The following selected financial data, other than the selected statutory data, is 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 is derived from our annual statements which were prepared in accordance with statutory accounting practices as required by insurance regulatory authorities. See Note 19 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.
Federal income tax expense (benefit) includes expense of ($44.1) million and ($6.6) million in 2005 and 2004, respectively, related to the reversal, change in or establishment of a deferred tax valuation allowance.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect amounts reported in the accompanying Consolidated Financial Statements and related Notes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in the Company’s earnings in the period those estimates changed. The following policies are those we believe to be the most sensitive to estimates and judgments or involve revenue recognition. Our other accounting policies are described in Note 1 to our Consolidated Financial Statements.
The various reserving methods described above produce a range of possible reserve amounts. The selection of the best estimate reserve within the range requires careful actuarial judgment and analysis of diagnostic statistics such as those described above. In an effort to better explain the inherent uncertainty in our net loss and loss adjustment expense reserves, we have developed a reasonable range of estimates around the net carried reserves as of December 31, 2008. The range is disclosed and explained in “- Financial Condition.”
as of the beginning of the period, but they can materially affect our results of operations when an adjustment is made. Due to the current volatility of losses in the medical professional liability industry, adjustments were necessary in each of the last several years. See Note 8 of Notes to Consolidated Financial Statements for a table showing changes in the loss reserve during each of the last three years, which table is incorporated herein by reference.
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. Based on such a review in 2005, we transferred a significant portion of our fixed-income security portfolio from the available-for-sale category to the held-to-maturity category. Securities were transferred at their estimated fair value. Any unrealized gains or losses, net of taxes, at the date of transfer continue to be reported as a component of accumulated other comprehensive income, and are being amortized over the remaining life of the securities through other comprehensive income.
We currently have only two Level 1 securities in our investment portfolio, which are publicly traded equity securities. We have two Level 3 securities, one of which is valued by a pricing vendor using a pricing model as discussed above. However, due to a lack of comparable values from other pricing vendors with which to validate the fair value of this security, we have elected to classify this security as a Level 3. The other Level 3 security is valued based on cash flows, interest rate and other assumptions made by us, and results in a fair value for the security that approximates its par value. The rest of our fixed-income security portfolio consists of securities deemed to be Level 2, and are valued in accordance with the processes and procedures discussed above and in Note 4 of the Notes to Consolidated Financial Statements included elsewhere in this report for Level 2 fair values.
We periodically review our investment portfolio for any potential credit quality or collection issues and for any securities with respect to which we consider a decline in fair value to be other than temporary. Investments which are considered to be other than temporarily impaired, or OTTI, are written down to their estimated fair value as of the end of the period in which the OTTI was noted and the amount written down is recognized as a current period expense. Subsequent recoveries in the fair value of impaired securities are not reported in income, but rather as unrealized gains, net of tax, in comprehensive income. Inherent in our evaluation of a particular security are
A portion of the coverage that physicians purchase under claims-made policies is for an additional death, disability and retirement, or DDR, insurance benefit. 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 recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of expected future premiums associated with this DDR coverage. The reserves for these claims fluctuate based on the number of physicians who are eligible for this coverage and their age. Any changes in the DDR reserves are reflected as an expense in the period in which we become aware that an adjustment is necessary. At December 31, 2008 and 2007, our recorded DDR reserves were $13.0 million and $15.0 million, respectively, which include a discount related to the present value calculation of approximately $3.6 million and $4.5 million, respectively.
We review the financial stability of all of our reinsurers each quarter. This review includes a ratings analysis, as well as the most recent financial information, of each reinsurer participating in a reinsurance contract. At December 31, 2008, there were no known issues with the financial solvency of our reinsurers or their ultimate ability to pay amounts due to us. If we determine that the ultimate ability of a reinsurer is uncertain, we would be required to recognize a reserve and a corresponding expense in the period in which the determination is made. Our reinsurance arrangements are discussed in more detail in “Item 1. Business - Medical Professional Liability Operations” and in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - 2008 Compared to 2007” and in Note 10 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Deferred policy acquisition costs, or DAC, are those costs that vary with and are primarily related to the production of new or renewal business. Costs such as commissions and premium taxes are 100% related to new or renewal business production. Other costs, such as employee salaries, bonuses and benefits, must be allocated between that portion that pertains to new or renewal business production and that which does not. Such cost estimates are made on a department by department basis and are based on time studies.
Loss Ratio: This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The calendar year loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The accident year loss ratio, which is a non-GAAP financial measure, uses only those loss and loss adjustment expenses that relate to the current accident year (i.e., excludes the effect of development on prior year loss reserves). We believe the accident year loss ratio is useful in evaluating our current underwriting performance, as it focuses on the relationship between current premiums earned and losses incurred related to the current year. In the case of each loss ratio, calendar year or accident year, the lower the percentage, the more profitable our insurance business is, all else being equal.
These ratios, when calculated using our reported statutory results, will differ from the 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.
In addition to these measures of operating performance, we also use certain measures to monitor our premium writings and price level changes. We measure policy retention by comparing the number of policies that were renewed during a given period with the number of policies that expired. This retention ratio helps us to measure our success at retaining insured accounts. We also monitor our insured physician count, which counts the number of doctor equivalents associated with all policies. For this purpose a corporation or ancillary health care provider on a
The decrease in net premiums written was relatively consistent with the decrease in direct premiums written. The terms of our 2008 reinsurance treaty were very similar to those in the 2007 treaty, both in terms of coverage and premium rates. However, there was a small increase, approximately 0.5%, in the premium rate charged in 2008
compared with 2007, which accounted for the 0.5% decrease in net premiums written as a percentage of direct premiums written from 2007 to 2008. Our 2009 reinsurance treaty contains terms and rates that are similar to those of the treaty effective in 2008. As such, we anticipate that our net premiums written, as a percentage of direct, would remain at approximately 96%.
Net premiums earned decreased 10.5%, compared with the decrease in direct and net premiums written of 7.7% and 8.2%, respectively. The decrease in net premiums earned was greater than premiums written in 2008 due to the time delay between when premiums are written versus earned. Premiums are earned pro rata over the policy term, usually one-year. Therefore, premiums written in 2008 will be earned partially in 2008 and partially in 2009 depending on when the premium was written in 2008. Accordingly, the premiums earned in 2008 related to premiums that were written in 2008 and 2007, whereas premiums earned in 2007 were attributable to premiums written during 2007 and 2006.
The following table shows the current year verses prior year composition of our net incurred loss and loss adjustment expenses for the years ended December 31, 2008 and 2007.
Of the $31.5 million of 2008 favorable prior year development, excluding the $0.6 million effect of the 2005 treaty year commutation, $33.4 million was attributable to medical professional liability reserves, partially offset by
As discussed in “- Critical Accounting Policies,” the effect of changes in claims frequency introduces a great deal of variability in our reserve estimation process. We have a practice of being cautious with the assumptions we make concerning emerging trends in claim frequency and severity and do not immediately reflect the impact that any short-term declines in frequency may have on our ultimate losses. In addition, because the historical claims data we use to project future expected results covers more than 30 years, the impact of recent claims trends is often moderated by the substantial pool of historical data. However, we have now experienced the trend of declining claim frequency and relatively stable paid loss severity for several years in a row, and as a result these trends will begin to be more fully reflected in our reserve assumptions.
As a result of the continued better than expected reported claim frequency and relatively stable paid loss severity, we again experienced favorable development on prior years’ medical professional liability loss reserves in 2008. While claim frequency has declined and paid loss severity remained consistent, our average net case reserves, a potential indicator of future paid claim severity, has been increasing over the last several years. The following table shows our reported claim frequency, average net paid loss and average net case reserve per open claim over the last five years. We calculate the average net paid loss by dividing net paid losses for the year by the number of claims closed with a payment, indemnity or expense.
The adverse development on workers’ compensation prior years’ loss reserves is mostly attributable to increases in the medical portion of indemnity loss reserves on a small number of claims. With lines of business such as workers’ compensation where it can take a long time for claims to ultimately be resolved and settled, it is often difficult to ascertain whether increases in case reserves represent a strengthening of the case reserves or if the increases are indicative of an increase in the ultimate severity of the claims. While we believe that the reserve increases in 2008 represent reserve strengthening, we have taken a reasonably cautious approach with regard to the overall reserve levels, which is the reason for the adverse development in 2008.
Underwriting expenses decreased $2.7 million, or 8.9%, in 2008. The decrease in underwriting expenses was primarily attributable to the decline in our premium volume and the corresponding decline in those expenses that vary with premium volume. The underwriting expense ratio increased 0.4% to 22.1% in 2008, from 21.7% in 2007. The increase in the underwriting expense ratio was also attributable to our decline in premiums, as we had a lower premium base over which to spread underwriting costs that do not vary with premium volume, such as depreciation, property taxes and other overhead related costs, as well as certain personnel related expenses.
We anticipate that our underwriting expense ratio will increase approximately 1% to 2% in 2009 as we launch our new policy and claims system. Many of the costs related to this project have been capitalized over the last
Net realized losses of $0.7 million in 2008 were largely the result of a pre-tax charge of $0.9 million for the impairment of bonds issued by CIT Group. Although we believed that the ultimate collectability of these securities was not at issue, consistent with our philosophy of maintaining a strong, high-quality asset base and thereby protecting the strength of our financial position, we elected to dispose of the securities in question early in the second quarter of 2008 to mitigate any further down-side risk from continued declines in the market value of these securities. As the decision to sell the securities was made prior to the release of our first quarter 2008 results, the impairment charge was recorded in our first quarter 2008 results.
Other expenses consisted of the following for the years ended December 31, 2008 and 2007.
2007 Compared to 2006. Net income increased $9.6 million, or 22.2%, in 2007 compared to 2006, primarily as the result of favorable development on prior years’ loss reserves, which totaled $34.2 million in 2007 compared to $12.9 million in 2006. Partially offsetting the increase in favorable development were declines in realized gains and investment income, and an increase in federal income tax expense. Although net premiums earned decreased $10.8 million, this was largely offset by a $9.7 million decrease in current accident year losses and a $380,000 decrease in underwriting expenses. The decreases in accident year losses and underwriting expenses were largely the result of the lower premium volume. The significant amount of favorable prior year development experienced in 2007 was the result of favorable loss trends experienced throughout 2007.
The following table shows our direct premiums written by major geographical market as well as total net premiums written and earned for the years ended December 31, 2007 and 2006.
Premiums are generally earned pro rata over the policy term, usually one-year, and as a result fluctuations in earned premiums typically lag fluctuations in written premium. Accordingly, net premiums earned during 2007 did
not decline as much as net premiums written as we continued to earn in 2007 some of the higher premium volume that was written in 2006.
Underwriting expenses decreased $380,000, or 1.2%, in 2007 compared with 2006. The decrease in underwriting expenses was largely attributable to the decline in net premiums earned, which decreased 7.2% in 2007 compared to 2006, partially offset by $668,000 of additional underwriting expense in 2007 for costs incurred in connection with the development of our new policy and claims system. These cost primarily related to activities that could not be capitalized, such as data migration.
Other expenses for the years ended December 31, 2007 and 2006 consisted of the following.
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. These limitations are described more fully in Note 19 of the Notes to Consolidated Financial Statements. Such cross-referenced information is incorporated
We continued the repurchase of shares of our outstanding common stock in 2008. A total of 1,333,970 shares were repurchased in 2008 at a total cost of $53.2 million. See Note 12 of the Notes to Consolidated Financial Statements as well as “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for further details regarding our share repurchase plans. Such cross-referenced information is included herein by reference.
At December 31, 2008, we had $25.9 million of long-term debt obligations, which are described in greater detail in Note 9 of the Notes to Consolidated Financial Statements. This debt is the obligation of APCapital and pays a variable interest rate of approximately 4.15% plus the three month LIBOR rate. In May 2008 this debt became callable, in whole or in part, and we repaid $5.0 million of the original outstanding $30.9 million in August 2008. We frequently evaluate our capital management strategies with the intention of providing the most value to APCapital shareholders and making prudent use of APCapital’s cash resources. Any decision to make further repayments would be based on such evaluations, as well as changes in our available cash resources, capital needs and other relevant factors.
Our net cash flow provided by operations was approximately $41.4 million for the year ended December 31, 2008, compared to $46.0 million provided by operations in 2007 and $56.0 million in 2006. The following table shows the composition of our net cash flows from operations for the years ended December 31, 2008, 2007 and 2006.
We have no material planned expenditures for the acquisition of assets, or other expenditures in 2009 and beyond, other than expenses incurred in the normal course of operations and the remaining costs associated with the development and implementation of a new policy and claims system. The original projected cash outflow associated with the project was expected to be approximately $6.0 million. Through December 31, 2008 the total cost of the project had reached approximately $7.0 million, which represented substantially all of the costs associated with the project.
At December 31, 2008, we had $101.6 million of cash and cash equivalents and approximately $222.9 million of available-for-sale fixed-income securities and $19.4 million of available-for-sale equity securities that could be sold 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, 2008, we had approximately $74.5 million, $163.8 million and $88.4 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 $150.8 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 various claim statistics and reserve averages for our medical professional liability line of business at or for the years ended December 31, 2008, 2007 and 2006.
Our open and reported claim counts continued to decrease in 2008. While our claim counts have continued to decrease, our average net case reserve per open claim increased 15% in 2008. Average net case reserves are one measure of the severity of claims currently in our inventory. Our medical professional liability net IBNR reserves have also been increasing over the last several years as a result of assumptions we have made in our actuarial projections regarding future case reserve development and ultimate claim severity. At the same time, the decrease in reported claims has led to a decrease in the number of actuarially projected IBNR claims, resulting in an even greater increase in the average net total reserve per open plus estimated IBNR claim than average net case reserve per open claim. However, this is appropriate from an actuarial standpoint as it is assumed that the ultimate cost of settling the IBNR claims will exceed the cost of settling claims in our current inventory due to loss cost inflation and other factors.
The following table shows our net case, IBNR and total reserves at December 31, 2008, 2007 and 2006 for our medical professional liability line of business, as well as our net total reserves for our other lines of business that are in run-off.
The following table shows the development of the net liability for unpaid loss and loss adjustment expenses from 1998 through 2007. 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.
uncertainty in our net loss and loss adjustment expense reserves, we have developed a reasonable range of estimates around the net carried reserves as of December 31, 2008, as shown below.
The reserve range is a normal distribution, meaning that reserves are more likely to develop around the center of the range, or carried reserves, and less likely as you approach either the high or low end of the range. However it is meaningful to note the potential variability in the Company’s net income before the effect of income taxes if actual claims experience were to emerge more favorably, the lower end of the range, or less favorably, the higher end of the range, than anticipated. The following table shows the effects on pre-tax net income if the carried reserves as of December 31, 2008 develop at the low or high end of the range.
Our fixed-income investment security portfolio consists principally of high quality corporate, government-sponsored agency, tax-exempt municipal and mortgage-backed securities. The following table shows the total fixed-income investment portfolio allocation of each of these different types of securities as of December 31, 2008 and 2007.
of “conforming” mortgage loans that were issued prior to April 2005, are guaranteed by the issuing government-sponsored agency and have support tranches designed to promote the predictability of principal repayment cash flows.
The following table shows the distribution of our fixed-income security portfolio by Standard & Poors’ credit quality rating at December 31, 2008 and 2007.
Non-investment grade securities typically bear more credit risk than those of investment grade quality. In addition, we try to limit credit risk by not maintaining fixed-income security investments pertaining to any one issuer, other than U.S. Government and agency backed securities, in excess of $6 million. We also diversify our holdings so that there is not a significant concentration in any one industry or geographical region. For additional information regarding the risks inherent in our investment portfolio see “Item 7A, Quantitative and Qualitative Disclosures About Market Risk.”
The increase in other investments to $24.3 million at December 31, 2008 from $11.5 million at December 31, 2007 was primarily attributable to the acquisition of additional equity securities. At December 31, 2008 our available-for-sale equity securities included in other investments had a fair value of approximately $19.4 million. These equity securities represent strategic investments in two insurance companies. These companies were identified as being undervalued and potentially a long-term strategic partner for us. Accordingly, we view these as long-term investments and part of our overall capital strategy. However, as they are marketable securities, they are subject to the volatility inherent in today’s equity markets. At December 31, 2008 both securities were trading above our cost basis. However, subsequent to December 31, 2008 their market values have declined significantly. While we view these as temporary declines and our long-term strategy has not changed, there could be the potential for other than temporary impairment charges in future periods should their market values not recover. See “Item 7A, Quantitative and Qualitative Disclosures About Market Risk,” for additional information about the risks inherent in our equity security investments.
Reinsurance recoverables decreased $20.6 million, or 19.2%, to $86.4 million at December 31, 2008. As noted in “- Results of Operations,” we commuted our 2005 medical professional liability reinsurance treaty effective December 31, 2008. The commutation resulted in a decrease in our ceded loss and loss adjustment reserves of $16.0 million, partially offset by an increase in recoverable on paid losses of $3.8 million due to commutation proceeds that were not collected prior to December 31, 2008.
Shareholders’ equity at December 31, 2008 was $254.0 million, a decrease of $9.6 million, from $263.6 million at December 31, 2007. The decrease was the result of share repurchases totaling $53.2 million and shareholder dividends of $3.8 million. Partially offsetting these decreases in equity were $45.2 million of net income, $1.8 million of increase in unrealized gains, net of tax, and $0.5 million related to share-based payment awards. Our book value per common share outstanding at December 31, 2008 was $28.83 per share, based on 8,811,802 shares outstanding, compared to $26.02 per common share outstanding at December 31, 2007. Total shares outstanding at December 31, 2007 were 10,127,740.
We have formed two subsidiary statutory trusts for the purpose of issuing mandatorily redeemable trust preferred securities, referred to as “trust preferred securities”. The proceeds from the trust preferred securities that were issued were used by the trusts to purchase debentures issued by APCapital, which are shown as long-term debt in the Consolidated Balance Sheets included elsewhere in this report. APCapital used the amounts borrowed pursuant to these debentures to increase its available capital and has subsequently contributed substantially all of the proceeds to American Physicians to increase its statutory surplus. The debentures and the trust preferred securities have terms and maturities that mirror each other. In accordance with the guidance given in Financial Accounting Standards Board Interpretation No. 46, “Variable Interest Entities,” we have not consolidated these subsidiary trusts. APCapital has guaranteed that amounts paid to the trusts related to the debentures, will subsequently be remitted to the holders of the trust preferred securities. In accordance with the nature of the transactions, the amounts guaranteed by APCapital, are also recorded as liabilities in the Consolidated Financial Statements, as they represent obligations to the trusts, which are in turn obligated to the holders of the trust preferred securities. The obligations are more fully described in Note 9 of the Notes to Consolidated Financial Statements included elsewhere in this report, which description is incorporated herein by reference.
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, 2008:
At December 31, 2008 we had no planned material capital expenditures or other commitments other than those disclosed in the table above. We are, however, contingently liable to fund certain infrastructure improvement assessments associated with our investment in a real estate limited liability company as disclosed in Note 18 of the Notes to Consolidated Financial Statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and Subsidiaries at December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Physicians Capital, Inc.’s internal control over financial reporting as of December 31, 2008, 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, 2009 expressed an unqualified opinion thereon.
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers. The Company previously provided workers’ compensation, health and personal and commercial insurance, the results of which were combined and previously reported as the Company’s other insurance lines segment. In accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company has determined that it has a single reportable segment, which includes all of the Company’s operations.
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. 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. Premiums associated with these extended reporting endorsements are classified as occurrence. For each of the years in the three year period ended December 31, 2008, approximately 65% of the
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 the amortized cost, (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 amortized cost that is deemed to be other than temporary, results in a write-down of the cost basis of that security to fair value.
The fair values of our investment securities are determined by following the guidance and hierarchy in SFAS No. 157, Fair Value Measurements. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and quoted bid or ask prices are just a few of the observable inputs utilized. Prices determined by the model are then compared with prices provided by other pricing vendors and against prior prices to confirm that deviations are within tolerable limits. If the pricing vendors are unable to provide a current price for a security, a fair value is developed using alternative sources based on a variety of less objective assumptions and inputs (Level 3). See Note 4 for additional information regarding the fair values of our investment securities.
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. After considering future investment income, management has determined that all deferred policy acquisition costs are recoverable as of December 31, 2008. See Note 6 for activity in the deferred acquisition cost asset.
Property and equipment at December 31, 2008 and 2007, in the accompanying Consolidated Balance Sheets includes approximately $4.6 million and $4.5 million, respectively, of costs incurred in connection with the development of internal use software. These costs have been capitalized in accordance with American Institute of Certified Public Accountant’s Statement of Position No. 98-1 (“SOP 98-1”), Accounting for Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires that costs incurred in the planning and post-implementation stages, as well as costs associated with data migration be expensed as incurred, while costs associated with the acquisition or development of the actual application are capitalized. Once the software is placed into production, the Company will amortize the capitalized costs associated with the development of the software over a five-year period. During the fourth quarter of 2008, the claims module of the software, representing an asset of $3.8 million, was placed in service and reclassified from property and equipment to other assets in the accompanying Consolidated Balance Sheets. Amortization expense of $189,000 was recorded on the portion of the software placed in service in 2008. The following table shows the expected amortization expense for the next five years for internally developed software placed in service in 2008.
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 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 adjustments are made.
The Company evaluates each ceded reinsurance contracts at inception to determine if there is sufficient risk transfer to allow the contract to be accounted for as reinsurance under current accounting guidance. At December 31, 2008 all ceded contracts are accounted for as risk transferring contracts.
Income taxes are accounted for under the asset and liability method. Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. 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.
On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment” using the modified prospective transition method. Accordingly, the Company recorded share-based compensation expense of $44,000, $160,000 and $571,000 for the years ended December 31, 2008, 2007 and 2006, respectively, for awards granted prior to, but not vested as of January 1, 2006, adjusted for estimated forfeitures, using the fair value method. Additional information regarding the Company’s share-based award plans can be found in Note 16.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” Which clarifies how Statement No. 60 applies to financial guarantee insurance contracts issued by insurance companies. SFAS No. 163 addresses the differing views in SFAS No. 60 regarding the recognition and measurement of premium revenues and claim liabilities and enhances the disclosure requirements for financial guarantee insurance contracts. SFAS No. 163 is effective for financial statements issued
for fiscal years beginning after December 15, 2008. The Company does not expect the provisions of SFAS No. 163 to have a material effect on its Company’s consolidated results of operations, financial position or liquidity as it does not write financial guarantee insurance.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 improves financial reporting by providing a consistent framework for selecting accounting principles to be used when preparing GAAP financial statements. This statement assigns a hierarchical rank to the various sources of accounting literature from Level A through Level D. SFAS No. 162 is effective 60 days after the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board’s amendments to AU Section 411. The Company does not expect the provision of SFAS No. 162 to have a material effect on its consolidated results of operations, financial position or liquidity.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations, a replacement of SFAS No. 141, Business Combinations. SFAS No. 141R provides revised guidance on how an acquirer recognizes and measures in its financial statements, the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination. SFAS No. 141R also provides guidance specific to the recognition, classification, and measurement of assets and liabilities related to insurance and reinsurance contracts acquired in a business combination. SFAS No. 141R applies to business combinations for acquisitions occurring on or after January 1, 2009. The Company does not expect the provisions of SFAS No. 141R to have a material effect on its consolidated results of operations, financial position or liquidity unless a business combination transaction is consummated after January 1, 2009.
The composition of the Company’s available-for-sale investment security portfolio, including unrealized gains and losses at December 31, 2008 and 2007, was:
The following table shows the carrying value, gross unrecognized holding gains and losses, as well as the estimated fair value of the Company’s held-to-maturity fixed-income security portfolio as of December 31, 2008 and 2007. The carrying value at December 31, 2008 and 2007 includes approximately $1.9 million and $2.8 million of unrealized gains, respectively, as a result of the transfer of certain securities from the available-for-sale to the held-to-maturity category in previous years. These unrealized gains continue to be reported as a component of accumulated other comprehensive income in the accompanying Consolidated Balance Sheets, and will be amortized over the remaining life of the security through comprehensive income.
Those securities in the tables above that are in an unrealized or unrecognized loss position at December 31, 2008 or 2007 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, 2008 or 2007 were considered investment grade. The Company defines investment grade securities as those that have a Standard & Poors’ credit rating of BBB and above. In addition, all mortgage-backed securities held by the Company were issued by U.S. government sponsored agencies, consist of “conforming” mortgage loans that were issued prior to April 2005, are guaranteed by the issuing government-sponsored agency and have support tranches designed to promote the predictability of principal repayment cash flows. Based on the absence of significant negative factors regarding the issuer’s credit-worthiness, combined with the Company’s ability and intent to hold the securities above that are in an unrealized or unrecognized loss position until their maturity, or for a sufficient period of time to allow for the recovery of the securities market value, the decline in their market value is deemed to be temporary in nature.
During the first quarter of the year ended December 31, 2008, the Company incurred other than temporary impairment losses of $858,000 due to its decision to sell a bond at a loss early in the second quarter of 2008. There were no other than temporary impairment losses recorded during 2007, and $178,000 during 2006.
The components of pre-tax investment income and net realized gains for the years ended December 31, 2008, 2007 and 2006 were:
The estimated fair value of fixed-income securities classified as available-for-sale and the carrying value and estimated fair value of fixed-income securities classified as held-to-maturity at December 31, 2008, by contractual maturity, were:
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. During the years ended December 31, 2008 and 2007, the Company received no call premiums. Any call premiums would be recorded as investment income in the period in which the security is called.
As discussed in Note 1, effective January 1, 2008, the Company implemented SFAS No. 157 relating to its financial assets and liabilities. SFAS No. 157 establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The following is a description of the Company’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a recurring or nonrecurring basis:
Other non-financial assets that are measured at fair value on a nonrecurring basis for the purposes of determining impairment include such long-lived assets as property and equipment and investment real estate. The Company’s non-financial liabilities measured at fair value subsequent to initial recognition are limited to those liabilities associated with certain exit costs initiated in previous periods. Due to the nature of these assets and liabilities, inputs used to develop the fair value measurements will generally be based on unobservable inputs and therefore most of these assets and liabilities would be classified as Level 3. However, recent purchase and/or sales activity with regard to real estate investments adjoining the property owned by the Company may qualify such investments for Level 2 classification. The Company will apply the fair value measurement and disclosure provisions of SFAS No. 157 effective January 1, 2009 to these non-financial assets measured on a nonrecurring basis.
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, 2008, 2007 and 2006.
Depreciation expense associated with property and equipment for the years ended December 31, 2008, 2007, and 2006, was $915,000, $1.0 million and $1.4 million, respectively.
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and three-month LIBOR plus 4.20% for the second trust issuance, payable quarterly. In May 2008, these debentures became callable, and APCapital repaid $5.0 million of the outstanding $30.9 million obligation in August 2008. The interest rate is adjusted on a quarterly basis. The average interest rates of 7.2% (Trust I issuance) and 7.6% (Trust II issuance) resulted in interest expense of approximately $2.1 million for the year ended December 31, 2008. Interest expense for the years ended December 31, 2007 and 2006 was $2.9 million and $2.8 million, respectively. At December 31, 2008 and 2007, accrued interest payable to the trusts was approximately $190,000 and $320,000, respectively. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS. As the amounts that could potentially be payable under the guarantees are recorded as liabilities by the Company, no additional liability related to these guarantees has been accrued.
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation. A reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2008, 2007 and 2006, is as follows:
The provision (benefit) for income taxes for the years ended December 31, 2008, 2007 and 2006, consists of:
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, 2008 and 2007. The fair value of fixed-income held-to-maturity securities is disclosed in Note 3.
The Company offers benefits under certain defined contribution plans. In 2008, 2007 and 2006 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 $841,000, $855,000, and $831,000 for 2008, 2007 and 2006, respectively.
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 10,350 remain available at December 31, 2008 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 of the Company’s common stock for the options that were in-the-money at December 31, 2008. For the years ended December 31, 2008, 2007 and 2006, the total intrinsic value of options exercised was $503,000, $2.5 million, and $5.9 million, respectively, determined as of the date of option exercise.
The Company determines its pool of “windfall” tax benefits accumulated in additional-paid-in-capital following the ’short-cut” method as permitted by FASB Staff Position No. FAS 123(R)-3: Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. During the years ended December 31, 2008, 2007 and 2006, the excess tax benefit realized from the exercise of options and vesting of other share-based awards resulted in increases in additional-paid-in-capital of $164,000, $1.0 million, and $2.1 million, respectively.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2008, 2007 and 2006:
In accordance with SFAS No. 128, “Earnings per Share,” the diluted weighted average number of shares outstanding includes an incremental adjustment for the assumed exercise of dilutive stock options and non-vested share awards. Stock options are considered dilutive when the average stock price during the period exceeds the exercise price and the assumed conversion of the options, using the treasury stock method as required by SFAS No. 128, produces an increased number of shares outstanding. Stock options with an exercise price that is higher than the average stock price during the period are excluded from the computation as their impact would be anti-dilutive. There were no stock options that were considered to be anti-dilutive, and therefore excluded from the calculation, during any of the three years ended December 31, 2008.
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, 2008 and 2007, 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 was not subject to any litigation at December 31, 2008 other than routine litigation in the ordinary course of the Company’s business. Management does not expect these cases to have a material adverse effect on the Company’s financial condition or results of operations.
American Physicians, APSpecialty and ICA, insurance companies each domiciled in the State of Michigan, are included in the accompanying Consolidated Financial Statements in accordance with GAAP. These entities are subject to regulation by the State of Michigan Office of Financial and Insurance Regulation and file financial statements using statutory accounting practices prescribed or permitted by the state insurance regulators. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Such practices vary in certain respects from GAAP. The principal variances are as follows:
The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period without prior regulatory approval 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 on an individual company basis. In accordance with these limits, during 2008 APCapital’s insurance subsidiaries paid it dividends totaling $63.0 million. The insurance subsidiaries could pay dividends to APCapital of approximately $48.0 million in 2009 without prior regulatory approval. However, the $48.0 million that may be paid in 2009 is subject to limitation based on the timing and amount of the dividends that were paid in the preceding 12 months. Accordingly, no dividends may be paid, without prior regulatory approval, until the third quarter of 2009, at which time dividends of $25.0 million may be paid. The remaining $23.0 million in “ordinary” dividend payments are not permitted until December of 2009.
The unaudited operating results by quarter for 2008 and 2007 are summarized below:
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’s subsidiaries, APManagement Ltd and APIndemnity (Bermuda) Ltd., were liquidated effective February 28, 2006 and May 10, 2006, respectively.
The Company files a consolidated federal income tax return with the following entities: