Chicago, Illinois; Louisville, Kentucky; Boca Raton, Florida; Eden Prairie, Minnesota; and Albuquerque, New Mexico. We also own various real estate investment properties as part of our investment portfolio. We have been successful subleasing the majority of our leased office space in Chicago and Eden Prairie, as that space is no longer needed as a result of our decision to exit the workers’ compensation line of business.
The following selected financial data, other than the selected statutory data, are derived from our Consolidated Financial Statements which were prepared in accordance with GAAP. The data should be read in conjunction with the Consolidated Financial Statements, related Notes and other financial information included elsewhere in this report. The selected statutory data are derived from our annual statements which were prepared in accordance with statutory accounting practices as required by insurance regulatory authorities. See Note 20 of the Notes to Consolidated Financial Statements for a discussion of the principal differences between GAAP and statutory accounting practices. Such information is incorporated herein by reference.
An insurance company earns investment income on what is commonly referred to as the “float.” The float is money that we hold, in the form of investments, from premiums that we have collected. Although most of these premiums will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period of time that we hold the float prior to paying losses can extend over several years. The key factors that determine the amount of investment income we are able to generate are: 1) the rate of return, or yield, on the float, and 2) the amount of time we are able to hold the float.
which we earn the premiums associated with the business written. Other costs that do not vary with the production of new and renewal business are charged to income as incurred.
The most significant factor contributing to the increase in medical professional liability premiums in recent years is the increase in average paid loss severity. To combat rising loss costs, we have initiated several actions including:
Tort reform is another factor that affects our business. Tort reform encompasses a variety of subject matters; however, the one most critical to the medical professional liability insurance market is limits on non-economic damages and punitive damages. Historically, tort reform has occurred on a state by state basis. Accordingly, losses can vary dramatically by state depending on the level of tort reform the state has enacted. We monitor state tort reform closely and evaluate any changes for impacts on our current business strategies and estimated loss reserves. Tort reform is currently being considered in various forms by Congress. If enacted, such reform could preempt state tort reforms currently in effect in the markets in which we do business. If federal reforms are less favorable than those currently in place in our markets, such reforms could have a material adverse effect on our business.
Anticipated losses will generally be the primary determinant of premium rates. We establish medical professional liability premium base rates for particular medical specialties within a given state and sometimes for a specific geographic region within a state. We also offer discounts or add surcharges for particular policyholder characteristics, such as claims history or participation in any risk-management programs. Our premium rates are based on anticipated losses on claims and related expenses, expected investment income,
Medical professional liability insurance can be written on both a claims-made and an occurrence basis. Claims-made policies, which are the most common, 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. During the last three years, approximately 70% of our medical professional liability direct premiums represented claims-made policies, with the remainder representing occurrence-based policies. Although we have discontinued writing occurrence based policies in certain states and markets, we have not seen an overall decrease in occurrence based premiums as a result of premium rate increases in New Mexico, where we are required to write occurrence based policies by law, and in other states such as Michigan.
Commissions SCW receives on premiums it writes for APCapital’s insurance subsidiaries typically account for 65% to 75% of its revenues. Direct premiums written for us by SCW during 2004, 2003 and 2002
Prior to Mr. Cheeseman’s retirement, there were various safeguards to protect the Company from actual or potential conflicts of interest arising from this relationship. Mr. Cheeseman was prohibited from acting as a director, officer or employee of SCW and, pursuant to Company policy, did not participate in day-to-day discussions between the Company and SCW or in decisions about whether to underwrite business proposed to be written by SCW prior to his retirement. Moreover, we applied and continue to apply the same underwriting rating rules to business written by SCW as we apply to business written by other agencies. These underwriting rating rules are generally filed with the regulatory agencies in the various states in which we do business and are established solely by the Company in order to control the quality of business submitted by all agents, including SCW. We also monitor our loss experience on the business written by our agents, including SCW.
Our Consolidated Financial Statements include estimated reserves for unpaid losses and loss adjustment expenses related to our various insurance lines of business. We have a team of actuaries on our staff that analyzes and develops projections of ultimate payments that will be made to settle all losses incurred as of each balance sheet date, and the related loss adjustment expenses. Our actuaries utilize standard actuarial techniques to project ultimate losses based on our paid and incurred loss information and claim count, as well as industry data. These projections are done using the Company’s data, including the number of claims reported and paid, and the average severity of reported and paid claims, as well as industry data. This process
assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. A key projection used in the actuarial estimation of ultimate losses takes an average payment (severity) times a projected total number of claims (frequency). Accordingly, any changes in the frequency or severity of claims reported to us can have a significant impact on actuarial estimates of ultimate losses and recorded reserves. Based on these quantitative as well as other qualitative factors, such as a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and the current reserving practices of the Company’s claims department, we select a “best estimate” of ultimate future losses, and then record this best estimate in the Company’s Consolidated Financial Statements. As required by insurance regulatory authorities, we receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves.
The assumptions and methodologies used in estimating and establishing the reserve for unpaid losses and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded 8% of our recorded net reserves as of the beginning of the period, but can materially and adversely affect our results of operations when an adjustment is made. Due to the current volatility of losses in the medical professional liability industry, adjustments have occurred in each of the last several years.
In late 2004, we started the liquidation of our equity securities portfolio. At December 31, 2004, we had approximately $1.2 million of non-affiliated private placement equity securities remaining in our portfolio. These equity securities were carried at market value, as determined by management, with the assistance of the Company’s third-party equity investment manager. This market value is an approximation of the net realizable value of the equity securities in light of management’s intent to sell the securities in 2005.
The fair value of fixed maturity securities is based on market quotations provided to us by our third-party custodian who engages independent third party pricing sources that use valuation models. The valuation models used by the independent third party pricing sources use indicative information such as ratings, industry, coupon, and maturity along with publicly traded bond prices to determine security specific spreads, and the ultimate fair value of the non-publicly traded fixed maturity securities. Real estate is carried at the lesser of historical cost, less accumulated depreciation or estimated fair value as determined by recent appraisals, offers from prospective independent third-party buyers, or the undiscounted future cash flows associated with the property. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
For further information regarding our investments, including the maturity distribution of fixed-maturity securities and unrealized holding gains and losses, see Note 5 of the Notes to Consolidated Financial Statements. Such information is incorporated herein by reference.
conditions, including the availability and pricing of reinsurance. Our reinsurance arrangements are generally renegotiated annually.
Future reversals of existing taxable temporary differences (i.e., deferred tax liabilities);
In making our assessment of the future realization of deferred tax assets, we considered all of the above sources of future taxable income. Our taxable losses in 2003, 2002 and 2001 mean that there is no taxable income available in the carryback years. We do not currently have any viable tax planning strategies. However,
unrealized gains related to our investment portfolio and other taxable temporary differences do create a source of future taxable income that we have considered in our realization assessment. Future taxable income exclusive of reversing temporary difference and carryforwards is the most subjective of the available sources of taxable income as it is based on future earnings projections. These subjective projections of future taxable income must be weighed against the objective evidence of our recent history of losses. The net income that we reported in 2004 is a positive factor indicating the availability of future taxable income; however, we do not believe that it is sufficient to overcome the negative evidence presented by our losses in 2003, 2002 or 2001. Accordingly, at December 31, 2004, we maintained a 100% valuation allowance.
Changes in the valuation allowance during 2004 were allocated in the accompanying Consolidated Financial Statements to federal income taxes (a component of net income), other comprehensive income, or other components of shareholders’ equity, depending on the nature of the deferred item that gave rise to the change. The establishment of the valuation allowance in 2003 was all recorded as federal income tax expense in the accompanying Consolidated Statements of Income, included elsewhere in this report. See Note 11 of the Notes to Consolidated Financial Statements for further discussion of the deferred tax valuation allowance and its impact on our financial condition and results of operations. Such information is incorporated herein by reference.
Deferred policy acquisition costs, or DAC, are those costs that vary with and are primarily related to the production of new, or renewal, business and include such costs as commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Under GAAP, the premiums that will be earned in future periods, to which these deferred costs relate, must produce sufficient profits to offset the future expense that will be recognized from the amortization of the DAC, that is, the DAC must be recoverable. In evaluating the recoverability of DAC, we have made certain assumptions regarding future costs associated with the business written, such as costs to maintain the policies and the ultimate projected loss and loss adjustment expense payments associated with these policies. In addition, we have considered future investment income in determining the recoverability of DAC, which requires certain assumptions regarding the timing of payments of future loss and loss adjustment expenses, as well as the yield on our investment portfolio. Based on our analysis as of December 31, 2004, the DAC carried on the Consolidated Balance Sheets, included elsewhere in this report, of $8.1 million, was deemed to be fully recoverable. However, during 2004, we wrote-off approximately $300,000 of DAC associated with our other insurance lines as it was deemed to not be recoverable. While we believe that our assumptions and estimates related to the recoverability of DAC are reasonable, historically, our accident year loss ratios have developed unfavorably. In the event that future unfavorable adjustments to loss reserves occur, the likelihood of our being able to recover these deferred costs will diminish, and the possibility of a write-off of a portion or all of our DAC in future periods will increase.
The statutory ratios will differ from GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, compared to net premiums written for the statutory underwriting expense ratio.
The following table sets forth our results of operations for the years ended December 31, 2004, 2003 and 2002 on a consolidated basis. The discussion that follows should be read in connection with the Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.
2004 Compared to 2003. The net income reported for 2004 was primarily attributable to the continued improvements in the underwriting performance (i.e. underwriting gain) of our medical professional liability segment combined with increased investment income over the prior year. Partially offsetting these positive factors were increases in the underwriting losses of the other insurance lines segment, which were primarily attributable to the run-off of the workers’ compensation and health lines of insurance, and increases in general and administrative expenses. The net loss reported in 2003 was the result of the unfavorable development on
prior year loss reserves, primarily related to our medical professional liability segment, and an increase in paid loss severity noted during the third quarter, particularly in our Florida, Ohio and Kentucky markets. We also established the deferred tax valuation allowance of $49.9 million in the third quarter of 2003, as we determined at that time there was not adequate support regarding the availability of future taxable income based on our recent loss history. Once the Company has re-established a pattern of profitability, the deferred tax asset valuation allowance may be reduced, or eliminated, based on the availability of future taxable income, which will create a federal income tax benefit in the period of reversal.
The increase in investment income was the result of strong returns on our collateralized-mortgage obligations and high-yield bond portfolios during the first part of the year, one-time call premiums of $1.5 million and a decrease in the percentage of our investment portfolio allocated to short-term investments. The yield on our investment portfolio was 5.93% for 2004 compared to 5.55% for 2003.
Underwriting expenses were $42.7 million for the year ended December 31, 2004, a decrease of $8.4 million from 2003. This decrease was the result of our lower premium volume, which lowered the corresponding commission and premium tax expense. In addition, we downsized the non-operational support staff in our home office during the first half of 2004. In total, we eliminated approximately 20 positions with severances totaling approximately $1.5 million during the year ended December 31, 2004. These 20 positions represent annual salary and employee benefit costs of approximately $1.4 million.
Investment expenses were $2.5 million for the year ended December 31, 2004, a decrease of $480,000 from the same period of 2003. This decrease is primarily related to the liquidation of our high-yield portfolio during the first half of 2004 and the sale of some of our investment real estate.
The decrease in federal income tax expense in 2004 was the result of the establishment of the deferred tax valuation allowance in 2003. Once we have re-established a pattern of profitability, and can demonstrate the availability of future taxable income, the deferred tax valuation allowance may be reduced, which will create a federal income tax benefit in the period of reduction.
2003 Compared to 2002. The net loss reported for 2003 was primarily attributable to unfavorable development on prior year loss reserves of $43.4 million and the establishment of a deferred tax valuation allowance of $50.6 million. The unfavorable development on prior year loss reserves was primarily related to our medical professional liability segment, and was the result of an increase in paid loss severity noted during the third quarter, particularly in our Florida, Ohio and Kentucky markets. We also established the deferred tax valuation allowance in the third quarter of 2003. Our net loss in 2002 was primarily the result of a $55.1 million underwriting loss, and a $9.1 million charge, net of tax, for the write-off of goodwill, which was recorded as a cumulative effect of a change in accounting principle, partially offset by $44.8 million of investment income.
Net premiums earned decreased during 2003, as compared to 2002, primarily as a result of the restructuring of our workers’ compensation book of business that began in 2002. In the fourth quarter of 2003, we announced our intention to exit the workers’ compensation and health insurance lines of business.
Underwriting expenses increased during 2003 as a result of increased salary and employee relation costs, amortization of our deferred policy acquisition costs, and the inclusion of Physicians Insurance Company, PIC, in our consolidated results during 2003. PIC was a start up medical professional liability insurance
company in Florida in which we had a 49% ownership interest during 2003. For more information regarding PIC, see Note 1 - Minority Interests of the Notes to Consolidated Financial Statements.
Amortization expense during 2003 relates to a definite-lived intangible asset acquired in connection with our investment in PIC.
Our general and administrative expenses increased during 2003 primarily as a result of increased legal, audit, and other professional fees pertaining to compliance with the new Sarbanes-Oxley legislation, and related SEC rules, and legal and investment banking fees incurred in the fourth quarter pursuant to the Board of Directors’ evaluation of strategic alternatives to maximize shareholder value after the loss reported in the third quarter.
Restructuring expenses incurred during 2003 were recorded during the fourth quarter and relate to employee separation costs as a result of terminations in connection with the initiation of our exit from the workers’ compensation segment.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our medical professional liability insurance operations for the years ended December 31, 2004, 2003 and 2002.
December 31, 2004, an increase of 13.5%. Although we began our exit from the Florida market in December 2002 and our premiums written in that state have declined significantly, we continue to have direct premiums written in that state as a result of installment premiums on extended reporting coverage, which we were required by Florida State law to offer insureds as we non-renewed their policies. The premiums for these policies may be paid in annual installments, not to exceed three years. Accordingly, with the exception of premiums related to PIC, we should not have any premium writings in Florida after 2005. Direct premiums written by PIC in the state of Florida increased $4.0 million during 2004 to $7.8 million compared to 2003. Our investment in, and consolidation of PIC is more fully described in Note 1 of the Notes to Consolidated Financial Statements. Such information is incorporated herein by reference
The increase in underwriting expenses is attributable to the higher direct written premiums, the payment of severance costs relating to a reduction in headcount, and an increase in professional service costs relating to our initial internal controls audit required by the Sarbanes-Oxley Act and related SEC rules.
The loss ratio, on an accident year basis, was 96.5% for the year ended December 31, 2003 compared to 106.1% for the year ended December 31, 2002. The decrease in the accident year loss ratio was primarily the result of rate increases in all markets.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our other insurance lines operations for the years ended December 31, 2004, 2003 and 2002.
The decreases in net premiums written were relatively consistent with the decreases in direct premiums written. Net premiums earned, however, did not decrease as much as direct and net premiums written, as premiums associated with workers’ compensation policies written in 2003 continue to be earned in 2004. At December 31, 2004, approximately $1.1 million of net unearned premium related to the workers’ compensation line of insurance remained. However, approximately $1.0 million of this net unearned premium relates to involuntary reinsurance that we are required to assume in many states. This assumed reinsurance is based primarily on the amount of direct premium we write in a given state. Accordingly, we anticipate that we will
see this assumed reinsurance decrease dramatically in 2005, which should reduce both our premium revenues and incurred losses.
Incurred loss and loss adjustment expenses decreased primarily as a result of the decrease in exposure associated with the reduced number of covered lives in our health line, and the number of policies in-force for workers’ compensation. Prior year reserves developed unfavorably during the year by $8.9 million, primarily those relating to the workers’ compensation business. The unfavorable development on prior accident year reserves is primarily the result of increasing reserve estimates due to an increasing paid severity trend. In addition, with the centralization of remaining workers’ compensation claims processing in our Louisville, Kentucky office, and in an effort to expedite the run-off process, we have reviewed a substantial portion of all outstanding claim files and are attempting to settle claims as quickly as possible. At December 31, 2004 and 2003, we had 1,087 and 2,176, respectively, open workers’ compensation claims. This increased effort has resulted in higher reported losses than those originally projected in the December 31, 2003 reserve estimates. As we continue the run-off of other insurance claims, loss reserves will continue to be volatile and additional adverse development on prior year losses may occur.
2003 Compared to 2002. Other insurance lines direct premiums written decreased during 2003 as a result of the restructuring of the books of business initiated in 2002 and the subsequent decision to exit these lines completely in 2003.
Net premiums earned did not decrease as much as direct premiums written as we continued to earn in 2003 the premiums that were written in 2002.
additional capital. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, and the repurchase of APCapital stock.
At December 31, 2004, we had no material planned expenditures for the acquisition of assets, or other expenditures, other than expenses incurred in the normal course of operations, with the exception of the potential acquisition of up to approximately 24% of the outstanding common stock of Physicians Insurance Company of Wisconsin, Inc., or PICW, described below.
In September 2003, the Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439. In 2004, we did not repurchase any shares pursuant to this plan. We repurchased 272,800 and 1,555,100 shares, at a cost of $7.7 million and $27.5 million, during 2003 and 2002, respectively, bringing the total number of shares purchased pursuant to these plans to 3,197,070, at a total cost of $60,382,000, or an average price per share of $18.89. Our repurchase of shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock 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 requirements. As of December 31, 2004, there are approximately 418,369 shares of the September 11, 2003 stock repurchase program remaining to be purchased. We continually evaluate the benefits of repurchasing our shares.
Our net cash flow generated by operations was approximately $52.0 million for the year ended December 31, 2004, compared to $9.1 million provided by operations for 2003. The cash generated by operations in 2004 was primarily the result of premiums collected, net of reinsurance premiums paid, of approximately $190.9 million, which exceeded losses paid of approximately $160.6 million. Premiums collected in excess of losses paid in 2003 were approximately $10.9 million. In general, our investment income
Based on historical trends, market conditions and our business plans, we believe that our existing resources and sources of funds will be sufficient to meet our short and long-term liquidity needs. However, economic, market and regulatory conditions may change, and there can be no assurance that our funds will be sufficient to meet these liquidity needs.
Our statutory capital and surplus, which we refer to collectively as surplus, at December 31, 2004 was approximately $210.9 million, which results in a net premiums written to surplus ratio of .87:1. Statutory surplus at December 31, 2003 was approximately $150.3 million, for a net premiums written to surplus ratio of 1.49:1. The decrease in our ratio of net premiums written to surplus was primarily the result of the exit from the other insurance lines of business in 2004, which resulted in lower premiums written during 2004, as well as our improved medical professional liability underwriting results. In addition, APCapital contributed $25 million to American Physicians in January 2004, American Physicians paid a dividend of $8 million to APCapital in December 2004, and APCapital made a surplus contribution to ICA for $4 million in December 2004.
The adequacy of our reserves for unpaid loss and loss adjustment expenses is another critical factor in evaluating our financial condition.
Also see “Part I - Item 1. Business - Loss and Loss Adjustment Expense Reserves” for a longer-term view on the development of our prior year loss reserves, as well as our estimated reserve ranges. The cross-referenced information is incorporated herein by reference.
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 the years ended December 31, 2004, 2003 and 2002, approximately 68%, 69% and 71% of the Company’s medical professional liability direct premiums written represented claims-made policies, with the remainder representing occurrence-based policies.
We write business throughout the United States of America, with an emphasis on markets in the Midwest. During 2004, approximately 77% of direct premiums written by the Company occurred in Midwestern states.
Write-downs for OTTI are recorded as realized losses in the period the security is considered impaired. The Company does not record realized gains for subsequent recoveries in the market value of an impaired security until the security is sold or otherwise disposed of.
At December 31, 2004 and 2003, the Company held approximately $5.1 million and $7.4 million, respectively, of interest-only certificates that the Company has determined contain an embedded derivative instrument as defined by Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” These certificates pay a variable rate of interest that is inversely related to the London Interbank Offered Rate (“LIBOR”), and due to their nature, may not allow the Company to recover substantially all of its investment.
These interest-only certificates are carried on the balance sheet at fair value as a fixed maturity security. These certificates are not linked to specific assets or liabilities on the balance sheet or to a forecasted transaction and, therefore, do not qualify for hedge accounting. In addition, the Company cannot 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, are recorded in current period earnings as investment income. During the year ended December 31, 2004, the fair value of these securities decreased by $338,000 and increased by $432,000 during the year ended December 31, 2003.
The Company’s internal actuaries develop projections of ultimate losses that are used to establish recorded reserves. Management utilizes these actuarial projections, as well as qualitative considerations, to establish a “best estimate” recorded reserve amount. Considerable variability is inherent in such estimates, especially in light of the 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.
The Company also recognizes premium income for any changes in its estimate for “earned but unbilled premiums.” Earned but unbilled premiums represent the portion of estimated future audit premiums, associated with workers’ compensation insurance policies, that will be billed in future periods, but have been earned during the period based on the effective dates of the policies that are expected to generate the future audit premium billings. Earned premiums during the years ended December 31, 2004 and 2003 were reduced by $339,000 and $606,000, respectively, as a result of decreases in the estimates for earned but unbilled premiums. Earned premiums during the year ended December 31, 2002 included $945,000 related to an increase in the estimate for earned but unbilled premiums. At December 31, 2004 and 2003, the estimates for earned but unbilled premiums, included in the premiums receivable balance on the accompanying Consolidated Balance Sheets, were $0 and $339,000, respectively.
Goodwill consists of the excess of cost over fair market value of the net assets of acquired businesses. Effective January 1, 2002, the Company completed the transitional impairment testing required by SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). Based on the results of the impairment testing, net goodwill of $13.9 million, $9.1 million net of tax, was written off as a cumulative effect of a change in accounting principle. See Note 4 for additional information regarding the effects of the adoption of SFAS No. 142.
In accordance with SFAS No. 123, as amended by SFAS No. 148, the Company is required to disclose the pro forma effects on operating results as if the Company had elected the fair value approach to account for its stock-based employee compensation plans.
Had compensation expense been determined based on the fair value at the grant date, consistent with the provisions of SFAS No. 123, our net income (loss) and net income (loss) per share would have been as follows for the years ended December 31, 2004, 2003 and 2002:
As the Company was in a net loss position for the years ended December 31, 2003 and 2002 no effect of options or other stock awards was calculated as the impact would be anti-dilutive.
Minority interests on the accompanying Consolidated Balance Sheets and Income Statements represents the 51% ownership interest of other investors in Physicians Insurance Company (“PIC”). PIC is included in the Company’s Consolidated Financial Statements as it has been determined to be a variable interest entity and the Company’s subsidiary, American Physicians, has been determined to be the primary beneficiary in accordance with the guidance given in FIN No. 46R, “Consolidation of Variable Interest Entities.”
Net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents (stock options and stock grants) outstanding during each year. As the Company was in a net loss position for the years ended December 31, 2003 and 2002, no effect of options or other stock awards was calculated as the impact would have been anti-dilutive (See Note 18).
Under the transitional guidance given in SFAS No. 123R, the Company may choose one of three transition methods. The Company intends to use the modified prospective transitional method upon adoption. Under the modified prospective method, there would be no compensation charge for vested awards that are outstanding on the effective date of SFAS No. 123R. Unvested awards that are outstanding on the effective date would be charged to expense over the remaining vesting period. Accordingly, the Company anticipates that it will recognize approximately $39,000 of incremental compensation costs in future periods related to unvested outstanding awards as of the effective date.
SFAS No. 130, “Reporting Comprehensive Income,” requires unrealized gains or losses on the Company’s available-for-sale investment securities arising during the period to be included in other comprehensive income, net of tax. Adjustments must be to other comprehensive income to avoid double counting in comprehensive income items that are included in net income that have also been included in other comprehensive income in that period or previous periods. Realized gains and losses, net of tax, related to the Company’s available-for-sale investment securities are included in net income of the period in which the securities are sold or an other than temporary impairment is determined. These realized gains and losses, however, have also been included in other comprehensive income as unrealized appreciation or depreciation in either the current period or previous periods, and therefore must be deducted from other comprehensive income in the current period to avoid including them in comprehensive income twice. The amount of net realized gains related to available-for-sale investment securities that must be deducted from other comprehensive income as a reclassification adjustment was $4,580,000, $1,587,000 and $235,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The reclassification adjustments for 2004, 2003 and 2002 are net of taxes of $2,466,000, $854,000 and $126,000, respectively.
was written off as the fair value, as determined by various fair value estimation approaches, including multiples of projected future net income and market capitalization of the Company’s reporting units, did not support the carrying value of previously recorded goodwill. The goodwill impairment was recorded as a cumulative effect of a change in accounting principle, net of a deferred income tax benefit of $4.9 million.
There was no goodwill acquired, amortized or impaired during 2004 or 2003.
In 2003, the Company acquired intangible assets related to certain non-compete agreements in connection with its investment in PIC and a covenant not to compete from the former President and Chief Executive Officer of the Company. The gross carrying amount and accumulated amortization of these intangible assets was $1.8 million and $1.2 million for the year ended December 31, 2004 and $1.8 million and $261,000 for the year ended December 31, 2003. Amortization expense related to intangible assets was $914,000 and $261,000 for the years ended December 31, 2004 and 2003, respectively. The estimated amortization expense related to these intangible assets is expected to be $625,000 for the year ended December 31, 2005. There will be no amortization expense related to these intangible assets beyond December 31, 2005.
The composition of the investment portfolio including unrealized gains and losses at December 31, 2004 and 2003 was:
The components of pretax investment income and net realized investment gains (losses) for the years ended December 31, 2004, 2003 and 2002 were:
Realized investment losses above exclude approximately $3.4 million, $7,000, and $293,000 during the years ended December 31, 2004, 2003 and 2002, respectively, of realized losses on the sale or disposal of fixed assets.
During the years ended December 31, 2004, 2003 and 2002, the Company recorded losses of $1.5 million, $1.3 million, and $770,000, respectively, on investments whose decline in market value was considered other than temporary. Net realized gains for the year ended December 31, 2004 are reduced by an OTTI charge of $489,000 for various stocks, as well as $1,050,000 of impairment losses on investment real estate. Net realized gains for the year ended December 31, 2003 include a $1.3 million charge for OTTI on enhanced equipment trust certificates issued by Delta Airlines. Net realized losses for the year ended December 31, 2002 includes an OTTI charge of $520,000 for the write down of bonds issued by Frontier Corporation, which were subsequently converted into equity securities of Global Crossings, Frontier’s parent company, as well as $250,000 impairment loss on investment real estate.
The carrying amount of bonds that were on deposit with various state regulatory authorities as of December 31, 2004 and 2003 was $8,283,000 and $8,311,000, respectively.
Approximately $3.3 million of the $3.4 million realized loss recorded during the year ended December 31, 2004 was related to the impairment of assets. The Company wrote-off capitalized software costs of $2.5 million associated with an information system project involving a computer system to administer medical professional liability policies and claims that was abandoned in the second quarter of 2004. Also during 2004, the Company wrote-off $815,000 of leasehold improvements related to leased office space that the Company no longer intends to occupy.
During 2003, the Company experienced a sharp increase in the severity of paid losses in our medical professional liability segment, which indicated a much higher trend in claims severity. As a result, actuarial projections resulted in higher ultimate severities of loss on currently existing claims related to the 1999 through 2002 accident years, which resulted in management increasing its estimate of incurred but not reported claims related to the 1999 through 2002 accident years by approximately $43.0 million in the third quarter of 2003.
In the second half of 2001, the Company encountered a large increase in reported losses, primarily in its Florida, Ohio and Kentucky medical professional liability markets. These higher than expected reported loss trends continued into 2002, but at a much lower level. As a result, the Company increased prior year loss reserves in 2002, primarily in its Ohio and Florida markets.
Management believes that the estimate of the ultimate liability for losses and loss adjustment expenses at December 31, 2004 is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Company’s actual incurred loss and losses 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.
In accordance with FIN No. 46R, “Consolidation of Variable Interest Entities,” these trusts are not consolidated in the Company’s Consolidated Financial Statements.
A reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2004, 2003, and 2002 is as follows:
The Company commuted its ceded reinsurance treaties with Gerling during 2004. The Company recognized the $13.5 million cash settlement received from Gerling as reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) in the current year. 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.
As the Company’s deferred tax assets and liabilities change, the valuation allowance also changes. Any change in the valuation allowance related to the tax effect of items that are included in continuing operations is recorded as federal income tax expense (benefit) from continuing operations in the period of change. In periods of reported net income, the change in the deferred tax valuation allowance that pertains to items that are not related to continuing operations, such as unrealized appreciation or depreciation on investment securities, is reported as a component of that measure of income to which those items pertain. Accordingly, the Company has recorded the effect of the change in the valuation allowance related to unrealized appreciation or depreciation on investment securities, as well as expenses from employee stock options that have different book and tax treatments, directly to either comprehensive income or shareholders’ equity in 2004.
SFAS No. 107, “Disclosures About Fair Value of Financial Instruments”, requires disclosures of fair-value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In situations where quoted market prices are not available, fair values are to be based on estimates using present value or other valuation techniques. SFAS No. 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements.
Under SFAS No. 107, the Company’s investment securities, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, long-term debt, and note payable constitute financial instruments. The carrying amounts of all financial instruments approximated their fair values at December 31, 2004 and 2003.
In the fourth quarter of 2003, the Company began to exit its workers’ compensation line of business. A total of twelve employees were terminated resulting in $808,000 of employee severance costs. Additional expenses of $185,000 were incurred in 2004 related to termination benefits associated with the run-off and exit of this line of business. These costs are included in the Other Expenses line in the income statement and are included in the loss before taxes reported for the workers’ compensation segment for the years ended December 31, 2004 and 2003.
In addition to the above amounts, certain employees related to the workers’ compensation line of business have been retained to manage the run-off of this line through June 2007. The employee separation costs
The former President and CEO of the Company is a majority owner of SCW Agency Group, Inc., an agency that sells the Company’s medical professional liability insurance in Michigan, Illinois, Kentucky, Florida and Nevada and workers’ compensation insurance in Michigan, Kentucky and other states. Direct premiums written by the agency during 2004, 2003 and 2002 totaled $74,372,000, $75,270,000 and $70,810,000, respectively, representing, 34.8%, 29.4% and 26.6% of direct premiums written during such years. Commission expense incurred related to SCW approximated $5,776,000, $5,962,000 and $5,560,000 in 2004, 2003 and 2002, respectively.
At December 31, 2003, the Company had a $286,000 non-interest bearing note receivable from SCW. At December 31, 2003, the Company had established an allowance in the full amount of the note. As part of the new master agency agreement between American Physicians and SCW, which was effective January 1, 2004, this note was forgiven in exchange for certain more favorable contract terms. Accordingly, the note and the allowance were written off during 2004, which did not result in a charge to income during 2004.
The Company has a $1.5 million note receivable from Chandler Office Park, LLC, a 50% owned real estate partnership accounted for on the equity method. The note is secured by the value of the land owned by the LLC.
The Company offers benefits under certain defined contribution plans. In 2004, 2003 and 2002, the defined contribution plans provide for Company contributions of 5% of employee compensation, as defined in the plan, and a 100% match of employee contributions on the first 3% of contributions and 50% match on the next 2% of contributions. Employer contributions to the plans were approximately $1,001,000, $986,000, and $995,000 for 2004, 2003, and 2002, respectively.
In December 2000, the Board of Directors adopted the American Physicians Capital, Inc. Stock Compensation Plan (the “Plan”). The Plan provides for the award of stock options and stock 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 which shall be available for options and stock awards is 1,200,000 shares.
Certain executive officers, board members and employees have been granted options to purchase shares of APCapital common stock. Options granted during 2004, 2003 and 2002 vest in annual installments of 33%, 33%, and 34% on the first through the third anniversaries, respectively, of the date of grant. All options expire on the tenth anniversary of the grant date.
A summary of the Company’s stock option activity is as follows:
In December 2000, the Company granted 135,200 restricted shares of APCapital common stock, having a per share market value of $13.50, to certain officers, board members and employees. The restricted shares vest in annual installments of 10%, 15%, 20%, 25% and 30% on the first through fifth anniversaries, respectively, of the date of grant. At that date, the Company also granted 200 shares of restricted stock to each full-time employee for a total grant of 39,600 shares at $13.50 per share. These shares vested annually at a rate of 20%, 35% and 45%, in 2001, 2002, and 2003, respectively. In January 2004, the Company issued an additional 30,000 shares of restricted stock to certain employees with a market value at the date of grant of $17.20 per share. The shares granted in 2004 vest annually at a rate of 33%, 33% and 34% in January 2005, 2006 and 2007, respectively, as long as the grantees remain employed by the Company. The Company recognizes compensation cost for the stock awards on a straight-line basis over the period of vesting based on the awards’ intrinsic value.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2004, 2003 and 2002:
As the Company was in a net loss position for the years ended December 31, 2003 and 2002, the effect of options or other stock-based awards was not calculated as they would have been anti-dilutive.
On December 30, 2003 and February 20, 2004, separate putative shareholder class action complaints were filed in United States District Court for the Western District of Michigan against the Company, its former President and Chief Executive Officer, and its Chief Financial Officer. The complaints alleged violations of federal securities laws for certain disclosures made by the Company between February 13, 2003 and November 6, 2003 regarding its operating results and the adequacy of its reserves, and each sought monetary damages in an unspecified amount. On March 23, 2004, the Court dismissed the first case and entered an Order approving a lead plaintiff in the second case. A consolidated amended complaint was filed by the lead plaintiff on May 7, 2004. On June 28, 2004, the Company and the individual defendants filed a motion to dismiss the complaint. The motion was successful and the complaint was dismissed with prejudice on January 12, 2005, and no appeal was filed prior to the now expired deadline.
The Company was not subject to any other material litigation at December 31, 2004. Though routine litigation matters may arise in the ordinary course of the Company’s insurance business, management does not expect these cases to have a material adverse effect on the Company’s financial condition or results of operations.
Approximately $1.046 billion of consolidated assets represent assets of the insurance companies that are subject to regulation as to the amount that may be transferred to APCapital in the form of dividends, loans or advances. The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding net realized gains (losses) on the sale of investments, or 10% of statutory surplus as of the preceding year end. Accordingly, as of January 1, 2005, approximately $20.6 million could be paid by the Company’s insurance subsidiaries without prior regulatory approval.
The Company is organized and operates principally in the property and casualty insurance industry and has three reportable segments - medical professional liability, other insurance lines and corporate and other.
The unaudited operating results by quarter for 2004 and 2003 are summarized below:
The significant loss in the third quarter of 2003, as compared to the first, second and fourth quarter of the same year, was primarily the result of adverse development on prior year loss reserves (Note 8) and the establishment of a deferred tax valuation allowance (Note 11).
APDirect Sales, LLC - a Michigan corporation that serves as APCapital’s direct sales channel.
American Physicians Capital Statutory Trust I - a trust formed in Connecticut for the purpose of issuing mandatorily redeemable trust preferred securities to institutional investors (Note 9)
APCapital Trust II - a trust formed in Delaware for the purpose of issuing mandatorily redeemable trust preferred securities to institutional investors (Note 9)
In 2003, APCapital issued $30.9 million of floating rate junior subordinated deferrable interest debentures (“Debentures”) to subsidiary trusts. The trusts have issued mandatorily redeemable trust preferred securities that have terms that are essentially the same as the Debentures issued by APCapital, which are the only assets of the trusts. See Note 9 of the Notes to Consolidated Financial Statements for a description of the Debentures and the transactions in which they were issued.