As a property and casualty insurer, our results of operations are primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While this measure is a key performance indicator of an insurance company’s operations, it is not uncommon for a property and casualty insurance company to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
An insurance company earns investment income on what is commonly referred to as the “float.” The float is money that we hold, in the form of investments, from premiums that we have collected. Although most of these premiums will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period of time that we hold the float prior to paying losses can extend over several years. The key factors that determine the amount of investment income we are able to generate are: 1) the rate of return, or yield, on the float, and 2) the amount of time we able to hold the float.
When a claim is reported to us, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon insurance reserving practices appropriate for the relevant line of business, and on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are periodically reviewed and adjusted as necessary by the claims staff as more information becomes available. Reserves for claims “incurred but not reported” provide for the future reporting of claims already incurred, and development on claims already reported. The reserve for claims incurred but not reported is determined based on historical loss trends.
Under our primary professional liability reinsurance contract, the portion of the policyholder premium ceded to the reinsurers is “swing-rated,” or experience rated on a retrospective basis. This swing-rated contract is subject to a minimum and maximum premium range to be paid to the reinsurers in the future, depending upon the extent of losses actually paid by the reinsurers. We pay a provisional premium during the initial policy year. A liability is recorded to represent an estimate of net additional payments to be made to the reinsurers under the program, based on the level of loss and LAE reserves recorded. To the extent that our estimate for unpaid losses and loss adjustment expenses changes, the amount of swing rated reinsurance premiums may also change.
Underwriting expenses increased during 2003 as a result of increased salary and employee relation costs, amortization of our deferred policy acquisition costs, and the inclusion of Physicians Insurance Company (“PIC”) in our consolidated results during 2003. Physicians Insurance Company is a start up medical professional liability insurance company in Florida in which the Company has a 49% ownership interest. As a result of recent changes in accounting rules, we are required to consolidate Physicians Insurance Company despite not having a controlling financial interest. See “- Effects of New Accounting Pronouncements,” for further discussion regarding our investment in PIC.
2002 Compared to 2001. The net loss reported in 2002 was primarily the result of a $55.1 million underwriting loss, partially offset by investment income of $44.8 million. Other significant items included the write-off of goodwill, which totaled $9.1 million net of tax, and was recorded as a cumulative effect of a change in accounting principle as a result of the adoption of SFAS No. 142. The 2002 loss ratio decreased to 102.7% from 127.4% in 2001, primarily as a result of rate increases, tighter underwriting standards and less development on prior year loss and loss adjustment expense reserves. Loss and loss adjustment expenses incurred during 2001 included $29.0 million of unfavorable development on prior year loss reserves, which were recorded in the third and fourth quarter as a result of emerging loss trends. Rate increases initiated in 2001 began to be earned in 2002, which resulted in a $33.2 million increase in net premiums earned from 2001 to 2002. The prior year unfavorable development, combined with the lower net premiums earned were the primary factors contributing to the recorded net loss of $43.8 million in 2001.
The decreases in underwriting expenses and the underwriting expense ratio were primarily due to the reduction of certain corporate overhead expenses related to the health insurance segment as well as a reduction in fees charged by a TPA who handles policy administration and premium collections on behalf of the Company.
For the year ended December 31, 2003, we recorded an increase in ultimate loss estimates, net of reinsurance, for accident years 2002 and prior of $43.4 million, or 8.0% of $542.0 million of net loss and loss adjustment expense reserves as of December 31, 2002. The increase in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2003 that differed from projected activity. Specifically, in the third quarter of 2003, a pattern of increasing paid severity emerged on our medical professional liability losses related to the 1999 through 2002 accident years. In light of this higher than expected trend of average paid severity, our internal and independent actuaries made significant upward revisions to their estimated ultimate severities on all claims incurred in those accident years, which had the effect of significantly increasing the projected ultimate losses on those years. Accordingly, recorded reserves on those years were adjusted to match these ultimate loss projections.
Due to the long-tailed nature of the medical professional liability line of insurance, changes in the actuarially projected ultimate loss severity can have an even greater impact on the balance of recorded reserves than with most other property and casualty insurance lines. While we believe that our estimate for ultimate projected losses related to our medical professional liability segment is adequate based on our open and reported claim counts, there can be no assurance that additional significant reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
Property and equipment are recorded at cost. Depreciation is computed for assets on a straight-line basis over the following periods: building - 40 years, furniture - 10 years, and computer equipment and software - 5 years. Upon the sale or retirement of property and equipment, balances are removed from the respective accounts and any gain or loss is included in income, as a realized gain or loss.
In January 2003, the 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 Consolidated Financial Statements. Also, during 2003, the Company invested $2,450,000 for 49% of the outstanding common stock of a start-up insurance company in the state of Florida, PIC. The Company has evaluated our investment in PIC, and based on the guidance given in FIN No. 46, have 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
Unrealized losses above are primarily related to mortgage-backed securities, which are typically slightly more sensitive to changes in prevailing interest rates than other fixed-maturity securities due to pre-payment options. The unrealized losses associated with mortgage-backed securities are considered by the Company to be interest rate related and temporary in nature.
There are no change in control limitations on the annual use of net operating losses related to the year ended December 31, 2003.
In addition, the Company had approximately $8.2 million of minimum tax credits which can be carried forward indefinitely.
SCW leased approximately 10,000 square feet of office space from the Company in 2003, approximately 13,000 square feet in 2002 and approximately 10,000 sq. feet in 2001. The Company received $214,000, $283,000, and $216,000 in rental income in 2003, 2002, and 2001, respectively, from the agency related to the leased office space.
On January 1, 2001, significant changes to the statutory basis of accounting became effective in all states in which the Company is licensed. The cumulative effect of these changes, known as Codification was recorded as a direct adjustment to statutory surplus. The effect of adoption resulted in an increase in statutory surplus of $16.7 million.
For periods where the Company incurred a loss, no effect of awards or options were calculated as the impact would be anti-dilutive).