(A) Net income for 1998 was reduced by $1.1 million which represents the cumulative effect (net of tax) of an accounting change for guaranty fund assessments due to the adoption of the American Institute of Certified Public Accountants' Statement of Position 97-3. The cumulative effect reduced net income per share of common stock (Basic and Diluted) by $0.05 per share.
The payment of losses, loss adjustment expenses, and operating expenses in the ordinary course of business is currently the Company's principal need for liquid funds. Cash used to pay these items has been provided by operating activities. Cash provided from these activities was sufficient during 1998 to meet the Company's operating needs, and the Company believes those sources will be sufficient to meet its cash needs for operating purposes for at least the next twelve months. Prolonged and increasing levels of inflation could cause increases in the dollar amount of losses and loss adjustment expenses and may therefore adversely affect future reserve development. To minimize such risk, the Company (a) maintains what management considers to be strong and adequate reinsurance; (b) conducts regular actuarial reviews to ensure, among other things, that reserves do not become deficient; and (c) maintains adequate asset liquidity.
Marketable equity securities at December 31, 1998 are recorded at a fair value of $44.1 million, including net unrealized gains of $2.9 million. The securities have exposure to price risk.
The Company, through Mutual Assurance, has been developing a marketing strategy to address the insurance needs of hospitals and vertically-integrated health care providers. The Company expects organizations such as these to represent increasing market opportunities for professional liability and related insurance products because of the trend toward the consolidation of health care providers. In certain instances, Mutual Assurance's surplus is a competitive factor in this "large account" market because its principal competitors are larger than those with whom Mutual Assurance has historically had to compete.
The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
The Company's comprehensive Year 2000 initiatives are designed to ensure that there is no adverse effect on the Company's core business operations and that transactions with customers, suppliers, and financial institutions are fully supported. The Company is well underway with these efforts, which are scheduled to be completed in mid-year 1999.
New application systems, including hardware, that the Company has acquired and implemented or that are currently being implemented function properly with respect to dates in the year 2000 and thereafter. The Company presently believes that with planned modifications to existing software and conversions to new software, the Year 2000 issue will not pose significant operational problems for its computer systems. Because Year 2000 compliance is incidental to implementing the new software systems, costs specifically related to Year 2000 compliance are minimal.
The Company has also evaluated the risk of claims against its policyholders for medical incidents resulting in bodily injury to patients as a consequence of Year 2000 computer or medical device failure. The Company has required that hospitals and other large health care facilities complete questionnaires as to their Year 2000 preparedness in underwriting their professional liability insurance policies. If the questionnaire of a health care facility is not returned or provides inadequate or unsatisfactory information regarding this issue, the policy issued to such facility will exclude coverage for medical incidents caused by Year 2000 problems. The Company has not surveyed insureds who are physicians and surgeons as to their Year 2000 compliance and intends to offer coverage for claims from such medical incidents because the Company does not believe that physicians and surgeons will have significantly greater risk of liability if they are not Year 2000 compliant.
The reserve for losses and loss adjustment expenses represents management's best estimates of the ultimate cost of all losses incurred but unpaid. The reserves were evaluated by independent consulting actuaries and reflect consideration of prior loss experience and changes in the frequency and severity of claims. Actual incurred losses may vary from estimated amounts due to the inherent difficulty in estimating development of long-tailed lines of business. The estimated liability is continually reviewed and any adjustments that become necessary are included in current operations. However, the Company's management believes its actual incurred losses and loss adjustment expenses will not vary significantly from reported estimated amounts.
The increase in the 1998 gross loss ratios reflects continued geographic expansion and additional coverages offered. When expanding into areas where the Company has no significant prior loss experience, the Company follows loss estimation processes which result in higher gross loss ratios. Additionally, the Company reinsures a higher proportion of these risks, thereby lowering the net loss ratio. Thus, the 1998 net loss ratio of 66% did not vary significantly from the 1997 net loss ratio of 65%.
The increase in underwriting, acquisition and insurance expenses is due to amortization of increased policy acquisition costs associated with new business and increased costs from state guaranty fund assessments, offset by additional ceding commissions earned. Ceding commissions earned increased primarily because during 1998 a greater portion of the Company's reinsurance treaties provided for a ceding commission than was the case during 1997. See Note 5 to the Consolidated Financial Statements.
RESULTS OF OPERATIONS - YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
preferred stocks and $21.7 million of common stocks compared to $22.3 million of fixed rate preferred stocks and $10.8 million of common stocks for 1996. Disposition of investments prior to maturity may result in a net gain or loss which would be classified as "Other Income."
The Consolidated Financial Statements and Financial Statement Schedules of MAI and subsidiaries listed in Item 14(a) have been included herein beginning on page 30. The Supplementary Financial Information required by Item 302 of Regulation S-K is included in Note 12 of the Notes to Consolidated Financial Statements of MAI and its subsidiaries.