expended $4.7 million for leasehold improvements and equipment in the fourth quarter of 1998, and estimates that a total of $6.9 million will be incurred.
amounts. For further discussion of earnings per share and Statement 128 see the notes to consolidated financial statements beginning on page 54.
The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this Form 10-K. The consolidated financial statements for 1998 and 1997 include the accounts and operations of SCPIE Holdings Inc. and its wholly-owned subsidiaries. The financial statements for 1996 include the operations of the Southern California Physicians Insurance Exchange (the "Exchange") and its wholly-owned subsidiaries and certain affiliates.
Certain statements in the following discussion that are not historical in fact constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements regarding the Company, its business, prospects and results of operations are subject to certain risks and uncertainties posed by many factors and events that could cause the Company's actual business, prospects and results of operations to differ materially from those that may be expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors are discussed below, and in "Year 2000" disclosure, and in periodic filings with the Securities and Exchange Commission ("SEC").
The availability of medical malpractice insurance, or the industry's underwriting capacity, is determined principally by the industry's level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy. Historically, the financial performance of the medical malpractice industry has tended to fluctuate between a soft insurance market and a hard insurance market. In a soft insurance market, competitive conditions could result in premium rates and underwriting terms and conditions that may be below profitable levels. For a number of years, the medical malpractice insurance industry in California and nationally has faced a soft insurance market. There can be no assurance as to whether or when industry conditions will improve or the extent to which any improvement in industry conditions may improve the Company's financial condition and results of operations.
American Healthcare Indemnity Company ("AHI"), a subsidiary of SCPIE Holdings, has formed a relationship with Poe & Brown, Inc. ("Poe & Brown") one of the nation's top independent insurance agency organizations, to provide professional liability insurance to physicians commencing January 1, 1998. This coverage is currently offered to solo physicians and medical groups in five states, the largest such states being Connecticut, Florida, Georgia and Louisiana. In 1999, the Company expects to offer this coverage in three additional states. This replaces an existing program Poe & Brown had established with another insurance company. There is no assurance, however, that the Company will successfully retain or expand this business through Poe & Brown or that it will ultimately be profitable.
The California medical malpractice insurance market for medical groups and physicians, in which the Company principally operates, has become extremely competitive in recent years. The Company's principal competitors are three physician-owned companies and a physicians' mutual protection trust. In addition, commercial insurance companies have recently returned to the California market to insure medical groups and physicians.
In the late 1980s, many medical malpractice insurance companies began to experience significantly improved claims cost trends and attempted to attract medical groups and physicians insured by other companies by reducing premium rates. Beginning in 1990, the Company implemented annual rate decreases aggregating more than 25% during the next three years, which resulted in a reduction in premium volume to approximately $107.1 million in 1992, and a deterioration of underwriting results. Between 1993 and 1998, however, the Company instituted annual overall rate increases ranging from 4.4% to 9.2% on its physician professional liability policies in order to improve its underwriting results. These rate increases were higher than those implemented by most of its competitors. As a result, the Company has lost some of its policyholders, in part due to these rate increases, but realized a modest increase in its premium volume and has improved its underwriting results.
Medical malpractice and other property and casualty loss and loss adjustment expense (LAE) reserves are established based on known facts and interpretation of circumstances, including the Company's experience with similar cases and historical trends involving claim payment patterns, loss payments and pending levels of unpaid claims, as well as court decisions and economic conditions. The effects of inflation are considered in the reserving process. Establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that currently established reserves will prove adequate in light of subsequent actual experience. The Company follows a practice of conservatively estimating its future liabilities relating to losses already incurred and has attempted to establish its loss and LAE reserves at the upper end of a reasonable range of reserve estimates. The Company believes that it has been particularly difficult to make such estimates for medical malpractice claims in California because of the uncertain benefits of tort reform measures and changes in the judicial process.
With its continued expansion into other states and markets, the Company has experienced an increase in its operating expense levels to achieve and service this expansion. Commissions for policies that are sold through agents and brokers typically range from 7.0% to 17.5% of premiums, whereas the Company does not incur commissions on products sold directly. Hospital and other healthcare provider policies are typically sold through brokers, as are physician and medical group policies sold through Poe & Brown and in the program acquired from Fremont. To the extent that these policies represent an increased percentage of the Company's business in the future, expense ratios will increase.
YEAR ENDED DECEMBER 31, 1998, COMPARED TO YEAR ENDED DECEMBER 31, 1997
NET INVESTMENT INCOME Net investment income decreased approximately $2.3 million, or 5.5%, to $40.4 million in 1998 from $42.7 million in 1997. Invested assets increased $7.9 million to $793.6 million in 1998 from $785.7 million at December 31, 1997. The average pretax yield on the investment portfolio decreased to 5.2% in 1998 compared to 5.6% in 1997 due to a general decline in interest rates and a greater proportion of lower-yielding, tax-exempt securities in the portfolio.
NET INVESTMENT INCOME Net investment income increased approximately $1.9 million, or 4.8%, to $42.7 million in 1997 from $40.8 million in 1996. Invested assets increased $67.8 million to $785.7 million in 1997 from $717.9 million at December 31, 1996. The average pretax yield on the investment portfolio decreased to 5.6% in 1997 compared to 6.1% in 1996, primarily due to lower yielding tax-exempt bonds.
LOSSES AND LAE Losses and LAE increased $14.6 million, or 13.4%, to $123.4 million in 1997 from $108.8 million in 1996. As a percentage of premiums earned, losses and LAE increased to 92.2% in 1997 from 90.3% for the same period in 1996. For 1997, the Company reduced loss and LAE reserves incurred in prior policy years approximately $53.2 million as compared to a reserve reduction of $59.7 million for 1996 for claims incurred in prior policy years.
OTHER OPERATING EXPENSES Other operating expenses increased $3.7 million, or 26.0%, to $18.0 million in 1997 from $14.3 million in 1996. This increase was principally attributable to increases in policy acquisition expenses, payroll/benefit expenses, and legal and consultation fees of $1.1 million, $0.7 million and $1.2 million, respectively. The expense ratio was 13.4% in 1997 and 11.8% in 1996.
FEDERAL INCOME TAXES Federal income taxes decreased $1.5 million, or 12.6%, to $10.2 million in 1997 from $11.7 million in 1996. The effective tax rate decreased to 24.1% in 1997 from 27.9% in 1996, due primarily to an increase in tax-exempt interest in 1997.
1997. The Company paid $9.0 million and $9.9 million of such dividends during the years ended December 31, 1997 and 1996, respectively. The Company paid no policyholder dividends in 1998, and has ceased paying such dividends to its policyholders.
The Company has consistently experienced positive cash flow from operations. Because of uncertainty related to the timing of the payment of claims, cash from operations for a property and casualty insurance company can vary substantially from year to year. Cash provided by operating activities for the Company was $9.2 million in 1998 compared to $13.5 million in 1997. The cash provided by operating activities in 1997 was before the payment of policyholder dividends.
The Company invests its positive cash flow from operations in both fixed-maturity securities and equity securities. The Company's current policy is to limit its investment in equity securities and real estate to no more than 8.0% of the total market value of its investments. Accordingly, the Company's portfolio of unaffiliated equity securities was $37.0 million at December 31, 1998. The Company plans to continue this focus on fixed-maturity securities for the indefinite future.
The Company has made limited investments in real estate, which have been used almost entirely in the Company's operating activities, with the remainder leased to third parties. In July 1998, the Company entered into a lease covering approximately 95,000 square feet of office space for new Company headquarters. The lease is for a term of 10 years and the Company moved its headquarters and principal operations to this space in early March 1999. The Company intends to lease its former headquarters to third parties. The Company expended $4.7 million for leasehold improvements and equipment in the fourth quarter of 1998, and estimates a total of $6.9 million will be incurred.
Common stock dividends paid to stockholders were $0.24 per share in 1998. These dividends were funded through dividends from the Company's insurance subsidiaries. The Company expects to pay dividends in the future. However, payment of dividends is subject to Board approval, earnings and the financial condition of the Company.
In 1995, the Company organized a multi-disciplinary Year 2000 Project Team. The Year 2000 Project Team has developed and is currently executing a comprehensive plan designed to make the Company's mission critical IT systems and embedded systems Year 2000 ready. Outside consultants have reviewed the Company's overall process, plan and progress to date. The Company's plan for IT systems consists of four phases: (1) inventory - identifying all IT systems and risk rating each according to its potential business impact; (2) assessment identifying IT systems that use date functions and assessing them for Year 2000 functionality; (3) remediation - reprogramming, or replacing where necessary, inventoried items to ensure they are Year 2000 ready; and (4) testing and certification - testing the code modifications and new inventory with other associated systems, including extensive date testing and performing quality assurance testing to ensure successful operation in the post-1999 environment.
The Company completed the remediation of substantially all of its mission critical IT systems by year-end 1998.
If the Company's Year 2000 issues were unresolved, potential consequences would include, among other possibilities, the inability to accurately and timely process claims, update policyholders' accounts, process financial transactions, bill policyholders, assess exposure to risks, determine liquidity requirements or report accurate data to management, stockholders, policyholders, regulators and others as well as business interruptions or shutdowns, financial losses, reputational harm, increased scrutiny by regulators and litigation related to Year 2000 issues. The Company is attempting to limit the potential impact of the Year 2000 by monitoring the progress of its
The Company has begun to develop contingency/recovery plans aimed at ensuring the continuity of critical business functions before and after December 31, 1999. As part of that process, the Company has begun to develop reasonably likely failure scenarios for its critical IT systems and external relationships and the embedded systems in its critical facilities. Once these scenarios are identified, the Company will develop plans that are designed to reduce the impact on the Company, and provide methods of returning to normal operations, if one or more of those scenarios occur. The Company expects contingency/recovery planning to be substantially complete by March 31, 1999.
Any critical unresolved Year 2000 issues at the Company or with its external relationships could have a material adverse effect on the Company's results of operations, liquidity or financial condition. In addition, the Company's expectations about the future costs and timely and successful completion of its Year 2000 program are subject to uncertainties that could cause actual results to differ materially from what has been discussed above under "Year 2000." Factors that could influence the amount of future costs and the completion dates and effectiveness of remediation, testing and certification and contingency planning efforts include the Company's success in identifying IT systems and embedded systems that contain two-digit year codes, the nature and amount of required reprogramming, testing and certification, the rate and magnitude of related labor and consulting costs, the availability of qualified personnel and the success of the Company's external relationships in addressing their own Year 2000 issues.
The primary effect of inflation on the Company is considered in pricing and estimating reserves for unpaid losses and LAE for claims in which there is a long period between reporting and settlement, such as medical malpractice claims. The actual effect of inflation on the Company's results cannot be accurately known until claims are ultimately settled. Based on actual results to date, the Company believes that loss and LAE reserve levels and the Company's ratemaking process adequately incorporate the effects of inflation.