Federal income tax expense includes (benefit) expense of ($44.1) million, ($6.6) million and $50.7 million in 2005, 2004 and 2003, respectively, related to the reversal, change in or establishment of a deferred tax valuation allowance.
As the Company was in a net loss position for the years ended December 31, 2003 and 2002, the dilutive effect of options or other share-based awards was not calculated as the impact would have been anti-dilutive.
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. The discussion that follows contains certain forward-looking statements relating to our anticipated future financial condition, operating results, cash flows and our current business plans. When we use words such as “will,” “should,” “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are detailed under “Item 1A - Risk Factors” and elsewhere in this report and from time to time in other reports we have filed with the Securities and Exchange Commission. The cross-referenced information is incorporated herein by reference.
When a claim is reported to us, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The process of estimating the reserves reflects an informed judgement based upon insurance reserving practices appropriate for the relevant line of business and on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. The variables considered include the effects on ultimate loss payments of internal factors such as claims handling practices and changes in the mix of our products, as well as external factors such as changes in loss severity trends, economic inflation, judicial trends and legislative and regulatory changes. Case reserves are periodically adjusted by the claims staff, as more information becomes available. The estimation
Insurance premium income is generally recognized on a daily pro rata basis over the respective terms of the policies in-force which is generally one year. Certain extended reporting endorsements, often referred to as tail coverage, allow extended reporting of insured events after the termination of the original claims-made policy by modifying the exposure period of the underlying contract. Tail coverage can modify the exposure period for a definite or indefinite period. Premiums associated with tail policies that provide coverage for a definite period are earned over the period additional coverage is provided using the daily pro rata method. Premiums for tail policies
that provide additional coverage for an indefinite period are fully earned at the date of issuance. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.
In 2003, as a result of its assessment of the realizability of its deferred tax assets, the Company recorded a full valuation allowance against its net deferred tax asset. However, in 2005, after several consecutive quarters of pre-tax income, the Company concluded that deferred tax asset valuation allowance was no longer necessary. Accordingly, the Company reversed the entire valuation allowance balance in 2005.
This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and operating the insurance segments. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more rigorous risk
management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio, and overall profitability.
as a decrease in other expenses, also contributed to the increase in net income before taxes. The decrease in net income of $29.2 million in 2006 compared to 2005 is primarily attributable to the $28.0 million federal income tax benefit in 2005, which includes a $44.1 million benefit related to the reversal of the deferred tax asset valuation allowance.
Net premiums written did not decrease as significantly as direct premiums written as a result of changes in our reinsurance program, which resulted in reduced premium cessions. Effective January 1, 2006, we began retaining a 50% participation in our excess of loss reinsurance layer, which is all losses in excess of $500,000, compared to a 20% participation in 2005. In addition to the increase in participation, our 2006 reinsurance treaty is no longer swing-rated. Swing-rated treaties and their impact on premium cessions is more fully discussed under “Item 1. Business - Reinsurance.” Ceded premiums written for our core medical professional liability business, excluding amounts attributable to PIC-Florida for comparative reasons due to its deconsolidation in 2006, were 6.4% and 11.8% of direct premiums written during 2006 and 2005, respectively.
The effects of the changes in our reinsurance program did not have as dramatic an effect on net premiums earned as it did on net premiums written for 2006 compared to 2005, as in 2006 we continue to cede earned premiums to reinsurers based on the increased ceded amounts written in 2005.
The decrease in our incurred loss and loss adjustment expenses was partially attributable to a decrease in net premiums earned in 2006. We also continued to benefit from the enhancements we have made in our underwriting processes and claims processes over the last several years. The changes in our underwriting processes have resulted in a more stable book of insured accounts, which has resulted in a steady decline in the number of claims reported to us each quarter. Reported claims for 2006 totaled 1,168, compared to 1,513 in 2005. While we anticipate that the benefits of the changes in our underwriting and claims handling practices will continue to result in decreases in the number of claims reported, we anticipate that the rate of decrease will be slower than the current rate.
Net realized gains of $3.3 million were reported for the year ended December 31, 2006. During 2006, the Company sold investment real estate resulting in a realized gain of $1.4 million. In addition, the sale of ProAssurance common stock, received in exchange for our investment of Physicians Insurance Company of Wisconsin, or PICW, stock in connection with ProAssurance’s acquisition of PICW in 2006, resulted in a realized gain of $2.1 million. These realized gains were partially offset by approximately $178,000 of impairment charges. We continue to own other investment real estate property located in East Lansing, Michigan. It is our intention to sell this property over the next several years.
The decrease in other expenses in 2006 was primarily the result of decreased depreciation expense related to investment real estate properties (investment expenses), the elimination of amortization expense as all intangible
2005 Compared to 2004. The increase in net income for 2005 was the result of improved underwriting results ($24.0 million) and the $28.0 million federal income tax benefit, which includes a $44.1 million benefit related to the reversal of the deferred tax asset valuation allowance.
The decrease in net premiums written is consistent with the decrease in direct premiums written. Net premiums earned decreased more significantly than net premiums written as premiums were still being earned in 2004 related to the exited lines of business written in 2003.
Losses and loss adjustment expenses decreased primarily as a result of re-underwriting efforts in our continuing medical professional liability line, the decrease in exposure associated with the reduced number of covered lives in our health line, and a reduction in the number of policies-in-force for workers’ compensation. The re-underwriting efforts have resulted in a decrease in both the frequency and severity of reported and paid medical professional liability losses. As a result of the trends of decreasing frequency and severity that were beginning to emerge, we adjusted downward our estimate of ultimate losses related to the 2004 and prior accident years by approximately $4.4 million. This favorable development in 2005 was especially prevalent in our Ohio and Michigan markets. The loss ratio decreased from 88.6% in 2004 to 77.4% in 2005.
for a valuation allowance and, based on our results of operations, concluded that a valuation allowance was no longer necessary. The reversal of the valuation allowance is the primary reason for the unusually large federal income tax benefit reported for 2005.
APCapital’s only material assets are cash and the capital stock of American Physicians and its other subsidiaries. APCapital’s cash flow consists primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. The payment of dividends to APCapital by its insurance subsidiaries is subject to certain limitations imposed by applicable law. Accordingly, $49.2 million of dividends can be paid in 2007 without prior regulatory approval. However, as dividends totaling $43.0 million were paid in 2006, only $6.2 million of dividends could be paid as of January 1, 2007, without regulatory approval. The remaining $43.0 million of dividends that can be paid in 2007 is subject to limitation based on the timing and amount of the dividends that were paid in the preceding 12 months. These dividends are being used to fund APCapital’s debt service and other operating costs, as well as the purchase of shares of APCapital’s outstanding common stock. At December 31, 2006, APCapital’s cash and cash equivalent resources totaled approximately $17.5 million.
We made net federal income tax payments of approximately $5.8 million in 2006. We anticipate that federal income tax payments will increase in future years as we have utilized the majority of our net operating loss carryforwards as of December 31, 2006. We do, however, still have approximately $6.2 million of minimum tax credits that can be used to reduce our regular tax liability to the alternative minimum tax amount.
At December 31, 2006, the Company had $108.2 million of cash and cash equivalents and approximately $255.0 million of available-for-sale fixed-income securities to meet short-term cash flow needs. On a long-term basis, fixed-income securities are purchased on a basis intended to provide adequate cash flows from future maturities to meet future policyholder obligations and ongoing operational expenses. As of December 31, 2006, we had approximately $78.5 million, $184.2 million and $78.9 million of held-to-maturity fixed-income securities that
mature in the next one to five years, five to ten years and more than ten years, respectively. We also have approximately $164.0 million of mortgage-backed securities that provide periodic principal repayments. See Note 3 of the Notes to Consolidated Financial Statements for further information regarding the anticipated maturities of our fixed-income securities.
The following table shows reported claim counts, open claim counts, the average net case reserve per open claim, and the average claim payment on claims that were closed with a payment for our medical professional liability segment at or for the years ended December 31, 2006, 2005 and 2004. Data in the table does not include PIC-Florida counts or reserves, as the data historically has not been available to us, and in 2006 PIC-Florida is no longer a consolidated entity.
Activity in the liability for unpaid loss and loss adjustment expenses for the year ended December 31, 2006 was as follows:
The following table shows the development of the net liability for unpaid loss and loss adjustment expenses from 1996 through 2005. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. The (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years. The years 2003 through 2005 have been restated to exclude reserves, payments and development related to PIC-Florida as effective January 1, 2006, PIC-Florida is no longer included in the Company’s consolidated amounts.
In an effort to better explain the inherent uncertainty in our net loss and LAE reserves, we have developed a reasonable range of estimates around the net carried reserves. Our reserve range as of December 31, 2006, in the table below was primarily established by reviewing the various actuarial methods, discussed under “- Critical Accounting Policies,” used to estimate net loss and LAE reserves.
There are several limitations to interpreting reserve ranges. There are macroeconomic effects that may impact the development of the reserves such as, but not limited to, tort reform, changes in the litigiousness of jurisdictions in which we write business, changes in unemployment rates by geographic location, the influence of legislative actions, and changes in political philosophy. As a result of these factors, as well as other unknown factors, there can be no assurance that reserves will develop within these ranges.
In early 2006 we purchased $192.5 million of tax-exempt fixed-income securities, which accounts for the $30.9 million and $159.9 million increases in available-for-sale and held-to-maturity, respectively, fixed-income securities and the majority of the $164.8 million decrease in cash and cash equivalents from December 31, 2005 to 2006. Tax-exempt securities comprised 23.8% of our total cash and investment portfolio at December 31, 2006, compared with 2.2% at December 31, 2005.
The decrease in other investments to $6.5 million at December 31, 2006, from $11.6 million at December 31, 2005 was primarily attributable to the sale of our $7.6 million investment in Physicians Insurance Company of Wisconsin, or PICW. Partially offsetting the decrease related the disposition of the PICW stock was the inclusion of our investment in PIC-Florida following equity method accounting in 2006, which resulted in an increase in other investments of $2.5 million. In 2005, PIC-Florida was included consolidated in our financial statements.
Deferred federal income taxes decreased $11.2 million to $32.8 million at December 31, 2006. The decrease is primarily related to the use of net operating loss carryforwards ($6.2 million) and minimum tax credits ($2.9 million) to reduce our current year tax liability.
Unearned premiums decreased $11.4 million, or 13.8%, to $70.7 million at December 31, 2006. The decrease is relatively consistent with the 15.4% decrease in medical professional liability direct premiums written from 2005 to 2006.
We are contractually obligated in accordance with various loan or borrowing agreements and operating leases as well as to our policyholders for insured events. The following table shows the nature and the timing of our contractual obligations as of December 31, 2006:
The long-term debt is more fully described in Note 8 of the Notes to Consolidated Financial Statements. Amounts included herein assume $3 million of annual interest payments and that the debt will be repaid in May 2008, the earliest date at which the debt may be retired.
While not a contractual obligation at December 31, 2006, in February 2007 we formally entered into a contract with a vendor to provide us with, and assist in the implementation of, a new policy administration software system. The total cash outflow of the project is anticipated to be approximately $6 million over the next 12 to 18 months.
See Note 2 of Notes to Consolidated Financial Statements included elsewhere in this report for information regarding the potential effects of new accounting pronouncements on our results of operations and financial condition. Such cross-referenced information is incorporated herein by reference.
We have audited the accompanying consolidated balance sheets of American Physicians Capital, Inc. and Subsidiaries (the “Company”) as of December 31, 2006 and 2005 and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the two years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Physicians Capital, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 13, 2007 expressed an unqualified opinion thereon.
The accounts of Physicians Insurance Company, a Florida domiciled insurance company (“PIC-FL”), were consolidated in the accompanying Consolidated Financial Statements during 2005 and 2004. However, as described under the heading “Minority Interests” near the end of Note 1, in 2006 PIC-Florida is no longer consolidated, but rather is accounted for using the equity method of accounting.
Prior to 2006 debt issue cost amortization was included as a component of amortization expense. In 2006, these costs are reported in the interest expense line item of the Consolidated Statements of Income. To conform to the 2006 financial statement presentation, debt issue cost amortization expense of $181,000 has been reclassified for the years ended December 31, 2005 and 2004 as well. This reclassification had no effect on income before taxes or net income.
With the adoption of Statement of Financial Accounting Standard (“SFAS”) No. 123R, “Share-Based Payments” effective January 1, 2006 certain 2005 and 2004 amounts related to share-based compensation expense, and the related tax benefits, have been reclassified within the Consolidated Statement of Cash Flows.
Effective November 1, 2006, the Company paid a three-for-two stock split of its common shares to shareholders of record as of the close of business on October 11, 2006. All share and per-share data, as well as share-based award information included in these Consolidated Financial Statement and Notes thereto, has been retroactively adjusted to reflect the stock split.
Medical professional liability coverage is written on both a claims-made and an occurrence basis. Claims-made policies cover claims reported during the year in which the policy is in effect. Occurrence-based policies cover claims arising out of events that have occurred during the year in which the policy was in effect, regardless of when they are reported. For each of the years in the three year period ended December 31, 2006, approximately 67.3% , 66.2% and 67.7% of the Company’s medical professional liability direct premiums written represented claims-made policies, with the remainder representing occurrence-based policies.
The Company classifies all investment securities as either held-to-maturity or available-for-sale at the date of purchase based on the Company’s ability and intent to hold individual securities until they mature. In addition, on a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. In 2005, the Company concluded that it had both the intent and ability to hold a significant portion of the Company’s fixed-income securities to maturity. Accordingly, the Company transferred fixed-income securities, with an estimated fair value of approximately $398.3 million at the date of transfer, from the available-for-sale category to the held-to-maturity category.
Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method for both available-for-sale and held-to-maturity investments acquired at other than par value. Amortization for loan-backed, or mortgage-backed, securities is adjusted prospectively for changes in pre-payment speed assumptions.
Pre-payment speed assumptions are updated at least annually and are based on the average of assumptions obtained from ten leading brokerage firms. Interest income is recognized when earned. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
The Company’s investments are evaluated for other than temporary impairment (“OTTI”) using both quantitative and qualitative methods that include, but are not limited to (a) an evaluation of the Company’s ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, (b) the recoverability of principal and interest related to the security, (c) the duration and extent to which the fair value has been less than cost for equity securities, or amortized cost for fixed-income securities, (d) the financial condition, near-term and long-term earnings and cash flow prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions, and (e) the specific reasons that a security is in a significant unrealized loss position, including market conditions that could affect access to liquidity. A decline in the market value of an available-for-sale or held-to-maturity security below its cost or amortized cost, referred to hereafter as cost basis, that is deemed to be other than temporary results in a write-down of the cost basis of that security to fair value.
These interest-only certificates were carried on the balance sheet at fair value as fixed-income securities. These certificates were not linked to specific assets or liabilities on the balance sheet or to a forecasted transaction and, therefore, did not qualify for hedge accounting. In addition, the Company could not reliably identify and separately measure the embedded derivative instrument. Accordingly, any changes in the fair value of the interest-only certificates, based on quoted market prices, were recorded in current period earnings as investment income. During the years ended December 31, 2005 and 2004, the fair value of these securities decreased by $1,095,000 and $338,000, respectively. These certificates were sold in 2005.
Deferred policy acquisition costs (“DAC”) (carried on the accompanying Consolidated Balance Sheets in other assets) include commissions, premium taxes and other costs incurred in and that vary with premium generation. These costs are deferred and amortized over the period in which the related premiums are earned, typically one year. Future investment income has been considered in determining the recoverability of deferred costs.
extended period of time that some medical professional liability claims take to settle and the relative uncertainty of the legal environment in the various markets in which the Company operates. However, management believes that the reserve for unpaid losses and loss adjustment expenses is adequate.
Claims-made policies provided by the Company include coverage for extended period reporting claims in the event of the death, disability or retirement (“DD&R”) of the insured. This DDR coverage provides coverage to the physician for any prior incidents occurring during the coverage period that are reported after their death, disability or retirement. The loss exposure associated with this product is known as extended reporting period claims. The reserve for extended reporting period claims coverage is recognized during the term of the original claims-made policy and is based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of future premiums associated with this coverage. The amount of this reserve is $13.0 million and $15.0 million at December 31, 2006 and 2005, respectively, which includes a discount of approximately $5.5 and $5.7 million at December 31, 2006 and 2005, respectively, related to the present value calculation. The reserve for DD&R benefits is included in unpaid loss and loss adjustment expenses in the accompanying Consolidated Balance Sheets. Changes in this reserve are charged or credited to income in the period in which the changes first become known.
On December 31, 2004, the Company consummated a transaction in which PIC-Florida’s other investor assumed ownership of 100% of PIC-Florida’s outstanding common stock. In exchange for its 49% ownership interest, American Physicians received a $3 million note that bears interest at a rate of eight-percent. The note is collateralized by 100% of the outstanding common stock of PIC-Florida. As the note received in exchange for American Physicians ownership interest is collateralized by the common stock of PIC-Florida, the exchange was deemed not to be a sale in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a replacement of FASB Statement 125,” but was rather accounted for as a secured borrowing with pledge of collateral.
During 2005, monthly interest-only payments were made on the note. Principal payments on the note began in January 2006 and will continue every month through December 2012 unless prepaid earlier. The principal payments that began in January 2006 resulted in deemed partial sales of the Company’s investment in PIC-Florida in accordance with SFAS No. 140. As a result of these deemed partial sales, and the resulting change in circumstance, the Company re-evaluated the appropriateness of continuing to consolidate PIC-Florida in accordance with the guidance in FIN 46(R) and determined that the Company was no longer the primary beneficiary as it was no longer at risk for a majority of PIC-Florida’s potential losses. Accordingly, the Company determined that as of January 1, 2006, its investment in PIC-Florida should be accounted for under the equity method of accounting and no longer consolidated.
The balance of the Company’s investment in PIC-Florida was approximately $2.5 million at December 31, 2006 and is included in the accompanying Consolidated Balance Sheet in other investments. The Company’s share of PIC-Florida’s earnings in 2006, under the equity method of accounting, was $420,000 and is included in investment income. PIC-Florida’s total assets included in the Consolidated Balance Sheet at December 31, 2005, were approximately $16.1 million and its net premiums earned included in the Consolidated Statements of Income were $3.3 million and $2.3 million, respectively, for the years ended December 31, 2005 and 2004. The note receivable balance related to the sale of PIC-Florida was $2.5 million and $3.0 million at December 31, 2006 and 2005, respectively, and is included in the Consolidated Balance Sheets in other assets. A deposit liability of an equal amount, which offsets the note receivable balance, is carried in accrued expenses and other liabilities.
In February 2006 the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments, an amendment of FASB Statements No. 133 and 140,” which permits, but does not require, fair value accounting for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities, as amended.” SFAS No. 155 also subjects beneficial interests issued by securitization vehicles to the requirements of SFAS No. 133. The
In March 2006 the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140,” which permits, but does not require, an entity to account for one or more classes of servicing rights at fair value, with the changes in fair value recorded in net income. The adoption of SFAS No. 156 in the first quarter of 2007 is not expected to have a material impact on the Company’s financial condition or results of operations.
Those securities in the tables above that are in an unrealized or unrecognized loss position at December 31, 2006 or 2005 were determined to be in that position primarily as a result of changes in prevailing interest rates. All securities in an unrealized or unrecognized loss position at December 31, 2006 or 2005 were considered investment grade. The Company defines investment grade securities as those that have a Standard & Poors’ credit rating of BBB and above. Based on the Company’s ability and intent to hold these securities until their maturity, or for a sufficient period of time to allow for the recovery of the securities market value, their decline in market value is deemed to be temporary in nature.
The following table shows the components of net unrealized gains on investments, net of deferred federal income taxes included in accumulated other comprehensive income in the shareholders’ equity section of the accompanying Consolidated Balance Sheets at December 31, 2006 and 2005:
The following table shows net unrealized gains (losses) on available-for-sale investment securities arising during the period, as well as the amortization of unrealized gains related to held-to-maturity securities, reclassification adjustments, and the related deferred income tax effects included in other comprehensive income for the years ended December 31, 2006, 2005 and 2004.
In 2004 the Company determined that the capitalized deferred acquisition costs associated with the other insurance lines segment were not recoverable and accordingly wrote-off $300,000 of capitalized costs.
Depreciation expense associated with property and equipment for the years ended December 31, 2006, 2005, and 2004, was $1.4 million, $1.7 million and $1.9 million, respectively.
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2006, 2005, and 2004, was as follows:
The Company has worked over the last few years to reunderwrite risks in virtually all markets. These efforts have resulted in a decrease in the frequency and severity of reported and paid losses that are now beginning to emerge in the loss data used to make actuarial projections of ultimate losses. Accordingly, the favorable
development in 2006 and 2005 was the result of fewer than anticipated reported claims and lower than expected claims settlement costs, especially in the Company’s Ohio and Michigan markets.
Management believes that the estimate of the ultimate liability for unpaid losses and loss adjustment expenses at December 31, 2006, is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Company’s actual incurred loss and loss adjustment expenses will not conform to the assumptions inherent in the estimation of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying Consolidated Balance Sheets.
The Company had reinsurance recoverables from the following reinsurers at December 31, 2006 and 2005:
incurred) in 2004. In connection with the commutation, the Company released Gerling from its obligations under the treaties, which resulted in a reduction of the Company’s reinsurance recoverables of approximately $17.9 million (thereby increasing losses and loss adjustment expenses incurred). The net effect of the commutation was an increase in losses and loss adjustment expenses of $4.4 million, partially offset by an $837,000 increase in net premiums earned.
The provision (benefit) for income taxes for the years ended December 31, 2006, 2005 and 2004, consists of:
In 2003, as a result of its assessment of the realizability of its deferred tax assets, the Company recorded a full valuation allowance against its net deferred tax asset. However, in 2005, after several consecutive quarters of pre-tax income, the Company concluded that the deferred tax asset valuation allowance was no longer necessary. Accordingly, the Company reversed the entire valuation allowance balance in 2005.
At December 31, 2006, the Company had approximately $1.8 million and $1.7 million of net operating loss carryforwards that expire in 2010 and 2011, and are limited to $575,000 and 340,000 annually, respectively. In addition, at December 31, 2006, the Company had approximately $6.2 million of minimum tax credits which can be carried forward indefinitely.
The Board of Directors has authorized the Company to purchase shares of its outstanding common stock under two separate plans. The Board of Directors has approved a series of authorizations to purchase shares of the Company’s outstanding common stock at the discretion of management (referred to as the “discretionary plan”). The total number of shares authorized to be repurchased under the discretionary plan since its inception is 6,060,659. At December 31, 2006, 289,804 shares remained available for repurchase under the discretionary plan, subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Global Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital resources and requirements. Shares repurchased under these authorizations during the years ended December 31, 2006, 2005 and 2004, as well as the total number of shares repurchased pursuant to prior authorizations under the discretionary plan are shown in the table below.
In April 2006 the Company announced that its Board of Directors had authorized a share repurchase of $20 million of its common shares pursuant to a plan adopted under Rule 10b5-1 of the Securities Exchange Act of 1934. In August 2006 the Board of Directors authorized an additional share repurchase of $10 million under this plan. Shares may be repurchased under a Rule 10b5-1 plan at times when the Company otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. A broker selected by the Company has the authority under the terms and limitations specified in the plan to repurchase shares on the Company’s behalf pursuant to a pre-determined formula.
At December 31, 2006, there was $6.4 million remaining to be purchased under the 2006 Rule 10b5-1 plan. On October 27, 2006, the Company’s Board of Directors adopted a new stock repurchase plan for 2007 under Rule 10b5-1 and authorized an additional share repurchase of $32 million of its common shares. In addition, the Board authorized the rollover into the 2007 plan of any unused dollars allocated to the 2006 10b5-1 plan. The Rule 10b5-1 plan share repurchases are expected to continue until the authorizations are fully utilized, subject to conditions specified in the Rule 10b5-1 plan. However, the Company may terminate the plan at any time.
Under SFAS No. 107, the Company’s investment securities, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, and long-term debt constitute financial instruments. With the exception of fixed-income securities classified as held-to-maturity, the carrying amounts of all financial instruments approximated their fair values at December 31, 2006 and 2005. The fair value of fixed-income held-to-maturity securities is disclosed in Note 3.
The Board of Directors and shareholders have authorized the American Physicians Capital, Inc. Stock Compensation Plan (the “Plan”). The Plan provides for the award of stock options and other share-based awards for officers, directors and employees of the Company.
These awards must be approved by the compensation committee of the board of directors. The total number of shares of the Company’s common stock authorized for issuance under the Plan is 1,800,000 shares, of which only 6,540 remain available at December 31, 2006 for future grants.
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted market price (adjusted for the effect of the stock split described in Note 1) of the Company’s common stock for the options that were in-the-money at December 31, 2006. For the years ended December 31, 2006, 2005 and 2004, the total intrinsic value of options exercised was $5.9 million, $2.1 million and $4.8 million, respectively, determined as of the date of option exercise.
A summary of the status and changes of nonvested shares issued under the Plan as of and during the year ended December 31, 2006 is presented below:
SFAS No. 123(R) also requires that the cash flows resulting from the excess tax benefits associated with the share-based compensation be classified as cash flows from financing activities. Accordingly, the Company has reported excess tax benefits of $2.1 million, $1.1 million and $1.0 million as cash inflows in the financing activities section of the statement of cash flows for the years ended December 31, 2006, 2005 and 2004, respectively. These incremental tax benefits are also credited to additional paid-in-capital. The pool of excess tax benefits credited to additional paid-in-capital has been determined using the alternative transition method as permitted by FASB Staff Position FAS 123(R)-3.
Expected volatility is based on historical volatility for the Black-Scholes valuation model. Under the binomial lattice model, expected volatility is based on a number of factors, including historical volatility, return on equity, price to book value ratios and trends impacting the medical professional liability insurance industry. The Company
uses historical data to estimate option exercise and employee termination behavior within both valuation models. The expected term represents an estimate of the period of time options are expected to remain outstanding based on the past exercise behavior of employees in relation to the Company’s current stock price. The risk-free interest rate is based on the yield of a zero-coupon U.S. Treasury security with a remaining term to maturity equal to the contractual term of the option, in the case of the binomial lattice model, and over the expected term for the Black-Scholes model.
Basic and diluted earnings per share are calculated in accordance with SFAS No. 128, “Earnings per Share.”
The Company participates in various guaranty associations in the states in which it writes business, which protect policyholders and claimants against losses due to insolvency of insurers. When an insolvency occurs, the associations are authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar years. The Company accrues for its portion of assessments in accordance with American Institute of Certified Public Accountants’ Statement of Position 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments.” Assessments to date are not significant; however, the ultimate liability for future assessments is not known. Accordingly, the Company is unable to predict whether such future assessments will materially affect the financial condition or results of operations of the Company. At December 31, 2006 and 2005, the Company had a recorded liability of $100,000 for amounts assessed by state guarantee associations, as well as the Company’s estimate of its share of any insolvencies not yet assessed.
The Company is obligated under operating leases, which have various expiration dates through October 2013. Minimum future lease payments are as follows: 2007 - $948,000; 2008 - $844,000; 2009 - $840,000; 2010 - $862,000 and 2011 and thereafter - $2,206,000. Rental expense was $546,000 in 2006, $710,000 in 2005, and $1,321,000 in 2004.
The following is statutory surplus at December 31, 2006, 2005, and 2004 and statutory net income for the years then ended.
The unaudited operating results by quarter for 2006 and 2005 are summarized below:
The audit referred to in our report dated March 13, 2007 relating to the consolidated financial statements of American Physicians Capital, Inc. and Subsidiaries, which is contained in Item 8 of this Form 10-K included the audit of the financial statement schedules listed in the accompanying index. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based upon our audit.
In our opinion such financial statement schedules present fairly, in all material respects, the information set forth therein.
APSpecialty Insurance Corporation - a stock insurance company incorporated under Michigan law (APSpecialty).