Diluted net income per share for 2003 has been restated to reflect implementation of Emerging Issues Task Force 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share”. The restatement reduced previously reported diluted net income per share by $0.01.
The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto accompanying this report. Throughout the discussion, references to ProAssurance, “we,” “us” and “our” refers to ProAssurance Corporation and its subsidiaries. The discussion contains certain forward-looking information that involves risks and uncertainties. As discussed under “Forward-Looking Statements” and “Risk Factors,” our actual financial condition and operating results could differ significantly from these forward-looking statements.
In late 2005 we reached an agreement to sell our personal lines operations. Accordingly, our Consolidated Financial Statements report our personal lines operations, which were formerly reported as a separate operating segment, as a component of discontinued operations in all periods presented.
We evaluate each of our ceded reinsurance contracts at its inception to determine if there is sufficient risk transfer to allow the contract to be accounted for as reinsurance under current accounting guidance. At December 31, 2005 all ceded contracts are accounted for as risk transferring contracts.
We evaluate the securities in our available-for-sale investment portfolio on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other than temporary declines. Some of the factors we consider in the evaluation of our investments are:
the extent to which the market value of the security is less than its cost basis,
the financial condition and near-term prospects of the security’s issuer, taking into consideration the economic prospects of the issuer’s industry and geographical region, to the extent that information is publicly available, and
Through our regional underwriting and claims office structure, we are able to gain a strong understanding of local market conditions and efficiently adapt our underwriting and claims strategies to regional conditions. Our regional presence also allows us to maintain active relationships with our customers and be more responsive to their needs. We believe these factors allow us to compete on a basis other than just price. We also believe that our presence in local markets allows us to monitor and understand changes in the liability climate and thus develop better business strategies in a more timely manner than our competitors.
We measure performance in a number of ways, but particularly focus on our combined ratio and investment returns, both of which directly affect our return on equity (ROE). We target a long-term average ROE of 12% to 14%.
We expect our future growth will be supported by controlled expansion in states where we are already writing business and into additional states within, or adjacent to, our existing business footprint. We also look to expand through the acquisition of other companies or books of business; however, such expansion is opportunistic and cannot be predicted.
We achieved average gross price increases of approximately 11%, 19% and 28%, on renewal business (weighted by premium volume) in 2005, 2004 and 2003, respectively. In 2006 we expect professional liability pricing to increase at a slower pace. The price increases implemented over the last several years have brought our pricing to a level that we believe is adequate to meet our return objectives. We plan to maintain this pricing level by using future rate increases to counteract loss cost inflation.
On August 3, 2005 ProAssurance acquired all of the outstanding common stock of NCRIC Corporation (NCRIC) in a stock for stock merger. NCRIC’s primary business is a single property and casualty insurance company that provides medical professional liability insurance in the District of Columbia, Delaware, Maryland, Virginia and West Virginia. The primary purpose for the transaction was to expand marketing opportunities for our professional liability insurance products.
As part of the NCRIC merger, we also acquired ConsiCare, a subsidiary which provides administrative and financial services to physician practices. ConsiCare’s business focus is not consistent with our strategy as a specialty insurance company, and we therefore sold ConsiCare for $1.7 million on December 28, 2005. The operating results of ConsiCare are presented in the accompanying Consolidated Financial Statements as a component of discontinued operations. There was no gain or loss on the sale because our carrying value for ConsiCare approximated the sale price less sale expenses, adjusted for the tax effects of the sale.
On January 4, 2006 we sold our personal lines operations (the MEEMIC companies), effective January 1, 2006. The transaction is worth $400 million to us before transaction expenses. Motors Insurance Corporation (Motors), a subsidiary of GMAC Insurance Holdings, Inc., paid approximately $325 million in cash for MEEMIC Insurance Company and its internal agency, and we retained approximately $75 million of the MEEMIC companies’ pre-sale capital. Sale proceeds will support the capital
requirements of our professional liability insurance subsidiaries and other general corporate purposes. Following the sale, our total assets will decline by $167.8 million ($567.8 million assets sold less proceeds of $400 million) and our liabilities will decline by $337.5 million. Our stockholders’ equity will increase by the gain recognized on the transaction, which we expect to be approximately $110 million after consideration of sale expenses and the tax effects of the sale.
Because these operations have been sold, the assets, liabilities and operating results of the MEEMIC companies are reported as a component of discontinued operations in our accompanying Consolidated Financial Statements for all periods presented. Previously, we reported our personal lines operations and our professional liability operations as separate reportable segments; net investment income of the parent holding company and interest expense on long-term debt (corporate income) were not allocated to either segment. This reporting structure was reflected in prior filings. Our continuing operations now represent a single reportable segment and combine corporate income with the results of the professional liability segment.
On December 8, 2005, we reached a definitive agreement with Physicians Insurance Company of Wisconsin, Inc. (PIC Wisconsin) whereby we agreed to acquire PIC Wisconsin in an all-stock merger transaction having an estimated value of $100 million.
PIC Wisconsin is a Wisconsin-domiciled stock insurance company; its shares are not registered under the Securities Exchange Act of 1934. There is no GAAP financial data available for PIC Wisconsin. Audited December 31, 2004 statutory reports for PIC Wisconsin present cash and invested assets of $247.3 million, loss and loss adjustment expense reserves of $140.8 million, capital and surplus of $89.3 million and 2004 earned premiums of $56.5 million. The transaction is subject to approval by PIC Wisconsin shareholders and required regulatory approvals. We filed a registration statement and a proxy statement/prospectus with the Securities and Exchange Commission (SEC) on February 15, 2006 which is not yet effective. For more information regarding the proposed merger refer to the registration statement, SEC file number 333-131874.
The following discussions of changes in our financial condition and operating results exclude amounts that are classified as discontinued operations in our consolidated financial statements, as discussed under the caption “Recent Significant Events” and in Note 3 of our Consolidated Financial Statements.
ProAssurance Corporation is a legal entity separate and distinct from its subsidiaries. Because the parent holding company has no other business operations, dividends from its operating subsidiaries represent a significant source of funds for its obligations, including debt service. The ability of those insurance subsidiaries to pay dividends is subject to limitation by state insurance regulations. See our discussions under “Regulation of Dividends from Our Operating Subsidiaries” in Part I, and in Note 15 of our Notes to the Consolidated Financial Statements for additional information regarding dividend limitations.
The cash flows of the personal lines segment have historically not been used to support our professional liability operations. It is not expected that the sale of the personal lines segment will have a detrimental effect on the liquidity of our continuing operations.
We manage our investment portfolio to ensure that it will have sufficient liquidity to meet our obligations, taking into consideration the timing of cash flows from our investments as well as the expected cash flows to be generated by our operations. At our insurance subsidiaries the primary outflow of cash is related to the payment of claims and expenses. The payment of individual claims cannot be predicted with certainty; therefore, we rely upon the history of paid claims in determining the expected future claims payments. To the extent that we have an unanticipated shortfall in cash we may either liquidate securities held in our investment portfolio or borrow funds under previously established borrowing arrangements. However, given the significant cash flows being generated by our operations and the relatively short duration of our investment portfolio we do not foresee any such shortfall.
At December 31, 2005, available-for-sale and trading portfolio equity investments total $15.2 million, representing approximately 0.6% of our total investments, and approximately 2.0% of our capital. These holdings decreased from $33.6 million at December 31, 2004.
For a more detailed discussion of the effect of changes in interest rates on our investment portfolio see Item 7A, “Quantitative and Qualitative Disclosures about Market Risk.”
The 2032 and 2034 Subordinated Debentures may be redeemed at our option in December 2007 and April 2009, respectively.
Losses are the largest component of expense for our operations. As discussed in critical accounting policies, net losses in any period reflect our estimate of net losses related to the premiums earned in that period as well as any changes to our estimates of the reserve established for net losses of prior periods.
The estimation of medical professional liability losses is inherently difficult. Injuries may not be discovered until years after an incident, or the claimant may delay pursuing the recovery of damages. Ultimate loss costs, even for similar events, vary significantly depending upon many factors, including but not limited to the nature of the injury and the personal situation of the claimant or the claimants’ family, the judicial climate where the insured event occurred, general economic conditions and the trend of health care costs. Medical liability claims are typically resolved over an extended period of time, often five years or more. The combination of changing conditions and the extended time required for claim resolution results in a loss cost estimation process that requires actuarial skill and the application of judgment, and such estimates require periodic revision.
In establishing our reserve for loss and loss adjustment expenses management considers a variety of factors including historical paid and incurred loss development trends, the effect of inflation on medical care, general economic trends and the legal environment. Given the number of factors considered it is neither practical nor meaningful to isolate a particular assumption or parameter of the process and calculate the impact of changing that single item. We perform an in-depth review of our loss reserve on a semi-annual basis. However, management is continually reviewing and updating the data
Generally, methods such as the Bornheutter-Ferguson method are used on more recent accident years where we have less data on which to base our analysis. As business seasons and we have an increased amount of data for a given accident year we begin to give more confidence to the development and average methods as these methods typically rely more heavily on our own historical data. Each of these methods treats our assumptions differently, and thus provides a different perspective on the particular business under review.
The various actuarial methods discussed above are applied in a consistent manner from period to period. In addition, we perform statistical reviews of claim data such as claim counts, average settlement costs and severity trends.
In performing these analyses we partition our business by type, coverage type, geography, layer of coverage and accident year. This procedure is intended to balance the use of the most representative data for each partition, capturing its unique patterns of development and trends. For each partition, the results of the various methods, along with the supplementary statistical data regarding such factors as the current economic environment, are used to develop a point estimate based upon management’s judgment and past experience. The process of selecting the point estimate from the set of possible outcomes produced by the various actuarial methods is based upon the judgment of management and is not driven by formulaic determination. For each partition of our business we select a point estimate with due regard for the age, characteristics and volatility of the partition of the business, the volume of data available for review and past experience with respect to the accuracy of estimates for business of a similar type. This series of selected point estimates is then combined to produce an overall point estimate for ultimate losses.
The Company has modeled implied reserve ranges around its single point reserve estimates for its professional liability business assuming different confidence levels. The ranges have been developed by aggregating the expected volatility of losses across partitions of our business to obtain a consolidated distribution of potential reserve outcomes. The aggregation of this data takes into consideration the correlation among the Company’s geographic and specialty mix of business. The result of the correlation approach to aggregation is that the ranges are narrower than the sum of the ranges determined for each partition.
The Company has used this modeled statistical distribution to calculate an 80% and 60% confidence interval for the potential outcome of our reserves. The high and low end points of the ranges are as follows:
The development of a reserve range models the uncertainty of the claim environment as well as the limited predictive power of past loss data. These uncertainties and limitations are not specific to the Company. The ranges represent an estimate of the range of possible outcomes and should not be confused with a range of best estimates. Any change in our estimate of reserves would be reflected in then-current operations. Due to the size of our reserve for losses, even a small percentage adjustment to
these estimates could have a material effect on our results of operations for the period in which the adjustment is made.
The following table, known as the Loss Reserve Development Table, presents information over the preceding ten years regarding the payment of our losses as well as changes to (the development of) our estimates of losses during that time period. Years prior to 2001 relate only to the reserves of Medical Assurance. In years 2001 and thereafter the table reflects the reserves of ProAssurance, formed in 2001 in order to merge Medical Assurance and Professionals Group. NCRIC reserves are included only in the year 2005 since NCRIC was acquired in that year. The table does not include the loss reserves of personal lines operations, which are reflected in our financial statements as discontinued operations.
The following may be helpful in understanding the Loss Reserve Development Table:
The section entitled “Re-estimated net liability as of” reflects the re-estimated amount of the liability previously recorded as Balance Sheet Reserves that includes the cumulative amounts paid and an estimate of additional liability based upon claims experience as of the end of each succeeding year (the Net Re-estimated Liability).
The professional liability legal environment deteriorated once again in the late 1990’s. Beginning in 2000, we recognized adverse trends in claim severity causing increased estimates of certain loss liabilities. As a result, favorable development of prior year loss reserves slowed in 2000 and reversed in 2001 and 2002. We have addressed these trends through increased rates, stricter underwriting and modifications to claims handling procedures.
During 2004 and 2005 we recognized favorable development related to our previously established reserves, primarily to reflect reductions in our estimates of claim severity.
At December 31, 2005 our reserve for losses, net of the receivable from reinsurers, is $1.9 billion, an increase of $351.8 million over net reserves at December 31, 2004, which includes NCRIC net reserves acquired in August of $139.7 million. Our receivable from reinsurers at December 31, 2005 is $327.7 million, of which $41.3 million is attributable to NCRIC. Our reserve for losses continues to grow given the generally long-tailed nature of professional liability lines of business. Several years can pass between the initial recognition of a claim and the ultimate settlement of that claim. This, coupled with the growth in the number of policies we issue has resulted in an increase in loss reserve. Activity in the net reserve for losses during 2005, 2004 and 2003 is summarized below:
The effective transfer of risk is dependent on the credit-worthiness of the reinsurer. We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance broker assists us in the analysis of the credit quality of our reinsurers. We base our reinsurance buying decisions on an evaluation of the then-current financial strength, rating and stability of prospective reinsurers. However, the financial strength of our reinsurers, and their corresponding ability to pay us, may change in the future due to forces or events we cannot control or anticipate.
At December 31, 2005 our receivable from reinsurers approximated $328 million. The following table identifies our reinsurers from which our recoverables (net of amounts due to the reinsurer) are $10 million or more as of December 31, 2005:
As discussed in Note 10 to our Consolidated Financial Statements, our 2032 and 2034 Debentures are held by, and are the sole assets of, related business trusts. The NCRIC Trust purchased the 2032 Debentures and the PRA Trusts purchased the 2034 Debentures with proceeds from related trust preferred stock (TPS) issued and sold by each trust. The terms and maturities of the 2032 and 2034 Subordinated Debentures mirror those of the related TPS. The NCRIC and PRA Trusts will use the debenture interest and principal payments we pay into each trust to meet their TPS obligations. In accordance with the guidance given in Financial Accounting Standards Board Interpretation No. 46R, “Variable Interest Entities,” (FIN 46R) the NCRIC and PRA Trusts are not included in our consolidated financial statements because we are not the primary beneficiary of either trust.
NCRIC and ProAssurance have issued guarantees that amounts paid to the NCRIC and PRA Trusts related to the 2032 and 2034 Subordinated Debentures will subsequently be remitted to the holders of the related TPS. The amounts guaranteed are not expected to at any time exceed our obligations under the 2032 and 2034 Subordinated Debentures, and we have not recorded any additional liability related to the guarantee.
Selected consolidated financial data for each period is summarized in the table below.
We acquired NCRIC on August 3, 2005 and our results for the year ended December 31, 2005 include NCRIC results since the date of acquisition only. In the following tables, in order to facilitate an understanding of the effect of NCRIC, we have segregated results attributable to NCRIC in a separate line item titled “NCRIC”. The designation “PRA, prior” refers to ProAssurance’s results excluding NCRIC. Unless otherwise indicated, our discussions of variances between operating periods are presented exclusive of the amounts attributed to NCRIC operations.
Premiums written changed in 2005 as a result of competition, selective underwriting, the reduced need for rate increases and the acquisition of NCRIC. This acquisition is consistent with our stated strategy to grow premiums both organically and through selective acquisitions.
Approximately $16.0 million of the 2005 decrease in premiums written, excluding NCRIC, represents a decrease in physician premiums for non-tail coverages, which is our principal insurance product, comprising 84% of our total 2005 written premiums. In 2005, rates on our renewed policies averaged 11% higher than the expiring premiums. However, the beneficial effect of the rate increases and new business was offset by the effect of policies that did not renew. In addition, some insureds chose to take lower limits of coverage, and in some cases we decided to move away from volatile jurisdictions where rates are higher toward stable states where rates may be lower. Our retention rate averaged 85% in 2005, as compared to 83% in 2004, but increased price competition in several states reduced the volume of new business that we were able to write. We remain committed to an adequate rate structure and have forgone business that we believed could not be written at profitable rates.
Because premiums are generally earned pro rata over the entire policy period after the policy is written, fluctuations in premiums earned tend to lag those of premiums written. Policies generally carry a term of one year. Professional liability tail policies are 100% earned in the period written because the policies are non-cancelable and insure only incidents that occurred in prior periods.
Premiums ceded represent the portion of earned premiums that we must ultimately pay to our reinsurers for their assumption of a portion of our losses.
Calendar year losses may be divided into three components: (i) actuarial evaluation of incurred losses for the current accident year; (ii) actuarial re-evaluation of incurred losses for prior accident years; and (iii) actuarial re-evaluation of the reserve for the death, disability and retirement provision (DDR) in our claims-made policies.
Current accident year net loss ratios are lower in 2005 as compared to 2004 due to several factors. We have focused for several years on developing and maintaining adequate rates. As rate adequacy has improved, loss ratios have decreased. Also, our expected loss ratios vary based upon geographic location, coverage type and coverage limits. In 2005 as compared to 2004, changes in the mix of insured risks reduced overall expected loss ratios. During 2005 we recognized favorable development of $23.0 million related to our previously established reserves, primarily to reflect reductions in our estimates of claim severity. The most significant reduction was seen in the 2003 accident year; however, favorable development was also seen in accident years 2002 and prior.
Assumptions used in establishing our reserve are regularly reviewed and updated by management as new data becomes available. Any adjustments necessary are reflected in current operations. Due to the size of our reserve, even a small percentage adjustment to the assumptions can have a material effect on our results of operations for the period in which the change is made.
Underwriting, acquisition and insurance expenses are comprised of variable costs, such as commissions and premium taxes that are directly related to premiums earned, and fixed costs that have an indirect relationship to premium volume, such as salaries, benefits, and facility expenses.
Guaranty fund assessments were approximately $226,000 for the year ended December 31, 2005 as compared to approximately $396,000 for the year ended December 31, 2004.
On December 16, 2004 the Financial Accounting Standards Board (FASB) issued SFAS 123 (revised 2004), Share-Based Payment, hereafter referred to as SFAS 123(R), which is a revision of SFAS 123, Accounting for Stock-Based Compensation (SFAS 123), which superseded APB 25, Accounting for Stock Issued to Employees and amends SFAS 95, Statement of Cash Flows. The provisions of SFAS 123(R) require all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. SFAS 123(R) also requires that the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. We plan to adopt SFAS 123(R) on January 1, 2006, the required effective date, using the “modified prospective” method permitted by the statement and will value future grants of stock options using the Black Scholes valuation method.
Results of Operations - Year Ended December 31, 2004 Compared to Year Ended December 31,
Premiums are earned pro rata over the entire policy period (generally one year) after the policy is written. Thus the increase in 2004 earned premiums reflects on a pro rata basis the changes in written premiums that occurred during both 2004 and 2003.
In both 2004 and 2003, we reduced our estimates of prior year gross losses. As a result of the features of our reinsurance contracts, we also reduced our estimates of ultimate ceded premiums. The reduction was $8.9 million in 2004 and $5.4 million in 2003. Premiums ceded were also reduced by $1.6 million in 2004 due to the commutation of certain reinsurance contracts. Also, insureds have purchased policies with coverage limits below our reinsurance attachment point. We do not cede these premiums, and as a result, premiums ceded declined.
We decreased our estimate of prior year net losses by $8.7 million in 2004 and $50,000 in 2003. The 2004 amount represents 0.7% of 2003 net reserves. These adjustments were in response to actuarial evaluations of loss reserves performed during the period. No change was made to our estimates of the reserves required for death, disability and retirement during 2004 or 2003.
In 2004, as was also the case in 2003, our actuarial analysis of our reserves indicated that our claims severity had continued to increase as expected in our retained layers. However, we did not experience the high level of losses in our reinsured layers that we originally anticipated and for which we established reserves. Accordingly, we reduced our estimates of prior accident year gross losses by approximately $60.4 million during the year ended December 31, 2004 and $74.2 million during the year ended December 31, 2003. These losses were heavily reinsured; therefore, we reduced expected reinsurance recoveries by $51.7 million in 2004 and $74.1 million in 2003. As previously discussed, these changes to prior year estimates reduced net losses by $8.7 million in 2004 and nominally reduced net losses in 2003. In both 2004 and 2003, the decrease to reinsurance recoveries for prior accident years more than offset reinsurance recoveries for current accident years resulting in a non-traditional relationship between gross losses and recoveries.
The increase in our net investment income in 2004 as compared to 2003 is due to higher average invested funds in 2004, offset by a slight decline in the yield of our fixed maturity securities. While prevailing market interest rates have remained historically low, changes in the duration and asset mix of the portfolio have helped to stabilize the yield of the portfolio. We increased the weighted average duration of the portfolio from 3.5 years at December 31, 2003 to 3.9 years at December 31, 2004 in order to take advantage of improved yields on certain longer term securities. We have also increased the proportion of the portfolio that is invested in tax-exempt securities because of the higher after-tax yields available on these securities. However, we continued to see some decline in our income yields as older, higher yielding securities matured or were sold. Our average income yield, on a consolidated basis, was 4.0% for the year ended December 31, 2004 as compared to 4.5% for the year ended December 31, 2003. Our average tax equivalent income yield on a consolidated basis was 4.4% for the year ended December 31, 2004 as compared to 4.9% for the year ended December 31, 2003.
The components of net realized investment gains are shown in the following table.
Our effective tax rate for each period is significantly lower than the 35% statutory rate because a considerable portion of our net investment income is from tax-exempt interest and dividends. The effect of tax-exempt income on our effective tax rate is shown in the table below:
The Consolidated Financial Statements and Financial Statement Schedules of ProAssurance Corporation and subsidiaries listed in Item 15(a) have been included herein beginning on page 70. The Supplementary Financial Information required by Item 302 of Regulation S-K is included in Note 17 of the Notes to Consolidated Financial Statements of ProAssurance and its subsidiaries.