1 million at
June 30, 2004. The decrease in the premiums receivable balance was primarily
the result of the collection of workers compensation premiums written in 2003.
With our exit from this line, these 35




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##### Table of Contents



premium writings were not replaced in 2004, and consequently, the premium
receivable balance has decreased. Reinsurance
recoverables decreased $9.4 million to $94.2 million at June
30, 2004, from $103.6 million at December 31, 2003. The decrease was primarily
the result of the commutation with Gerling, which resulted in a decrease of
$17.9 million, partially offset by an increase in ceded case reserves, as
several claims have been recently reserved at levels above our retention of
$500,000. At June 30, 2004, we had a $3.2 million reinsurance recoverable from
PMA Capital Insurance Company (PMACIC). We have not experienced any delays in
payments from PMACIC; however, effective July 29, 2004, PMA Capital,
PMACICs parent company, announced that it had revised the
companys corporate structure and had separated its on-going
operations from its run-off operations, which include PMACIC. This
action may have a negative impact on PMACICs future cash flows
and surplus levels. Following this corporate reorganization, A.M.
Best Company downgraded PMACICs financial strength rating from
B++ (Very Good) to B+ (Very Good), but, according to A.M. Bests
news release announcing the downgrade, it continues to expect
PMACICs operations will run-off adequately and the
rating remains in the secure category. At this time, it is difficult to predict
the impact of PMACICs recent actions on its future ability to
make payments to us. We intend to monitor this situation closely. At June 30, 2004 and December 31, 2003, we have no recorded deferred
federal income tax assets due to the establishment of a valuation allowance
during 2003. The valuation allowance was established in the third quarter of
2003 as the Companys recent loss experience increased the uncertainty with
respect to the generation of sufficient taxable income in the periods when the
deductible temporary differences that gave rise to the deferred tax assets are
expected to reverse. Once the Company has re-established a pattern of
profitability, the deferred tax asset valuation allowance may be reduced in
whole or in part upon evaluation of the availability of future taxable income. Other assets decreased $5.6 million from $41.0 million at December 31,
2003 to $35.4 million at June 30, 2004. This decrease was a result of
amortization of deferred policy acquisition costs as we continue to run-off our
workers compensation line of business, and the $2.5 million write-off of the
professional liability policy administration computer system described in
 Consolidated Results of Operations. Unearned premiums decreased $18.8 million from $103.8 million at December
31, 2003 to $85.0 million at June 30, 2004. This decrease was primarily the
result of our exit from the workers compensation line of business, which
continues to earn premiums written in 2003. As of June 30, 2004, workers
compensation unearned premiums were $3.4 million, a decrease of $13.1 million
compared to $16.5 million at December 31, 2003. Because we are in the process
of non-renewing all workers compensation business, the unearned premiums being
earned in 2004 are not being replaced with new workers compensation premium
writings. The $6.0 million obligation to our former President and CEO recorded at
December 31, 2003 was paid in its entirety in January 2004 in connection with
his retirement. Other liabilities increased $4.6 million from $44.7 million at December
31, 2003 to $49.3 million at June 30, 2004. In addition to accounts payable
and other accruals, other liabilities includes ceded reinsurance premium
payable, advanced premiums and a liability account for pending security
transactions. The $4.6 million increase is the result of a $17.0 million
increase in the liability for pending security transactions, partially offset
by a decrease in the ceded reinsurance premiums payable of $11.2 million during
the period as a result of an $11.0 million payment made in February related to
our swing rated medical professional liability reinsurance 36




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##### Table of Contents



treaty. The pending security transaction liability results when we
purchase securities near the end of the period, but those security transactions
do not settle until after the end of the period. Shareholders equity at June 30, 2004 was $193.1 million, a decrease of
$8.7 million from $201.8 million at December 31, 2003. The decrease was
primarily attributable to the unrealized depreciation on investment securities,
which, net of tax, totaled $18.3 million for the period. The decrease was
partially offset by reported net income of $9.0 million for the six months
ended June 30, 2004. The Companys book value per common share outstanding at
June 30, 2004 was $22.71 per share, based on 8,501,927 shares outstanding,
compared to $23.89 per common share outstanding at December 31, 2003. Total
shares outstanding at December 31, 2003 were 8,445,807. Contractual Obligations and Off-Balance Sheet Arrangements Our contractual obligations and off-balance sheet arrangements are
described in Item 7  Managements Discussion and Analysis of Financial
Condition and Results of Operations contained in our Annual Report on Form
10-K for the year ended December 31, 2003. Except as described elsewhere in
this report on Form 10-Q, there have been no material changes to those
obligations or arrangements outside of the ordinary course of business during
the most recent quarter. Effects of New Accounting Pronouncements The effects of new accounting pronouncements are described in Note 2 to
the unaudited Condensed Consolidated Financial Statements included elsewhere in
this report. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk General Market risk is the risk of loss due to adverse changes in market rates and
prices. We invest primarily in fixed maturity securities, which are
interest-sensitive assets. Accordingly, our primary market risk is exposure to
changes in interest rates. As of June 30, 2004, the majority of our investment portfolio was invested
in fixed maturity securities and short-term investments. The fixed maturity
securities primarily consisted of U.S. government and agency bonds,
high-quality corporate bonds, high-yield corporate bonds, mortgage-backed
securities and tax-exempt U.S. municipal bonds. Qualitative Information About Market Risk Investments in our portfolio have varying degrees of risk. The primary
market risk exposure to the fixed maturity portfolio is interest rate risk,
which is limited somewhat by our management of duration. The distribution of
maturities and sector concentrations are monitored on a regular basis. 37




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##### Table of Contents



Equity securities are carried at quoted market values. The fair value of
publicly traded fixed maturity securities is based upon independent market
quotations. The fair value of non-publicly traded securities is based on independent third party pricing
sources that use valuation models. The valuation models used by the
independent third party pricing sources use indicative information such as
ratings, industry, coupon, and maturity along with publicly traded bond prices
to determine security specific spreads, and the ultimate fair value of the
non-publicly traded fixed maturity securities. Realized gains or losses on
sales or maturities of investments are determined on a specific identification
basis and are credited or charged to income. At June 30, 2004, approximately 99.5% of our fixed maturity portfolio
(excluding approximately $13.5 million of private placement issues) was
considered investment grade. We define investment grade securities as those
that have a Standards & Poors credit rating of BBB and above. Non-investment
grade securities typically bear more credit risk than those of investment grade
quality. Credit risk is the risk that amounts due the Company by creditors may
not ultimately be collected. We periodically review our investment portfolio
for any potential credit quality or collection issues and for any securities
with respect to which we consider any decline in market value to be other than
temporary. In June 2003, the Company purchased the interest-only portion of several
mortgage-backed securities. Unlike traditional fixed maturity securities, the
fair value of these investments is not inversely related to interest rates, but
rather, moves in the same direction as interest rates as the underlying
financial instruments are mortgage-backed securities. In addition, with
mortgage-backed securities, as interest rates rise, prepayments will decrease,
which means that the interest-only certificates will generally generate
interest for a longer period of time than originally anticipated, which in turn
will increase the fair value of these investments. At June 30, 2004, the
Company had interest-only mortgage-backed securities with an estimated fair
value of $10.9 million. Approximately $6.7 million of these interest-only certificates have an
inverse floating rate of interest tied to LIBOR. The Company has determined
that these inverse floating interest-only certificates contain an embedded
derivative as defined by SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities. Because the Company cannot readily segregate the fair
value of the embedded derivative from the host debt instrument, the entire
change in the fair value of these inverse floating interest-only certificates
is reported in earnings as investment income. For the three and six months
ended June 30, 2004, approximately $85,000 and $293,000, respectively, of
income was included in investment income for the change in fair value of the
inverse floating interest-only certificates. Quantitative Information About Market Risk At June 30, 2004, our fixed income security portfolio was valued at $670.8
million and had an average modified duration of 2.57 years, compared to a
portfolio valued at $694.6 million with an average modified duration of 2.89
years at December 31, 2003. Of the $670.8 million at June 30, 2004, $10.9
million were interest-only certificates that had a modified duration of 1.00
year. The following tables show the effects of a change in interest rates on
the fair value and duration of our entire fixed maturity portfolio at June 30,
2004 and December 31, 2003, and then separately for our interest-only
certificates. We have assumed an immediate increase or decrease 38




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##### Table of Contents



of 1% or 2% in
interest rate for illustrative purposes. You should not consider this
assumption or the values shown in the table to be a prediction of actual future
results. Entire Fixed Maturity Portfolio (Including Interest-Only Certificates) June 30, 2004
    
    December 31, 2003Portfolio
    
    Change in
    
    Modified
    
    Portfolio
    
    Change in
    
    ModifiedChange in Rates
    
    Value
    
    Value
    
    Duration
    
    Value
    
    Value
    
    Duration(dollars in thousands)
    
    (dollars in thousands)+2%
    
    $
    638,389
    
    
    $
    (32,407
    )
    
    
    3.37
    
    
    $
    664,072
    
    
    $
    (30,561
    )
    
    
    3.07+1%
    
    
    655,091
    
    
    
    (15,705
    )
    
    
    2.76
    
    
    
    680,389
    
    
    
    (14,244
    )
    
    
    2.810
    
    
    670,796
    
    
    
    
    
    
    
    2.57
    
    
    
    694,633
    
    
    
    
    
    
    
    2.89-1%
    
    
    683,492
    
    
    
    12,696
    
    
    
    2.25
    
    
    
    708,257
    
    
    
    13,624
    
    
    
    2.80-2%
    
    
    696,385
    
    
    
    25,589
    
    
    
    2.25
    
    
    
    726,316
    
    
    
    31,683
    
    
    
    2.87
 Interest-Only Certificates June 30, 2004
    
    December 31, 2003Portfolio
    
    Change in
    
    Modified
    
    Portfolio
    
    Change in
    
    ModifiedChange in Rates
    
    Value
    
    Value
    
    Duration
    
    Value
    
    Value
    
    Duration(dollars in thousands)
    
    (dollars in thousands)+2%
    
    $
    13,979
    
    
    $
    3,100
    
    
    
    1.26
    
    
    $
    19,217
    
    
    $
    5,751
    
    
    
    1.57+1%
    
    
    13,026
    
    
    
    2,147
    
    
    
    1.19
    
    
    
    17,792
    
    
    
    4,326
    
    
    
    1.440
    
    
    10,879
    
    
    
    
    
    
    
    1.00
    
    
    
    13,466
    
    
    
    
    
    
    
    1.02-1%
    
    
    5,483
    
    
    
    (5,396
    )
    
    
    0.50
    
    
    
    7,136
    
    
    
    (6,330
    )
    
    
    1.03-2%
    
    
    3,164
    
    
    
    (7,715
    )
    
    
    0.33
    
    
    
    5,536
    
    
    
    (7,930
    )
    
    
    0.42
 
 Item 4. Controls and Procedures As of the end of the period covered by this report, the Company carried
out an evaluation, under the supervision and with the participation of the
Companys management, including its Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Companys
disclosure controls and procedures pursuant to Rule 13a-15 of the Securities
Exchange Act of 1934. Based upon that evaluation, the Companys Chief
Executive Officer and Chief Financial Officer concluded that the Companys
disclosure controls and procedures are effective to cause the material
information required to be disclosed by the Company in the reports that it
files or submits under the Securities Exchange Act of 1934 to be recorded,
processed, summarized and reported within the time periods specified in the
SECs rules and forms. There have been no changes in the Companys internal
controls over financial reporting during the quarter ended June 30, 2004 that
have materially affected, or are reasonably likely to materially affect the
Companys internal controls over financial reporting. 39




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##### Table of Contents



PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings On both December 30, 2003 and February 20, 2004, separate putative shareholder
class action complaints were filed in United States District Court for the
Western District of Michigan against the Company, its former President and
Chief Executive Officer, and its Chief Financial Officer. The complaints
allege violations of federal securities laws for certain disclosures made by
the Company between February 13, 2003 and November 6, 2003, regarding its
operating results and the adequacy of its reserves, and each seeks monetary
damages in an unspecified amount. The Company denies the allegations and
intends to vigorously defend the lawsuits. On March 23, 2004, the Court
dismissed the first case and entered an Order approving a lead plaintiff in the
second case. A consolidated amended complaint was filed by the lead plaintiff
on May 7, 2004. On June 28, 2004, the Company and the individual defendants
filed a motion to dismiss the complaint. While management believes that
meritorious defenses to the allegations exist, the ultimate disposition of this
litigation could have a material adverse impact on the Companys financial
position, liquidity and results of operations. 
 Item 4. Submission of Matters to a Vote of a Security Holders The Company held its Annual Meeting of Shareholders on August 4, 2004, at which
the shareholders elected four directors. Dr. Berglund was an incumbent, while
the other three nominees were nominated for their first term. All nominees
were elected. The following table sets forth the number of shares voted for and
withheld with respect to each nominee. Votes
    
    VotesNominee
    
    For
    
    WithheldR. Kevin Clinton
    
    
    7,974,425
    
    
    
    13,641Thomas R. Berglund, M.D.
    
    
    7,986,725
    
    
    
    1,341Daniel L. Gorman
    
    
    7,986,725
    
    
    
    1,341D. Joseph Olson, J.D.
    
    
    7,986,315
    
    
    
    1,751
 
 Item 6. Exhibits and Reports on Form 8-K (a)   Exhibits. The Exhibits included as part of this report are listed in the attached
Exhibit Index, which is Incorporated herein by reference. (b)   Reports on Form 8-K. During the three months ended June 30, 2004, the following reports on Form 8-K
were filed by the Company. Current Report on Form 8-K filed April 13, 2004 disclosing under Items 5 and 7
that APCapital has entered into an agreement with Daniel L. Gorman whereby Mr.
Gorman will be one of the
nominees to stand for election at the Companys 2004 annual meeting of
shareholders for a term expiring at the 2007 annual meeting. 40




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##### Table of Contents



Current Report on Form 8-K filed April 30, 2004 disclosing under Items 7 and 12
the issuance of a press release announcing its financial results for the three
months ended March 31, 2004 and certain other information. Current Report on Form 8-K filed May 11, 2004 disclosing under Items 7 and 12
the furnishing of supplemental information with respect to its financial
results for the three months ended March 31, 2004. Current Report on Form 8-K filed May 19, 2004 disclosing under Items 5 and 7
the issuance of a press release announcing a commutation of its reinsurance
agreements with Gerling Global Reinsurance Corporation of America. Current Report on Form 8-K filed June 10, 2004 disclosing under Items 7 and 9
the furnishing of presentation materials that were prepared for a presentation
to an institutional investor conference occurring on June 10, 2004. Current Report on Form 8-K filed June 25, 2004 disclosing under Items 5 and 7
the announcement of the completion of a strategic review process. The information included in the reports filed on April 30, 2004, May 11, 2004
and June 10, 2004 was considered furnished rather than filed. No financial
statements were filed with any of the reports on Form 8-K filed during the
quarter. 41




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Date: August 9, 2004 AMERICAN PHYSICIANS CAPITAL, INC.By:
    /s/ R. Kevin ClintonR. Kevin ClintonIts: President and Chief Executive OfficerBy:
    /s/ Frank H. FreundFrank H. FreundIts: Executive Vice President, Treasurer,
Chief Financial Officer and 
principal accounting officer 42




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##### Table of Contents



EXHIBIT INDEX Exhibit No.
    
    Exhibit Description10.37
    
    Standstill Agreement, dated April 7, 2004 between APCapital and Daniel
L. Gorman (filed as an exhibit to APCapitals Current Report on Form 8-K
filed April 13, 2004 and incorporated herein by reference.)31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under
the Securities Exchange Act of 1934.31.2
    
    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under
the Securities Exchange Act of 1934.32
    
    Certification of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities
Exchange Act of 1934.
 43