Our former insurance management operations, which provided insurance management services in New York and Pennsylvania, were discontinued in September 2006 in connection with the sale of these operations to a private investor. Our former TPA operations, which provided administrative and claims management services to employers, primarily in Florida, were sold in 2005. For additional information on our discontinued operations, see Item 8. Financial Statements and Supplementary Data, Note 17, Discontinued Operations.
Our consolidated income from continuing operations for the year ended December 31, 2006 increased 29% compared with the same period in 2005. Our consolidated income from continuing operations for the year ended December 31, 2005 increased 43% compared with the same period in 2004.
We have continued our targeted market focus, with 2006 policyholder retention in Florida at 94% and overall policyholder retention at 92% compared to 2005 and 2004 policyholder retention in Florida at 95% and overall policyholder retention at 94% and 89%, respectively.
Our net premiums earned for the year ended December 31, 2006 were flat compared with the same period in 2005 primarily because of the shift in business mix to lower risk specialties, a continued migration to lower policy limits for Florida-based physicians and a lower number of policyholders compared with the same period in the prior year. The impact of these factors was offset by the termination of cessions under the Hannover Re net account quota share reinsurance agreement, under which ceded earned premiums were $8.4 million for the twelve months ended December 31, 2005. Our net premiums earned for the year ended December 31, 2005 increased 51% compared with the same period in 2004 primarily as a result of the termination of cessions under the Hannover Re net account quota share reinsurance agreement.
During 2006, Fitch assigned an A- (strong) insurer financial strength rating to our insurance subsidiaries.
The Florida OIR is considering assertions made by the Consumer Advocate that Florida MPL insurance rates should be significantly lowered. In addition, bills have been introduced in the Florida Senate and House of Representatives that, if passed and enacted into law, would, among other things, require a prospective reduction in MPL rates for policies issued or renewed on or after October 1, 2007 to rate levels that are at least 25 percent less than the rates for the same coverage that were in effect on October 1, 2004 (under the Florida Senate bill) or September 15, (under the Florida House of Representatives bill). We cannot predict what, if any, future regulatory or legislative action may be taken with respect to Florida MPL premium rates or what effect any such action may have on our operations, but we believe that our premium rates are appropriate.
We believe the critical accounting policies discussed in the remainder of this section of our MD&A affect our more significant judgments and estimates used in preparation of the consolidated financial statements. These may be further commented upon in applicable sections on Results of Operations and Liquidity and Capital Resources that follow. Information about the significant accounting policies we use in the preparation of our consolidated financial statements is included in Item 8. Financial Statements and Supplementary Data, Note 2, Significant Accounting Policies.
Liability for Losses and LAE - Our liability for losses and LAE (also referred to as our loss and LAE reserves) is our largest liability and represents the financial statement item most sensitive to estimation and judgment. MPL insurance is our primary line of business and accounted for $630.2 million and $644.8 million, or 98% and 97%, of our total consolidated liability for losses and LAE as of December 31, 2006 and 2005, respectively.
The following table summarizes our liability for losses and LAE by line of business:
In 2005, we ended the year with 14,055 professional liability policyholders and paid a total of $60.8 million in loss payments (indemnity only) on 391 claims.
The net cumulative redundancy / (deficiency) shown in the table below for each year end includes accident year development for all years leading up to that year. For example, for the year ended December 31, 2006, there was $2.2 million of favorable development for accident year 2004 reserves (for all accident years leading up to 2004). This favorable development consists of $8.5 million of adverse development for accident years 2003 and earlier, offset by $10.7 million of favorable development for accident year 2004. Further, the net cumulative redundancy / (deficiency) shown in the table below also includes development for multiple calendar years. For example, the $36.4 million cumulative deficiency in 2003 consists of $8.5 million of development during calendar year 2006, $27.4 million of development during calendar year 2005, and $0.5 million of development during calendar year 2004.
Beginning in 1998, the composition of our business and our reserves changed because of acquisitions, geographic expansion, and increased writings in other lines of insurance, such as accident and health and assumed reinsurance. These events contributed additional volatility to our reserve estimates.
We experienced adverse development for accident years 1998 through 2004 due to a former assumed reinsurance program. This reinsurance program has been in run-off since 2004 and was commuted effective January 1, 2007 as discussed in Item 8. Financial Statements and Supplementary Data, Note 19, Subsequent Events.
Investments - Our invested assets comprise our largest single asset class and consist primarily of investment securities in the form of fixed income investments. Our fixed income securities and short-term investments are carried at their fair values and accounted for $720.7 million or 99% of our total investments and 59% of our total assets as of December 31, 2006, compared to $664.3 million or 99% of our total investments and 51% of our total assets as of December 31, 2005. Fair value is determined using the quoted market price of these securities provided by either independent pricing services, or when such prices are not available, by reference to broker or underwriter bid indications. Unrealized gains or losses in their fair values are recorded directly in shareholders’ equity, net of tax effects, as a component of accumulated other comprehensive (loss) income. Gross unrealized investment gains were $2.3 million and gross unrealized investment losses were $9.4 million as of December 31, 2006.
GAAP requires that the book value of investments be written down to fair value when declines in value are considered other-than-temporary. When such impairments occur, the decrease in value is reported in net income as a realized investment loss and a new cost basis is established. For the years ended December 31, and 2004, we recorded a pre-tax charge to earnings for investments that were other-than-temporarily impaired of $0.7 million and $0.8 million, respectively. No investment impairments were recorded during 2006. We evaluate our investment portfolio on a quarterly basis to identify securities that may be other-than-temporarily impaired. Our analysis takes into account relevant factors, both quantitative and qualitative in nature.
Our intent and ability to hold the investment for a sufficient period to allow for any anticipated recovery in fair value.
Income Taxes - We operate in income tax-paying jurisdictions and provide for income taxes in accordance with the provisions of FAS 109, Accounting for Income Taxes. Deferred tax assets and liabilities are estimated and recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We determine deferred tax assets and liabilities separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction.
A valuation allowance against deferred tax assets is estimated and recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. Valuation allowances are based on estimates of taxable income and the period over which deferred tax assets will be recoverable. In the event that actual results differ from our estimates or those estimates are adjusted in future periods, we may need to establish a valuation allowance, which would impact our financial position and results of operations. We have not established a valuation allowance, as we believe it is more likely than not that our deferred tax assets will be fully realized. For additional information concerning our income taxes, see Item 8. Financial Statements and Supplementary Data, Note 8, Income Taxes.
Share-Based Payments - On January 1, 2006, we adopted the provisions of FAS 123(R) using the modified prospective method. Prior period financial statements have not been restated to reflect fair value share-based compensation expense. Prior to the adoption of FAS 123(R), we followed the intrinsic value method in accordance with Accounting Principles Board (“APB”) 25 to account for our employee stock options. Accordingly, no compensation expense was recognized in connection with the issuance of stock options under our share-based compensation plans. However, compensation expense was recognized in connection with the issuance of restricted stock.
Beginning January 1, 2006, we recognized share-based compensation expense for (i) all share-based payments granted prior to, but not vested as of, January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of FAS 123 and (ii) all share-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of FAS 123(R). We recognize share-based compensation expense under FAS 123(R) ratably using the straight-line attribution method over the expected vesting period. In addition, pursuant to FAS 123(R), we are required to estimate the amount of expected forfeitures when calculating share-based compensation costs, instead of accounting for forfeitures as incurred, which was allowed under previous guidance. As of January 1, 2006, the cumulative effect of adopting the estimated forfeiture method was not significant as the amount related solely to our January 2005 restricted stock awards and our financial statements already reflected an appropriate adjustment to compensation expense for forfeitures. In determining the pool of windfall tax benefits for purposes of calculating assumed proceeds under the treasury stock method, we exclude the impact of pro forma deferred tax assets. We elected to use the short-cut method in determining our pool of windfall tax benefits upon adoption of FAS 123(R). For additional information on our share-based compensation plans, see Item 8. Financial Statements and Supplementary Data, Note 9, Share-Based Compensation Plans.
The following table shows comparative net income had share-based compensation expense been recognized in our financial statements under previous accounting guidance.
Pension Benefits - In September 2006, the Financial Accounting Standards Board (“FASB”) issued FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R). In accordance with FAS 158, we recognized a liability for the under-funded status of our defined benefit plans for the difference between the plans’ projected benefit obligation and the fair value of plan assets. We also recorded all unrecognized prior service costs and credits, unrecognized actual gains and losses and any unrecognized transition obligations or assets in accumulated other comprehensive (loss) income. Such amounts are reclassified into earnings as components of net periodic benefit cost pursuant to the current recognition and amortization provisions of FAS 106, Employers’ Accounting for Postretirement Benefits Other than Pensions. FAS 158 requires us to measure plan assets and benefit obligations as of the date of our statement of financial position. As allowed by the standard, we will adopt the measurement date requirement in fiscal year 2008. We currently use a measurement date of October 1 for our pension plans. The impact of adopting the measurement date requirement is not expected to be significant.
Derivative Financial Instruments - We account for our derivatives in accordance with FAS 133, Accounting for Derivative Instruments and Hedging Activities as amended by FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities and FAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. We use derivative financial instruments as cash flow hedges to manage market risks related to the effects of changes in interest rates on our floating rate long-term debt. The cost of these contracts is being amortized over their respective maturities. In addition, the remaining balances are adjusted and carried at their estimated fair values, with the changes therein reported as unrealized gains or losses in other comprehensive income. The differential, if any, to be paid or received as interest rates change is accrued and recognized as an adjustment to interest expense related to the hedged item. The related amount payable to or receivable from the counterparties is included as adjustments to accrued interest. See Item 8. Financial Statements and Supplementary Data, Note 11, Derivative Financial Instruments, for additional information on our derivatives.
Revenue Recognition - Premium income, which is our main source of revenue, is generally recognized pro-rata over the respective period of each policy. Premium receivables are recorded net of an estimated allowance for uncollectible amounts. Unearned premiums represent the portion of the premium applicable to the unexpired period of the insurance policy. In the event it is determined that the unearned premium reserve for a book of business will not be sufficient to recover the future expected losses and LAE and acquisition costs, including consideration of related investment income, recognition of a premium deficiency would be required through a write down of deferred policy acquisition costs and corresponding charge to income. In the event deferred policy acquisition costs are written off entirely, any remaining premium deficiency would be accounted for as a liability with a corresponding charge to income.
Commitments and Contingencies - For information concerning contingencies, to which we are subject, including assessments related to insolvencies in the states we operate, see Item 8. Financial Statements and Supplementary Data, Note 16, Commitments and Contingencies.
New Accounting Pronouncements - As described in Item 8. Financial Statements and Supplementary Data, Note 2, Significant Accounting Policies under the heading “New Accounting Pronouncements,” there are accounting pronouncements that have recently been issued but not been implemented by us. Note 2 describes the potential impact that these pronouncements are expected to have on our consolidated financial statements.
Consolidated income from continuing operations was $32.9 million, or $3.09 per diluted common share, for the year ended December 31, 2006, an increase of 29% and 30%, respectively, compared with $25.5 million, or $2.37 per diluted common share, for the year ended December 31, 2005. Consolidated income from continuing operations increased primarily due to higher net investment income and a decline in net losses and LAE. Partially offsetting these improvements were higher other underwriting expenses and interest expense.
Consolidated income from continuing operations for the year ended December 31, 2005 was $25.5 million, or $2.37 per diluted share, an increase of 43% and 38%, respectively, when compared with income from continuing operations of $17.9 million, or $1.71 per diluted share, for the year ended December 31, 2004. Consolidated income from continuing operations increased primarily because of an increase in underwriting profits on higher net premiums earned and higher net investment income. Partially offsetting these increases were net realized investment losses and higher interest expense.
Selected direct professional liability claims data is summarized in the table below.
Comparison of Results for the Years Ended December 31, 2006 and 2005
Net income increased for the year ended December 31, 2006 primarily due to higher net investment income and lower net losses and LAE offset to a certain extent by higher other underwriting expenses and interest expense.
Net premiums earned for the year ended December 31, 2006 was flat compared with the same period in 2005 primarily because of the factors mentioned above, offset by the termination of cessions under the Hannover Re net account quota share reinsurance agreement, under which ceded earned premiums were $8.4 million for the twelve months ended December 31, 2005.
Net income increased for the year ended December 31, 2005 primarily due to increases in underwriting and operating profits on higher net premiums earned and higher net investment income. The improvement in our net losses and LAE relative to net premiums earned is primarily the result of rate increases and other improvement in our underwriting results. The increases in underwriting profit were partially offset by higher other underwriting expenses due mainly to a reduction in ceding commissions earned and to a lesser extent, lower fronting fees, net of related expenses, under former fronting programs. The decrease in ceding commissions resulted primarily from the elimination of further cessions under the Hannover Re net account quota share reinsurance agreement effective June 30, 2004. Partially offsetting the increases in net income were net realized investment losses in 2005, compared with net realized investment gains for 2004, and higher interest expense on debt.
Direct and assumed premiums written decreased 8% for the year ended December 31, 2005 compared to the same period in 2004 primarily due to our planned exits from fronting programs and certain non-core states. We began exiting our fronting programs in 2002 to create capacity for our core MPL insurance business. All of these programs are now in run-off. The decrease was partially offset by the effects of pricing improvements.
Our investment revenues, which are comprised of net investment income and net realized investment gains and losses, decreased 2% for the year ended December 31, 2005 compared to the same period in 2004 primarily as a result of net realized investment losses compared with net realized investment gains for the year ended December 31, 2004. Included in net realized investment losses for the year ended December 31, 2005 was an other-than-temporary impairment charge of $0.7 million related to certain of our corporate fixed income securities. The net realized investment gains for the year ended December 31, 2004 were partially generated in the process of repositioning our portfolio to increase our mix of tax-exempt investments. Also included in net realized investment gains for the year ended December 31, 2004 was a gain of $2.1 million related to the sale of an investment in a limited partnership.
Other underwriting expenses increased 191% for the year ended December 31, 2005 compared to the same period in 2004. The increase in other underwriting expenses is primarily the result of a decrease in ceding commissions resulting from the termination of the Hannover Re net account quota share reinsurance agreement. In addition, the exit of our fronting programs has resulted in lower fronting fees, net of related expenses, resulting in a corresponding increase in other underwriting expenses. Other underwriting expenses also include return management fees of $1.7 million, which represents the proceeds from the settlement of litigation.
For additional information on our discontinued operations, see Item 8. Financial Statements and Supplementary Data, Note 17, Discontinued Operations. Financial data related to our discontinued operations is summarized in the table below.
Liquidity is a measure of a company’s ability to generate cash flows sufficient to meet short-term and long-term cash requirements of its business operations. As a holding company, we possess assets that consist primarily of the stock of our subsidiaries and of other investments. The sources of liquidity available to us for the payment of operating expenses, taxes, and debt-related amounts include management fees and dividends from our insurance subsidiaries. Management fees from our insurance subsidiaries are based upon agreements in place with First Professionals and APAC, pursuant to which we provide substantially all management and administrative services. In accordance with limitations imposed by Florida and Missouri laws, our insurance subsidiaries are permitted, within insurance regulatory guidelines, to pay us dividends of approximately $22.8 million during 2007 without prior regulatory approval.
Under the terms of the management agreements with First Professionals and APAC, we receive management fees equal to 115% of the costs incurred. The additional 15% provision in the First Professionals and APAC management fees is intended to cover overhead, corporate expenses and profit and is eliminated in the consolidated financial statements. In the case of the agreement with APAC, the total annual management fees are also limited to an amount not to exceed those that would have been paid under the terms of its former management agreement. The payment of losses and LAE and insurance operating expenses (including reinsurance costs) in the ordinary course of business are the principal needs for our insurance subsidiaries’ liquid funds. The principal sources of cash from their operations to meet ongoing liquidity requirements are the premiums collected for the insurance sold, and income on the investment of those funds.
Unexpected changes in operating costs, including new assessments or increased taxes;
Sources of liquidity include cash from operations, proceeds from the sale of subsidiaries, routine sales of investments and financing arrangements. As reported in the consolidated statement of cash flows, net cash provided by operating activities was $75.4 million for the year ended December 31, 2006 compared to $90.4 million and $58.1 million for the years ended December 31, 2005 and 2004, respectively. The decline in net cash flows provided by operating activities for the year ended December 31, 2006 compared to 2005 is due to a decline in premiums receivable associated with a decline in written premiums. Higher operating expenses and higher income taxes also contributed to the decline in net cash provided by operating activities during 2006. Partially offsetting these declines were lower net paid losses and LAE, higher investment income and lower commissions paid to our agents.
Net cash flows used in investing activities was $27.4 million for the year ended December 31, 2006, compared to $130.8 million and $22.8 million for the years ended December 31, 2005 and 2004, respectively. The changes in net cash provided by or used in investing activities are due primarily to transactions involving fixed income securities and short-term investments, which are dependent on our cash flows from operating activities and the management of our investment portfolio. Net purchases of fixed income securities and short-term investments, were $61.0 million for the year ended December 31, 2006, compared to $133.1 million and $25.1 for the same period in 2005 and 2004, respectively. Net cash flows used in investing activities also reflect proceeds from the disposition of our former insurance management and TPA operations, net of cash paid, of $34.4 million and $3.1 million during 2006 and 2005, respectively.
Capital resources consist of funds deployed or available to be deployed to support our business operations. We believe our financial strength provides us with the flexibility and capacity to obtain funds externally through debt or equity financing on both a short-term and long-term basis. Our ability to access the capital markets is dependent on, among other things, market conditions. We have accessed the debt market on certain occasions in the past.
Long-term debt - During 2003, we completed the placement of $10.0 million in senior notes and created three trusts that issued 30-year trust-preferred securities for which the proceeds from such issuances together with cash previously contributed to the trusts were used to purchase junior subordinated debentures from FPIC totaling $36.1 million. The debentures that we issued, which are reported as long-term debt in the consolidated statements of financial position, to the three trusts are subordinated to all senior indebtedness, including the senior notes, and are equal in standing with one another. In accordance with the guidance given in FASB Interpretation No. 46, “Variable Interest Entities,” we have not consolidated these subsidiary trusts.
Due from reinsurers on unpaid losses was $158.9 million as of December 31, 2006, a decrease of 48%, from $303.8 million as of December 31, 2005. The decrease is primarily due to a decrease of $110.0 million under the Hannover Re net account quota share reinsurance agreement, including an $84.0 million decrease as a result of the commutation of the agreement effective December 31, 2006. In addition, ceded loss and LAE reserves under former fronting programs also decreased $28.7 million. The remaining decline in due from reinsurers on unpaid losses is primarily attributable to ceded amounts under our primary reinsurance program, which are impacted by changes in our direct book of business including decreases in premiums and a reduction in policy limits.
Reinsurance payable was $10.7 million as of December 31, 2006, a decrease of 90%, from $104.6 million as of December 31, 2005. The decline in reinsurance payable as of December 31, is primarily due to the continued run-off of the Hannover Re net account quota share reinsurance agreement during 2006 along with a reduction of $84.0 million as a result of the commutation of the agreement effective December 31, 2006. As a result of the commutation, we no longer had funds withheld under the agreement as of December 31, 2006.
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. We also have items that represent contractual obligations, commitments and contingent liabilities that are not recorded or that are considered to possess off-balance sheet risks beyond their respective amounts otherwise reflected in our consolidated financial statements. These include: (1) derivative financial instruments, which are used to hedge interest rate risk, (2) employee benefit plans, and (3) guarantees by us and contractual obligations related to the trust-preferred securities issued by separately created, unconsolidated trusts. We were not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2006 that would give rise to previously undisclosed market, credit, or financing risk.
Historical returns of multiple asset classes were analyzed to develop a risk-free rate of return and risk premiums for each asset class included within our defined benefit plans. The overall rate for each asset class was developed by combining a long-term inflation component, the risk-free real rate of return, and the associated risk premium. A weighted average rate was developed based on those overall rates and the target asset allocation of the plans.
The following table summarizes our significant contractual obligations and commitments as of December 31, 2006, and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal payments on outstanding borrowings. Additional information regarding these obligations is provided in Item 8. Financial Statements and Supplementary Data, Note 10, Long-term debt, Note 13, Employee Benefit Plans, and Note 16, Commitments and Contingencies.