We operate in the MPL insurance sector of the property and casualty insurance industry. Our primary insurance products provide protection for physicians, dentists and other healthcare providers as individual practitioners or as members of practice groups. Our insurance protects policyholders against losses arising from professional liability claims and the related defense costs with respect to injuries alleged to have been caused by medical error or malpractice. Optional coverage is available for professional corporations under which physicians or dentists practice. Through our insurance subsidiaries, we are the largest provider of MPL insurance in Florida. Based on 2007 premiums reported by SNL Financial LC, Florida is the fourth largest market for MPL insurance in the United States in terms of direct premiums written. We focus on selected markets where we believe we have advantages in terms of our market knowledge, well-established reputation, meaningful market presence and resources.
Net income decreased 37 percent (29 percent on a diluted common share basis) for the year ended December 31, 2008 compared to 2007. Excluding the impact of the PRI commutation in February 2007, net income decreased 22 percent (12 percent on a diluted common share basis) for the year ended December 31, 2008. See the discussion below of certain factors, including, among other things, the PRI commutation, favorable prior year loss development, net realized investment losses and guaranty fund assessments that affect the comparability of our results from different periods.
Net premiums written increased 27 percent for the year ended December 31, 2008 compared to 2007. Excluding the impact of the PRI commutation on assumed premiums written for 2007, net premiums written declined 11 percent in 2008 as a result of lower premium rates in our Florida market offset to some extent by an increase in professional liability policyholders. The decrease in Florida premium rates over the last few years also drove a decline in net premiums earned.
As a result of the continuation of favorable loss trends, we recognized favorable net loss development related to previously established reserves of $17.0 million for the year ended December 31, 2008 compared to $16.0 million for the year ended December 31, 2007. The favorable net loss development in 2007 excludes the impact of the PRI commutation.
Book value per common share was $33.31 as of December 31, 2008 compared to $33.03 as of December 31, 2007. We received $47.5 million in dividends from our insurance subsidiaries during 2008. The statutory surplus of our insurance subsidiaries as of December 31, 2008 was $242.8 million compared to $261.6 million as of December 31, 2007.
We believe the critical accounting policies discussed in the remainder of this section of our MD&A affect our more significant judgments and estimates used in preparation of our consolidated financial statements. These may be further commented upon in applicable sections on Consolidated Results of Operations and Liquidity and Capital Resources that follow. Information about the significant accounting policies we use in the preparation of our consolidated financial statements is included in Note 2, Significant Accounting Policies to the consolidated financial statements included elsewhere herein.
Liability for Losses and LAE - Our liability for losses and LAE (also referred to as our loss and LAE reserves) is our largest liability and represents the financial statement item most sensitive to estimation and judgment. MPL insurance is our primary line of business and accounted for nearly 100 percent of our total consolidated liability for losses and LAE for both 2008 and 2007.
IBNR as a component of our total reserves has increased in recent years primarily as a result of higher estimates of LAE, such as legal defense and related costs, driven by the stricter claims philosophy we adopted in 2001, which focuses on the aggressive defense of non-meritorious claims in order to lower overall claims costs. While we believe this approach has been beneficial to our results in total, it has increased our estimates for LAE costs as an individual component. Establishing case reserves for LAE is inherently difficult since the level of costs ultimately necessary to resolve a case tends to increase over time and can vary significantly based on factors such as whether and when a case is taken to trial. Therefore, a substantial portion of total LAE reserves is reflected in our estimates for case reserve development. Additionally, our stricter claims philosophy has resulted in a relatively lower number of cases with an indemnity case reserve, which has also resulted in an increase in IBNR as a component of total reserves.
We also utilize and evaluate calculations contained in an actuarial study performed by an independent actuarial firm to corroborate the adequacy of our carried reserves. Our best estimate may differ from the selected reserve estimate of our independent actuary because of differences in evaluating such things as the impact of historical experience, legal and regulatory changes, expectations about future claim results and trends and certain other factors as discussed below. While our best estimate may differ, our carried reserves remain within a reasonable actuarial range of the independent actuary’s selected reserve estimate. The independent review of our reserves plays an important role in our overall assessment of the adequacy of our reserves. A typical range of reasonable values for MPL business is considered to be as wide as 15 percent. Therefore, in addition to the performance of the business itself, our financial condition, results of operations and cash flows are sensitive to our reserve estimates and judgments. Our range developed for our loss and LAE reserves, net of reinsurance, at December 31, 2008 was $364.4 million to $433.4 million with management’s best estimate of loss and LAE reserves at $420.0 million. The reserve opinions of our independent actuary for the years ended December 31, 2008 and 2007 have been filed with state insurance regulators along with the statutory financial statements of our insurance companies.
Inflationary trends that are expected to bear on future loss and LAE payments.
These factors, in turn, can be affected by external events, including changes in the judicial environment and tort-related trends over time. For example, the removal or significant weakening of one or more of the tort reforms passed in our largest market, Florida, could result in an unexpected increase in claim frequency and/or severity. In addition, these factors may also be impacted by internal events, such as changes in our business mix or claims handling philosophy. Determining whether such events are reasonably likely to occur and attempting to quantify the impact of an individual event are inherently difficult. We utilize our experience and judgment and consider these factors as well as historical experience and the results of applied actuarial techniques when evaluating the adequacy of carried loss and LAE reserves. All of the above-mentioned factors individually can and will generally vary from one period to the next over time but are estimated to approximate their ultimate values in setting reserve estimates.
In 2008, we paid a total of $66.7 million in loss payments (indemnity only), excluding the impact of commuted reinsurance agreements, on 330 claims.
For accident years 1998 through 2001, we experienced adverse development in our core Florida book primarily due to increases in ALAE for those report years as a result of the stricter claims handling philosophy implemented in 2001. This philosophy resulted in increases in ALAE costs for open claims including claims for prior accident years. Although our claims handling philosophy has positively impacted our overall loss costs, it had an adverse affect on older accident years where higher loss adjustment expenses were not entirely offset by lower indemnity expenses for those years.
Accident years 2003 through 2007 have developed favorably overall, in particular accident years 2004 through 2006. We have experienced favorable development on these years because of improved claim results compared to earlier estimates, including lower frequency, a lower number of claims closed with indemnity payment, and stable payment severity. A broad range of factors likely contributed to the improved claim results, including tort reform and the stricter claims philosophy adopted in 2001.
Data presented in the table above represents consolidated information of all our insurance subsidiaries commencing from their respective dates of acquisition. The 1998 year reflects losses and LAE data for First Professionals and APAC. The data presented from 1999 through 2008 reflects all of our insurance subsidiaries.
Level 1 includes unadjusted quoted prices for identical assets or liabilities in active markets.
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Reclassifications impacting Level 3 financial instruments are reported as transfers in (out) of the Level 3 category as of the beginning of the period in which the transfer occurs. Therefore, gains and losses in income only reflect activity for the period the instrument was classified in Level 3.
Our fixed income securities trade in less active markets and fair value is based on valuation methodologies, the significant inputs into which include, but are not limited to, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. These fixed income securities are classified within Level 2.
Equity securities that trade in active markets are classified within Level 1 as fair values are based on quoted market prices for identical assets as of the reporting date.
For our investment in the non-public entity, fair value is classified as Level 3 as it was based on net asset values and financial statements of the non-public entity.
Securities, predominantly mutual funds, held in rabbi trusts maintained by the Company for deferred compensation plans, and included in other invested assets, are classified within the valuation hierarchy on the same basis as the Company’s actively traded equity securities.
Our derivative instruments, principally interest rate swaps, are valued using models that primarily use market observable inputs and are classified as Level 2 because they are traded in markets where quoted market prices are not readily available. Pricing inputs include bid-ask spreads and current market prices for an underlying instrument.
For additional information on our fair value measurements, see Note 3, Fair Value Measurements to the consolidated financial statements included elsewhere herein.
Investments - Our invested assets comprise our largest single asset class and consist primarily of investment securities in the form of fixed income securities. Our fixed income securities, equity investments and short-term investments are carried at their fair values and accounted for $648.1 million or 99 percent of our total investments and 65 percent of our total assets as of December 31, 2008, compared to $705.6 million or 99 percent of our total investments and 66 percent of our total assets as of December 31, 2007. Unrealized gains or losses in their fair values are recorded directly in shareholders’ equity, net of tax effects, as a component of accumulated other comprehensive (loss) income. Gross unrealized investment gains were $11.8 million and gross unrealized investment losses were $24.3 million as of December 31, 2008 compared to $5.2 million and $5.5 million, respectively, as of December 31, 2007.
In accordance with FAS 115-1, investments in an unrealized loss position are reviewed at the individual security level to determine whether the impairment is other-than-temporary. For debt securities, impairment is considered to be other-than-temporary if we do not have the ability and intent to hold the security until recovery or if we do not believe the value of the security will recover. Equity securities are deemed other-than-temporarily impaired based on the severity of the unrealized loss and the time the security has been in an unrealized position. If the impairment is deemed to be other-than-temporary, a loss is recognized in net income for the difference between the fair value and cost basis of the investment and a new cost basis for the investment is established. For the years ended December 31, 2008 and 2007, we recorded pre-tax charges to earnings for investments that were other-than-temporarily impaired of $13.5 million and $1.1 million, respectively. The 2008 impairment charges included $6.3 million in fixed income securities, $6.8 million in equity securities and $0.4 million for other invested assets. Approximately $0.8 million of the other-than-temporary impairment in 2007 related to an investment in a limited partnership, with the remaining $0.3 million relating to certain fixed income securities. No investment impairments were recorded during 2006. We evaluate our investment portfolio on an ongoing basis to identify securities that may be other-than-temporarily impaired. Our analysis takes into account relevant factors, both quantitative and qualitative in nature. Among the factors we consider are the following:
Issuer-specific considerations, including an issuer’s short-term prospects and financial condition, recent events that may have an adverse impact on its results, and an event of missed or late payment or default;
Securities deemed to be in a held to recovery position may be sold without tainting our investment portfolio for reasons such as significant changes in asset-liability management, changes in the securities fundamentals (change in credit quality) or changes in asset allocation strategy. However, if we do not expect a security’s decline in fair value to be fully recovered prior to the expected time of sale, we would record an other-than-temporary impairment in the period in which the decision to sell is made.
The fair value of our investment holdings is affected by general economic conditions and changes in the financial and credit markets, and we rely on the investment income produced by our investment portfolio to contribute to our profitability. Changes in interest rates and credit quality may result in fluctuations in the income derived from, the valuation of, and in the case of declines in credit quality, payment defaults on our fixed income securities. In addition, deteriorating economic conditions could impact the value of our equity securities resulting in other-than-temporary impairments to such securities. These changes could have a material adverse effect on our financial condition, results of operations or cash flows. Our investment portfolio is also subject to credit and cash flow risk, including risks associated with our investments in asset-backed and mortgage-backed securities. Because our investment portfolio is the largest component of consolidated assets and a multiple of shareholders’ equity, adverse changes in economic conditions could result in other-than-temporary impairments that are material to our financial condition, operating results or cash flows. Such economic changes could arise from overall changes in the financial markets or specific changes to industries, companies or municipalities in which we maintain investment holdings. Our fixed income investment portfolio has an average Moody’s credit quality rating of Aa2 (High quality).
Income Taxes - We provide for income taxes in accordance with the provisions of FAS 109, Accounting for Income Taxes. Deferred tax assets and liabilities are estimated and recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We determine deferred tax assets and liabilities separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. Our continuing practice is to recognize interest accrued related to unrecognized tax benefits and any applicable penalties in income tax expense.
We evaluate the financial condition of our reinsurers and monitor concentrations of credit risk with respect to the individual reinsurers that participate in our ceded programs to minimize our exposure to significant losses from reinsurer insolvencies. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the applicable departments of insurance of the states that have jurisdiction over the underlying business. For additional information concerning our reinsurance, see Note 7, Reinsurance to the consolidated financial statements included elsewhere herein.
For additional information on our share-based compensation plans, see Note 11, Share-Based Compensation Plans to the consolidated financial statements included elsewhere herein.
FAS 158 requires us to measure plan assets and benefit obligations as of the date of our statement of financial position. Effective January 1, 2008, we adopted the measurement date provisions of FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, by electing the "two measurement approach" for current year-end measurement calculations. Under the "two measurement approach" we have appropriately recorded the net benefit expense for the transition period to retained earnings as of January 1, 2008. Additionally, changes in the value of plan assets and benefit obligations that occurred in the transition period between October 1, 2007 and December 31, 2007 were recorded to accumulated other comprehensive income, net of tax, at the beginning of the year. A second measurement was performed at January 1, 2008 to produce twelve months of net benefit expense to record during 2008. The impact of adopting the measurement date provisions of FAS 158 is shown in the table below:
The accounting for benefit plans is dependent on actuarial estimates, assumptions and calculations that result from a complex series of judgments about future events and uncertainties. The assumptions and actuarial estimates required to estimate the employee benefit obligations for our defined benefit plans include discount rate; expected salary increases; certain employee-related factors, such as turnover, retirement age and mortality (life expectancy); and expected return on assets. Our assumptions reflect our historical experiences and our best judgment regarding future expectations that have been deemed reasonable by management. The judgments made in determining the costs of our benefit plans may impact our results of operations. Consequently, we often obtain assistance from actuarial experts to aid in developing reasonable assumptions and cost estimates.
The discount rate used in calculating our pension benefit obligations as of December 31, 2008, is 5.9%, which represents a 0.4 percentage-point decrease from our December 31, 2007 rate of 6.3%. The discount rate for our defined benefit plans is based on a yield curve constructed from a portfolio of high quality corporate bonds for which the timing and amount of cash flows approximate the estimated payouts of the plans. The following table illustrates the sensitivity to a change in the discount rate for our defined benefit plans as of December 31, 2008:
Consolidated income from continuing operations was $32.1 million for 2008, or $3.72 per diluted common share, a decline of 37 percent and 29 percent, respectively, compared to $51.1 million, or $5.23 per diluted common share, for 2007. The decline in income from continuing operations for 2008 was primarily due to an increase in net realized investment losses associated with other-than-temporary impairments of securities and lower net premiums earned partially offset by lower net losses and LAE and other underwriting expenses. Net income for 2007 also includes an after-tax gain of $9.7 million on the reinsurance commutation between First Professionals and PRI. Other underwriting expenses for 2008 and 2007 were affected favorably and unfavorably, respectively, by the state insurance guaranty assessments and recoveries discussed below. The lower net losses and LAE in 2008 include favorable prior year loss development of $17.0 million compared to $16.0 million in 2007, excluding the PRI commutation. The decline in net premiums earned for 2008 is primarily the result of lower rates in our Florida market and to a lesser extent, lower policy limits and a change in business mix to lower risk specialties.
Our business is made up of our four insurance subsidiaries and certain other subsidiaries, and we currently engage only in insurance operations. Financial and selected other data, including professional liability claims data, related to our continuing operations is summarized in the table below.
Includes $2.9 million of premiums associated with alternative risk arrangements for the year ended December 31, 2008. Management fees for such arrangements are included in other income.
Other underwriting expenses includes recoveries of $2.7 million in 2008 and charges of $3.5 million (net of $0.7 million in recoveries) and $9.4 million in 2007 and 2006, respectively, for insurance guaranty fund assessments with respect to the insolvency of the subsidiaries of Poe Financial Group.
Comparison of Results for the Years Ended December 31, 2008 and 2007
Net realized investment losses increased for 2008 compared to 2007. We recognized $13.5 million in impairment charges for investments deemed other-than-termporarily impaired. For additional information on our other-than-temporary impairments, See Note 8, Investments to the consolidated financial statements included elsewhere herein. Our fixed income investment portfolio continues to have an average Moody’s credit quality rating of Aa2 (High quality).
Selected information concerning our professional liability insurance claim data is summarized in the table below.
Selected professional liability insurance claims data. There was a 2% increase in net paid losses and LAE on core professional liability business for 2008 compared with 2007. This increase corresponds with an increase in the number of claims with an indemnity payment. The number of reported claims and incidents for 2008 was up 8% compared to 2007. Although higher than 2007, the frequency of claims and incidents remained near historical lows and generally reflects continued lower levels of frequency in newly reported claims and incidents in our Florida market that began in the fourth quarter of 2003. The number of professional liability claims with indemnity payment (“CWIP”) increased 6% for 2008 compared to 2007. For 2008, the CWIP Ratio and the CWIP Ratio, including incidents, increased as a result of a higher number of claims with an indemnity payment and the decline in the number of closed claims and incidents following multiple years of lower reported claims and incidents. These ratios, although higher in 2008, continued to be within our expectations. It is not unusual for our claims data to fluctuate from period to period, and our claims data remains within our expectations.
Other underwriting expenses decreased for 2007 compared to 2006. Other underwriting expenses for 2007 and 2006 include charges of $3.5 million (net of recoveries of $0.7 million) and $9.4 million, respectively, for state-levied insurance guaranty fund assessments. Other underwriting expenses for 2007 also include a $1.7 million reduction in other underwriting expenses as a result of the PRI reinsurance commutation. Excluding the impact of the assessments and the PRI reinsurance commutation, other underwriting expenses increased 2 percent for 2007 compared to 2006 primarily due to the redeployment of corporate resources previously supporting our former insurance management segment to our insurance operations. Our expense ratio (defined as the ratio of other underwriting expenses to net premiums earned) was 22.6 percent and 22.5 percent for 2007 and 2006, respectively. Excluding the impact of the assessments, including recoveries, and the PRI commutation, our expense ratio was 21.7 percent for 2007 compared to 18.3 percent for 2006. The increase in the expense ratio is driven primarily by lower net premiums earned in 2007 compared to 2006.
Other expenses decreased during 2007 compared to 2006. The decline in other expenses is primarily due to our no longer incurring finance charges associated with the funds withheld under our former Hannover Re net account quota share reinsurance agreement. We commuted this reinsurance agreement with Hannover Re effective December 31, 2006.
During 2006, the Internal Revenue Service commenced an examination of our 2004 federal income tax return. The examination was closed in February 2007 with no significant adjustments. Our income tax returns for 2005 and 2006 have not been examined by the IRS.
We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance broker assists us in the analysis of the credit quality of our reinsurers. We base our reinsurance buying decisions in part on an evaluation of the then current financial strength and stability of prospective reinsurers. However, the financial strength of our reinsurers and their corresponding ability to pay us may change in the future due to forces or events we cannot control or anticipate. At December 31, 2008 our receivables from reinsurers, net of amounts due, totaled $147.3 million. We have not experienced difficulty in collecting amounts from reinsurers due to the financial condition of the reinsurers. Should future events lead us to believe that any reinsurer is unable to meet its obligation, adjustments to the amounts recoverable would be reflected in the results of current operations. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the applicable departments of insurance of the states that have jurisdiction over the underlying business. The table below identifies our reinsurers from which our recoverables (net of amounts due to the reinsurer) are $5.0 million or more as of December 31, 2008 and 2007.
Deferred income taxes increased 25 percent to $40.6 million as of December 31, 2008 from $32.6 million as of December 31, 2007. The increase in deferred income taxes is primarily related to additional deferred tax assets established for our derivative financial instruments and as a result of the unrealized loss position on our fixed income investment portfolio.
Interest on our long-term debt has been calculated considering the effect of our interest rate swaps, which fix the annual interest rate payable on our trust-preferred indebtedness until the termination of the swaps in 2013. Thereafter, interest on our long-term debt has been calculated using the implied LIBOR forward rate for variable rate debt.
(2) Employee benefit plans - We provide pension benefits to eligible employees through various defined benefit plans that we sponsor. For additional information about our employee benefit plans, see Note 14, Employee Benefit Plans to the consolidated financial statements included elsewhere herein.
(3) Guarantees and contractual obligations of our trust-preferred securities - We guarantee the floating rate interest and principal obligations under the trust-preferred securities issued by three separately created, unconsolidated trusts. In addition, the indenture agreements relating to our junior subordinated debentures and trust-preferred securities contain limitations, under certain circumstances, as to (i) the declaration or payment of dividends, or distributions thereon, or the redemption, purchase, acquisition or liquidation with respect to any capital stock of FPIC or its affiliates; (ii) the payment, in certain circumstances, of principal, premium or interest on, or the repayment, repurchase or redemption of, debt securities of FPIC or its affiliates that rank in equal standing with or are junior in interest to the debentures; or (iii) the payment, in certain circumstances, under any guarantees of FPIC or its affiliates that rank in equal standing with, or are junior in interest to, capital securities guarantees relating to the issuance of the debentures. Circumstances that would result in such limitations include a continuing event of default, as defined by the indenture agreements, a default with respect to payment of any obligations under capital securities guarantees, or a continuing interest deferral election by FPIC. See Note 12, Long-term debt to the consolidated financial statements included elsewhere herein for additional disclosures about our trusts and junior subordinated debentures.