Amounts derived from the audited consolidated financial statements of Midwest Holding.
As discussed under the Reinsurance section of Item 1 of this Form 10-K, the renewal of Midwest Medical’s reinsurance agreement resulted in a rate change effective January 1, 2003. The flat, ceded premium rate for the basic reinsurance component increased to 10% from 9.75%. Rates in the reinsurance market in general continue to rise in response to large losses from the September 11 terrorist attacks, asbestos and environmental claims, directors’ and officers’ claims, growing property and casualty claims severity and declining investment income. Midwest Medical’s reinsurance rate increase was considerably lower than other medical malpractice insurance companies due primarily to more favorable loss experience. The rate change, however, coupled with growing premium volume, will result in greater reinsurance costs in 2003.
The Board of Directors of Midwest Medical will periodically declare and pay dividends to Midwest Holding to provide capital for holding company and noninsurance business operations including new business ventures. In 2001, a dividend from Midwest Medical was also used by Midwest Holding to retire an $8,500,000 loan used to fund stock restructure payments in 2000. In 2002, Midwest Medical did not pay any dividends to Midwest Holding. Midwest Medical declared and paid dividends of $11,400,000 and $3,000,000 to Midwest Holding in 2001 and 2000, respectively.
Net premiums earned increased $20,375,000 in 2002 from 2001. The increase was the result of the following significant factors:
Rate increases and granting fewer premium discounts increased earned premium by approximately $8,412,000 in 2002.
Premiums from reporting endorsements that provide policyholder tail coverage increased earned premium by approximately $761,000 in 2002.
Due to the increase in reinsurance rates and premiums written, particularly for excess component reinsurance layers, current year reinsurance costs were $6,398,000 greater in 2002 compared to 2001. This decreased 2002 net premiums earned.
Rate increases and granting fewer premium discounts increased earned premium by approximately $3,400,000 in 2001.
The estimated reinsurance premium applicable to the two reinsurance agreements covering the years 1992-1994 and 1995-1997, which is based in part on reinsured claims experience, increased $3,125,000 in 2001 compared to an increase of $634,000 in 2000. This resulted in a net decrease in premiums earned between years of $2,491,000.
Realized capital gains decreased $5,213,000 to $1,358,000 in 2002 and decreased $3,931,000 to $6,571,000 in 2001. Net capital gains of approximately $3,668,000 were realized on sales of fixed maturity investments in 2002. This was partially offset by $1,613,000 for losses realized on the declines in market values of fixed maturity investments that were deemed other-than-temporary and by $690,000 for net capital losses realized on sales of equity securities. The sales of fixed maturity and equity securities were primarily initiated by the investment managers who manage the portfolios to maximize pretax total return while adhering to the guidelines provided by the Company’s investment policy. During 2001, sales of equity securities realized $6,752,000 of net capital gains while sales of fixed maturity investments realized $(181,000) of net capital losses. Approximately $3,000,000 of the net realized capital gains on equity securities resulted from the sale of common stocks in the first quarter to fund the additional real estate investment trust purchase of $10,000,000. All other 2001 realized capital gains and losses resulted from the management of the portfolio on a pretax total return basis.
Losses and loss adjustment expenses are the costs associated with the settlement of insurance claims and are the Company’s principal expense. Losses and loss adjustment expenses were $74,819,000 in 2002 compared to $58,299,000 in 2001 and $39,587,000 in 2000. As a percentage of premiums earned, losses and loss adjustment expenses were 106.2%, 116.4% and 95.8% in 2002, 2001 and 2000, respectively. As shown in Note 6 to the audited consolidated financial statements, the current year’s provision for losses and loss adjustment expense, which is based upon policyholder exposure, expected frequency of losses and severity of losses, increased by $13,792,000 in 2002 compared to $10,664,000 in 2001. The increases were primarily driven by additional policyholder exposure from the increase in premium volume and the increase in Midwest Medical’s retention from $750,000 to $1,000,000 per insured for the basic component (or primary layer) of coverage beginning 2001. Also, since a significant portion of the increase in premium volume came from new business, the Company took a conservative loss position due to the lack of experience with these new policyholders. Losses and loss adjustment expenses also include adjustments of prior years’ estimates. These adjustments to the liability for unpaid losses and loss adjustment expenses are evaluated by management and supported by an outside actuarial analysis performed at the conclusion of the year. As shown in Note 6 of the audited consolidated financial statements, these evaluations resulted in an increase of $2,900,000 in 2002 to the estimated liability applicable to prior years versus an increase of $172,000 in 2001. The unfavorable development on prior years resulted primarily from an increase in claims severity and a Minnesota legislative action that extended the statute of limitations from two to four years.
The following schedule summarizes the development of the liability for unpaid losses and loss adjustment expenses from 1992 through 2002. This schedule is presented net of reinsurance, which the Company believes best explains the development as it affects operating results. Midwest Medical has had a conservative loss reserving policy that, when coupled with a decline in claim frequency during the early to mid-1990s, resulted in redundancies in the liability for unpaid losses and loss adjustment expenses. The redundancies in the loss liability, which develop as actual results become known, have significantly decreased since 1992 to where deficiencies developed the last two years. Downward competitive pressure on premium rates during the latter portion of the 1990s, coupled with increasing claims severity, have primarily driven this unfavorable development.
The Company does not discount the liability for unpaid losses and loss adjustment expenses in its consolidated financial statements. While the Company believes that its liability for unpaid losses and loss adjustment expenses is adequate, there can be no assurances that the Company’s ultimate losses and loss adjustment expenses will not deviate from the estimates in the Company’s consolidated financial statements. If the liability proves to be inadequate, the Company will need to increase it, which could have a material adverse effect on the Company’s consolidated financial position or results of operations.
Policyholder dividends are generated from unanticipated profits on prior coverage years. No policyholder dividends were declared by the Board of Directors of Midwest Medical in 2002. The decision was based on the 1998 coverage year, which did not develop unanticipated profits that could be returned to policyholders. Policyholder dividends of $4,050,000 and $8,108,000 were declared in 2001 and 2000, respectively, and were paid to policyholders the following year. The decrease in policyholder dividends from 2000 to 2001 is primarily due to less favorable loss experience on the 1997 coverage year on which the 2001 policyholder dividend was based.
Underwriting, acquisition and insurance expenses increased $1,274,000 from $7,570,000 in 2000 to $8,844,000 in 2001. Greater premium volume drove a $1,179,000 increase in commission payments and a $399,000 increase in premium taxes. These increases were partially offset by greater ceding commissions earned by Midwest Medical of approximately $243,000 resulting from the increase in premiums ceded to the excess component of the treaty reinsurance contract for the current year.
Other operating expenses increased $1,213,000 from $6,901,000 in 2001 to $8,114,000 in 2002. Medical Solutions drove $976,000 of the increase from supplier and staff costs primarily to sell, install and support electronic practice management and electronic medical records software. Medical Solutions also incurred an additional $107,000 of rent expense from leasing separate office space beginning December 2001. Launching Office Solutions in 2002 increased other operating expenses by another $149,000.
Other operating expenses increased $79,000 from $6,822,000 in 2000 to $6,901,000 in 2001. Additional staff for Medical Solutions’ technology consulting services and practice management software initiatives and greater commissions paid to Benefits’ producers for new business primarily drove the increase. This was partially offset by the decrease in stock restructure expenses, which were all incurred in 2000 by Midwest Holding.
Loss from continuing operations before income taxes was $(6,448,000) in 2001 compared to income of $6,022,000 in 2000. The decrease resulted primarily from greater loss liabilities estimated for the current year, less favorable development on prior years’ loss liabilities and lower realized capital gains. This was partially offset by an increase in net premiums earned and lower policyholder dividends. Income in 2000 also benefited from some nonrecurring items such as the realized capital gains recorded on sales of domestic equity securities to fund the stock restructure as well as interest on federal tax refunds.
Income taxes decreased $2,659,000, resulting in an income tax benefit of $(2,222,000) for 2001 compared to an income tax expense of $437,000 for 2000. The effective tax rates for 2001 and 2000 were 34.5% and 7.3%, respectively. The principal factor in the increase in the effective tax rate was a recovery of prior year taxes recorded in 2000. The tax recovery in 2000 was primarily due to federal tax refunds received by Midwest Medical from the Internal Revenue Service for the 1992 to 1996 tax years.
Net (loss) income recorded by the Company increased $1,045,000 to a net loss of $(3,556,000) in 2002 and decreased $(9,887,000) to a net loss of $(4,601,000) in 2001 due to the factors discussed above.
The discussion and analysis of the Company’s consolidated financial position and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires estimation and judgment that affect the reported amounts of assets, liabilities, revenues and expenses. Management bases its estimates on historical experience, outside actuarial analyses and on various other assumptions that are believed to be reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Following are the Company’s most critical accounting policies that affect significant areas and involve judgment and estimates. If these estimates differ materially from actual results, the impact to the consolidated financial statements may be material.
Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they apply. A portion of premiums written is deferred to recognize Midwest Medical’s obligation to provide reporting endorsement coverage without additional premium upon the death, disability or retirement of policyholders. This amount is recorded as an unearned premium reserve and represents an actuarial estimate of the present value of future benefits to be provided less the present value of future revenues to be received. The actuarial estimate involves making assumptions with respect to the Company’s physician population including mortality and future premium costs.
Realized gains and losses on sales of investments are reported on a pretax basis as a component of income and are determined on the specific identification basis. When evidence indicates a decline, judged to be other-than-temporary, in the underlying value or earning power of individual investments, such investments are written down to fair value by recording a realized investment loss. Factors that management may consider in determining whether an other-than-temporary impairment condition exists include:
whether a market decline is attributable to specific adverse conditions for a particular investment
the intent and ability of management to retain the investment for a period of time sufficient to allow for prudent anticipation of a recovery in market value
Significant judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against the deferred tax assets. Based on estimates of future taxable income, management has judged that it is more likely than not that the Company will realize the benefit of the deferred tax assets and therefore has not established a valuation allowance. In the event that actual results differ from these estimates or these estimates are adjusted in future periods, a valuation allowance may need to be established, which could materially affect the Company’s financial position and results of operations.
Management considers inflation in pricing and estimating the liability for unpaid losses and loss adjustment expenses. Inflation can have an impact on medical malpractice claims where there is a long period of time from when the claim is reported to when it is settled. The actual effect of inflation on the Company’s results cannot be accurately known until claims are ultimately settled. The Company believes that its premium rate-making process and its evaluation of the liability for unpaid losses and loss adjustment expenses adequately address the effects of inflation.
The audited consolidated financial statements of Midwest Medical Insurance Holding Company and Subsidiaries are presented on the following pages 33 through 60 of this Annual Report on Form 10-K.
During 1997, the Company formed Medical Solutions as a business development company to strengthen and promote the independence and interdependencies of physicians, clinics and hospitals that the Company serves. Business development opportunities being pursued include practice enhancement, strategic consulting and technology services and support.
Benefits was incorporated in 1995 and began active operations in January 1999 with the acquisition of a block of business from Johnson-McCann Benefits, Inc. Benefits is an insurance agency specializing in providing clients with group insurance products such as health, dental, life, disability and workers’ compensation.
Office Solutions began operations in February 2002 to provide physicians with business office outsourcing services. The main outsourcing service is the billing and collection of patient accounts.
Midwest Holding provides management and administrative services to Midwest Medical and Medical Solutions for a fee generally equal to the cost of services provided. Benefits and Office Solutions operate independently and do not have management agreements with Midwest Holding.
Midwest Medical provides professional liability insurance to physicians, clinics, hospitals and healthcare systems in Minnesota, Iowa, Nebraska, North Dakota, South Dakota, Wisconsin and Illinois. Insurance policies issued by Midwest Medical are on a “claims made” basis and provide coverage for the policyholder for claims first made against the policyholder and reported to Midwest Medical during the policy period for claims which occurred on or after the retroactive date stated in the policy.
Prior acts coverage may be purchased by policyholders who were previously insured under a “claims made” policy with another professional liability insurer for an additional premium at the option of the insured in lieu of purchasing reporting endorsement coverage from the previous insurer.
The consolidated financial statements have been presented in conformity with accounting principles generally accepted in the United States, which differ in certain respects from statutory accounting practices followed by Midwest Medical in reporting to the Minnesota Department of Commerce (see Note 14).
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates.
The Company manages its investment portfolio to achieve its long-term investment objective of providing for the financial stability of the Company through preservation of assets and maximization of total portfolio return. Although management believes the Company has the ability to hold its fixed maturity investment portfolio to maturity, these investments are classified as “available for sale,” as management may take advantage of opportunities to increase total return through sales of selected securities in response to changing market conditions.
Consistent with management’s classification of its investment in debt and equity securities as available for sale, such investments are carried at fair value, with unrealized holding gains and losses reflected as a component of other comprehensive income, net of applicable deferred taxes.
Realized gains and losses on sales of investments are reported on a pretax basis as a component of income and are determined on the specific identification basis.
The Company engages in securities lending through its investment custodian, U.S. Bank, whereby certain securities are loaned to other institutions for short periods of time. Such securities are in investments on the consolidated balance sheets. The market value of the loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as the market value of the loaned securities fluctuates. Initial collateral, primarily cash, is required at a rate of 102% of the market value of a loaned security. The collateral is deposited by the borrower with U.S. Bank, and retained and invested by U.S. Bank according to the terms of the securities lending agreement to generate additional income. The agreement also provides that U.S. Bank will indemnify the Company if the borrower defaults, becomes insolvent or fails to return the loaned securities. As of December 31, 2002, the Company had securities on loan with a fair market value of $78,042,000, which were collateralized by $80,654,000 of cash. The fair market value of the collateral was 103.3% of the fair market value of the securities on loan. The Company has not repledged the collateral.
Other revenues consist primarily of Benefits’ commission income from insurance carriers and Medical Solutions’ technology consulting and software sales and support to healthcare providers. Generally, such revenues are earned as the related services and products are performed or provided.
Midwest Holding has also issued one share of Class B voting stock that carries with it the right to elect the Board of Directors of Midwest Holding. The Minnesota Medical Association and the Iowa Medical Society currently exercise these voting rights. A majority of the Class C shareholders may at any time, by a two-thirds vote, elect to redeem the Class B share at cost.
Proceeds from sales of available-for-sale investments and the related gross realized gains and losses are as follows:
Net unrealized appreciation of fixed maturities (decreased) increased by $(1,902,000), $4,908,000 and $3,198,000 and net unrealized appreciation of equity securities decreased by $(13,047,000), $(19,411,000) and $(22,003,000) for the years ended December 31, 2002, 2001 and 2000, respectively. Net unrealized appreciation of other long-term investments (decreased) increased by $(3,712,000), $701,000 and $915,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
In 1999, Midwest Medical instituted a policyholder dividend program that replaced the previous retrospective premium credit program for physicians. To implement the program, Midwest Medical issued participating policy endorsements to all active physician, clinic and hospital accounts during 1999 and 2000. Participating policies represented approximately 94%, 96% and 96% of total premiums in force and premium income at December 31, 2002, 2001 and 2000, respectively. Dividends declared for the years ended December 31 are as follows:
Dividends are generated from unanticipated profits on prior coverage years. Declared dividends are allocated to policyholders proportionately based on current year written premium. To receive a dividend, a policyholder is required to have been insured in the applicable coverage year and remain insured throughout the year the dividend is paid. Declared dividends are generally paid in quarterly installments in the year following declaration.
Other revenues consist primarily of net realized capital gains and interest received on federal income tax refunds.
The Company’s income taxes differ from the federal statutory rate applied to income before tax as follows:
To reduce overall risk, including exposure to large losses, Midwest Medical participates in various reinsurance programs. Midwest Medical would only become liable for losses in excess of its retention limits in the event that any reinsuring company were unable to meet its obligations under the existing agreement. Management is not aware of any such default at December 31, 2002. Midwest Medical evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Reinsurance recoverables on paid and unpaid losses of $4,602,000 and $8,167,000 are associated with a single reinsurer, General Reinsurance Corporation, at December 31, 2002 and 2001, respectively. Midwest Medical also holds collateral under related reinsurance agreements in the form of letters of credit totaling $5,290,000 that can be drawn upon in the event the applicable reinsuring company is unable to pay its obligation to Midwest Medical.
The effect of reinsurance on premiums written and earned for 2002, 2001 and 2000 is as follows:
In 2002, Medical Solutions negotiated an installment loan in the amount of $1,930,000 to finance the purchase of an unlimited license agreement to resell electronic practice management and electronic medical records software. The loan calls for 36 monthly payments of $58,634 with an effective interest rate of approximately 5.9%. The first and second loan installments of $1,036,000 and $279,000 have been received in December 2002, while the remaining two loan installments will be received in 2003. No interest expense was incurred in 2002.
Under Minnesota insurance statutes, Midwest Medical is required to maintain statutory surplus in excess of ten times its per risk reinsurance retention limit. Since Midwest Medical limited its retention to $1,000,000 on any single risk, the minimum statutory surplus level was $10,000,000 for 2002.
Dividends that exceed the greater of 10% of Midwest Medical’s prior year-end policyholder surplus or Midwest Medical’s prior year net income excluding realized capital gains are considered extraordinary under Minnesota insurance statutes. Payment of extraordinary dividends is subject to the approval of the Commissioner of the Minnesota Department of Commerce. At December 31, 2002, the maximum dividend that may be paid by Midwest Medical in 2003 without regulatory approval is approximately $10,268,000. Cash dividends paid to Midwest Holding by Midwest Medical in 2002, 2001 and 2000 were $-0-, $11,400,000 and $3,000,000, respectively.