APSG also leases approximately 1,200 square feet of office space for the Company at 5401 North Central Expressway, Suite 316, LB #B4, Dallas, Texas.
Reserve for Loss and Loss Adjustment Expense. Loss and loss adjustment expense reserves represent management’s best estimate of the ultimate costs of all reported and unreported losses incurred. The reserves for unpaid losses and loss adjustment expenses are estimated using actuarial analysis. These estimates include expectations of what the ultimate settlement and administration of claims will cost based on the company’s assessments of facts and circumstances then known, review of historical settlement patterns, estimates in trends in loss severity, frequency, legal theories of liability and other factors. Other factors include the nature of the injury, the judicial climate where the insured event occurred, and trends in health care costs. In addition, variables in reserve estimation can be affected by both internal and external events, such as economic inflation, legal trends and legislative changes. The estimation of medical professional liability loss and loss adjustment expense is inherently difficult. Injuries may not be discovered until years after an incident, or a claimant may delay pursuing recovery for damages. Medical liability claims are typically resolved over an extended period of time, often five years or more.
The following table reflects the activity in the liability for reserve for losses and loss adjustment expenses showing the changes for the twelve month periods beginning January 1, 2004 and ending December 31, 2006.
During 2005, we continued to review the impact of tort reform and while current accident year reported claims were substantially lower, loss costs and legal expenses on prior-year claims continued to trend significantly higher. We determined that the effect of tort reform not only increased the number of claims reported in 2003, but also increased the cost of litigating remaining open cases for other open prior accident years. As a result, during 2005, we continued to increase incurred loss and loss adjustment expense reserves related to prior accident years by $15,715,000. The net incurred increase in claim estimates related to prior years did not result in any direct accrual of additional premiums nor did it result in any additional ceded premiums during 2005 and 2004.
If reserves ultimately prove to be too high, then the excess amount will be recognized as a reduction to loss and loss adjustment expenses in the current period of operations that the change in estimate is made. If reserves prove to be inadequate in the future, we would have to increase such reserves and incur a charge to earnings in the period that such reserves are increased, which could have a material adverse affect on our results of operations and financial condition. These specific risks described above, combined with the variability that is inherent in any reserve estimate, could result in significant positive or adverse deviation from our carried reserve amounts.
Premiums Ceded. We enter into reinsurance agreements whereby other insurance entities agree to assume a portion of the risk associated with the policies issued by the Company. In return, we agree to pay a premium to the reinsurers. We utilize reinsurance to provide for greater diversification of business, which allows management to control exposure to potential losses arising from large risks, and allows us to have additional capacity for growth.
The effect of reinsurance on premiums written and earned is as follows (in thousands)
Reinsurance Recoverables. Ceded reserves for loss and loss adjustment expenses are recorded as reinsurance recoverables. Reinsurance recoveries are the estimated amount of future loss payments that will be recoverable from reinsurers, and represent the portion of losses incurred that are estimated to be allocable to reinsurers.
Similar to the estimate for reserves, due to the long-tailed nature of the medical professional liability line of insurance, relatively small changes in the actuarial assumptions for trends, inflation, severity, frequency for projected ultimate loss and loss adjustment expense reserves can have a greater impact on the recorded balance for reinsurance recoverables than with most other property and casualty insurance lines. While we believe that our estimate for ultimate projected losses related to loss and loss adjustment expense in the reinsurance layer is adequate based on reported and open claim counts, there can be no assurance that additional significant reinsurance reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
Reinsurance contracts do not relieve us from our obligations to policyholders. We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. Any amount found to be uncollectible is written off in the period in which the uncollectible amount is identified. We require letters of credit from any reinsurance company that does not meet certain regulatory requirements, and or credit ratings. As of December 31, 2006, all of our reinsurance contracts were with companies in strong financial condition with an AM Best rating of A are better or have established letters of credit to cover potential claims, and management believes there is not a need to establish an allowance for uncollectible reinsurance recoverable.
Unsecured reinsurance recoverables at December 31, 2006 and December 31, 2005, that exceeded 10% of total reinsurance paid and unpaid loss and loss adjustment expenses are summarized as follows (in thousands):
Deferred Policy Acquisition Costs. The costs of acquiring and renewing insurance business that vary with and are directly related to the production of such business are deferred and amortized ratably over the period the related premiums are earned. Such costs include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred acquisition costs are recorded net of ceding commissions. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed in the period the determination is made.
Refundable Deposits. We were initially capitalized by contributions from our subscribers. While no new deposits have been required since 1992, we have an obligation to repay these amounts and have classified these as a liability in accordance with Statement of Financial Accounting Standards (“SFAS”) No.150, Accounting for Certain Financial Instruments with characteristics of both Liabilities and Equity. Additionally, see Note 8 of our audited financial statements included herein for more complete information. Effective with the conversion and merger, the remaining balances of refundable deposits were extinguished in exchange for APSG Series A redeemable preferred stock.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believes it is more likely than not our deferred tax assets will be fully recovered.
We delivered positive results in 2006 and 2005, despite rate decreases in both years, which lowered gross premiums and maintenance fees written. Despite lower premiums, improvements in the Company’s terms on reinsurance contracts coupled with lower loss and loss adjustment expenses post-tort reform allowed us to deliver positive income from operations and net income after taxes. For the years ended 2006, 2005 and 2004, we had income from operations of $24,148,000, $13,218,000 and $9,237,000, respectively and net income, after taxes of $15,751,000, $9,031,000 and $5,815,000, respectively.
In 2004 and 2005, reported claims counts were substantially lower than pre-tort reform years. Prior to September 1, 2003, the effective date of the new tort reform law, we saw claim counts rise sharply as a result of increased filings. In 2003, 2004 and 2005, after careful evaluation of open claims and trend assumptions, we increased our loss and loss adjustment expense substantially for prior year development on pre-tort reform claims based on the potential impact of these claims in relation to post-tort reform claims and the associated cost of litigation. We believe that the full impact of tort reform will not be known for several years since many cases filed prior to the effective date of the tort reform laws still remain open. In addition, the full impact of the non-economic cap on damages itself is still unknown since many of the post-tort reform cases are still in litigation and remain open.
Premiums ceded decreased from $12,885,000 for the year ended December 31, 2005 to $4,709,000 for the year ended December 31, 2006. The decrease of $8,176,000 in premiums ceded is primarily the result of lower estimated ceded premiums for treaty years 2002 through 2005 related to profit sharing provisions of these treaties. The Company, supported by independent actuarial reviews continually monitors the development of claims subject to reinsurance and adjusts the reinsurance premium ceded for the estimated profit sharing provision based on claims development in the reinsurance layer. We enter into reinsurance contracts, which provide coverage for losses in excess of the Company’s retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The reinsurance contracts for 2002 through 2006 contain variable premium ceding rates based on loss experience. The actual percentage rate charged by reinsurers under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties. During 2006 we lowered the estimated ceding rates for prior treaty years 2002 through 2005, which caused us to recognize $7,743,000 in positive development as a reduction in ceded premium. Additionally, ceded premiums decreased year over year due to the Company retaining 10% of any claim in excess of $250,000 for the 2006 reinsurance treaty. We did not retain any excess on the 2005 treaty. We are retaining this additional risk in the reinsurance layer in excess of $250,000 based on decreases in claims since the passage of tort reform legislation in 2003. In addition, ceded premiums are lower for the current period due to lower earned premiums in 2006 as compared to 2005. Offsetting these above decreases in ceded premiums was an increase in premium ceded of $979,000 related to increased claim and loss activity in 2006 as compared to 2005.
Net premiums and maintenance fees earned increased $6,676,000 to $70,859,000 for the year ended December 31, 2006 from $64,183,000 for the year ended December 31, 2005. The increase is primarily the result of a decrease in premiums ceded discussed above. Additionally, higher net earned premiums and maintenance fees are the result of an increased number of insured physicians purchasing extended reporting coverage upon cancellation. Total extended reporting period coverage endorsement premiums were $2,713,000 for the year ended December 31, 2006 as compared to $2,510,000 for the same period in 2005. The increase in extended reporting coverage endorsement premiums is primarily attributable to one large physician group terminating coverage and purchasing an extended reporting period coverage endorsement. These increases were offset by the earn-out of written premiums which decreased $4,468,000 from $79,301,000 for 2005 to $74,833,000 for 2006 due primarily to rate decreases.
Loss and loss adjustment expense decreased by $5,006,000 from $43,976,000 for the year ended December 31, 2005 to $38,970,000 for the year ended December 31, 2006. The decrease of $5,006,000 is the result of the following factors. First, for the year ended December 31, 2006 as compared to the year ended December 31, 2005, we increased current accident year loss and loss adjustment expenses by $15,170,000 as a result of the increase in the number of claims filed in 2006 and the growth in the number of policyholders as compared to 2005. For the year ended December 31, 2006, 495 claims were reported as compared to 336 reported claims for 2005. Additionally, we increased the number of policyholders from 3,919 as of December 31, 2005 to 4,712 as of December 31, 2006. Claims open at December 31, 2006 were 809, an increase of 107 over the prior year end. The increase in the number of open claims is primarily the result of increased claims opened during the current year. Second, we re-evaluated all open claims and trend assumptions for prior year open claims. As a result of this review, in consultation with the Company’s outside independent actuary, we recorded favorable development of $4,461,000 for the year ending December 31, 2006 related to prior years as compared to unfavorable development of $15,715,000 for the year ending December 31, 2005. The favorable development of prior-year claims in 2006 was primarily the result of 2004 and 2005 report year loss severity falling below expectations. Additionally, the total number of claims closed with indemnity for the 2004 and 2005 report years were developing favorably from prior estimates.
We had net premiums and maintenance fees earned of $64,183,000 and $64,616,000 for the years ended December 31, 2005 and 2004, respectively. The decrease is primarily the result of the previously discussed rate decreases and partially offset by the increased number of insured physicians.
Other underwriting expenses which consist primarily of management fees, commissions to agents, premium taxes and general operating expenses were $12,768,000 and $12,103,000 for the years ended December 31, 2005 and 2004, respectively. APSG, through a wholly owned subsidiary of APSG, serves as our attorney-in fact. In accordance with the terms of a management agreement, the attorney-in-fact performs the administrative functions related to our operations. The attorney-in-fact receives a management fee for providing these services. The management fee is calculated as a percentage of the direct gross earned premiums plus a contingent management fee that is based upon our financial performance. The contingent management fee is calculated based upon 50% of our statutory pre-tax and pre-contingent fee income, capped at 3% of direct gross earned premiums. Total management fees of the Company totaled $11,000,000 and $10,600,000 in 2005 and 2004, respectively. Of these total management fees incurred, $6,000,000 and $5,400,000 were allocated to other underwriting expenses for 2005 and 2004, respectively. The remaining management fees for each of the years were allocated to loss adjustment expenses and investment expenses.
We believe that we have the ability to fund our continuing operations from premiums written and investment income. We plan to continue our focus on the efficient operation of our core business.
The following table shows the development of the net liability for unpaid loss and loss adjustment expenses from 1996 through 2006. 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.
We maintain a portion of our investment portfolio in short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and loss expenses. We also invest a substantial part of our cash flow from operations principally in bonds/fixed income securities. We plan to continue our emphasis on fixed income securities investments.
Cash and cash equivalents and invested assets totaled $144,583,000 and $116,749,000 at December 31, 2006 and December 31, 2005, respectively. Cash and cash equivalents and invested assets represent 70.1% and 66.8% of our total assets for the same respective periods. We believe that all of our short-term and fixed-maturity securities are readily marketable and have scheduled maturities in line with projected cash needs.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure certain financial assets and liabilities at fair value which are otherwise measured on a different basis in existing literature. Additional disclosures are required. It is effective for the Company, if elected, as of January 1, 2008. Early adoption is permitted with several constraints. Management is currently evaluating the impact of this Statement.
There were no off-balance sheet arrangements as of December 31, 2006 or 2005.