In July 1998, the Company entered into a lease covering approximately 95,000 square feet of office space for its Company headquarters. The lease is for a term of 10 years ending in 2009 and the Company has options to renew the lease for an additional 10 years. The Company moved its headquarters and principal operations to these offices in March 1999. The Company expended $5.3 million for leasehold improvements through 2000.
Certain statements in the following discussion that are not historical in fact constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements regarding the Company, its business prospects and results of operations are subject to certain risks and uncertainties posed by many factors and events that could cause the Company's actual business, prospects and results of operations to differ materially from those that may be expressed or implied by such forward- looking statements. Such risks, uncertainties and other factors are discussed below and in periodic filings with the Securities and Exchange Commission.
The availability of healthcare liability insurance, or the industry's underwriting capacity, is determined principally by the industry's level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy. Historically, the financial performance of the healthcare liability industry has tended to fluctuate between a soft insurance market and a hard insurance market. In a soft insurance market, competitive conditions could result in premium rates and underwriting terms and conditions that may be below profitable levels. Reinsurance of property and casualty lines is subject to these same market influences.
The Company has rapidly expanded its assumed reinsurance operations since the division was formed in late 1999. Treaties include professional, commercial and personal liability coverages, commercial and residential property risks, accident and health coverages and marine coverages on a worldwide basis. During 2000, assumed reinsurance premiums earned were approximately $27.1 million (not including fronting arrangements), and the Company expects this premium volume to approximately triple for 2001, based on treaties in existence. Loss experience for 2000 is based almost entirely on actuarial estimates, as actual losses are still in the early stages of development. Actual experience could materially exceed or be less than these estimates. If the losses are excessive, there could be a significant adverse effect on the Company's results and financial condition at the increased premium volumes expected in 2001.
Other Non-California Physician and Medical Group Business. AHI has also --------------------------------------------------------- expanded its operations outside California through sales of professional liability policies to physicians who do not meet the normal underwriting criteria of the Company. These policies are sold through various brokers typically at a higher premium. The broker relationships were developed from the medical malpractice insurance businesses AHI acquired from Fremont Indemnity Company (Fremont) and a small midwestern insurance company in 1998 and 1999, respectively.
In 2000, the Company derived more than 30% of its physician and medical group premium volume from policies issued outside the state of California. This expansion is in its early stages. There is no assurance, however, that the Company will successfully retain or continue to expand this business or that it will ultimately be profitable.
Other Insurance Products. The Company offers a variety of other insurance ------------------------ products to complement its professional liability insurance policies, including principally directors and officers liability insurance and managed care errors and omissions policies to medical groups and hospitals. In late 1999, the Company began offering a newly designed product that provides physicians and medical groups with protection for defense expenses and certain liabilities related to governmental investigations into billing errors and omissions to Medicare (and other governmentally subsidized) patients. Premium volume for all of these products has been small, but the Company considers these products important to its expansion plans.
Medical malpractice and other property and casualty loss and loss adjustment expense (LAE) reserves are established based on known facts and interpretation of circumstances, including the Company's experience with similar cases and historical trends involving claim payment patterns, loss payments and pending levels of unpaid claims, as well as court decisions and economic conditions. The effects of inflation are considered in the reserving process. Establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that currently established reserves will prove adequate in light of subsequent actual experience. The Company follows a practice of conservatively estimating its future liabilities relating to losses already incurred and for years prior to 2000 attempted to establish its loss and LAE reserves for the current year at the upper end of a reasonable range of
With its continued expansion into other states and markets, the Company has experienced an increase in its operating expense levels to achieve and service this expansion. Commissions for policies that are sold through agents and brokers typically range from 7.0% to 20.0% of premiums, whereas the Company does not incur commissions on products sold directly. Hospital and other healthcare provider policies are typically sold through brokers, as are physician and medical group policies sold through Brown & Brown and in the program acquired from Fremont. To the extent that these policies represent an increased percentage of the Company's business in the future, expense ratios will increase.
Total revenues were $211.5 million in 2000, an increase of 10.5% over total revenues of $191.3 million in 1999. Premiums earned increased $23.3 million, or 15.2%, in 2000. The increase was principally attributable to assumed reinsurance premiums of $27.1 million earned in 2000 compared to $6.8 million earned in 1999.
The Company had small realized investment losses in both years. Equity earnings from affiliates in 2000 of $0.9 million was attributable to a minority equity interest in a small personal lines insurance company.
Total expenses were $189.1 million in 2000, an increase of 24.3 % over total expenses of $152.1 million in 1999. The increase in total expenses was attributable to a decrease in the recognition of prior-year loss reserve development and an increase in loss costs generally in the direct healthcare liability insurance segment and higher operating expenses. The increased operating expenses reflect a greater proportion of commissioned premiums and higher employee related expenses in 2000.
Net income for 2000 was $ 17.3 million, or $1.84 diluted earnings per share, a decrease of 42.2% from net income of $ 29.9 million, or $2.62 diluted earnings per share, in 1999. Operating earnings, which do not include realized gains or losses, were $1.87 per share in 2000 compared to $2.64 per share in 1999.
Losses and LAE. Losses and LAE in the direct healthcare liability --------------- insurance segment increased to $129.3 million, or 86.5% of premiums earned in 2000, from $116.6 million, or 79.6% of premiums earned in 1999. The increase was due to a reduction in 2000 in the favorable loss reserve development experienced by the Company with respect to prior policy years, partially offset by a reduction in the estimated losses incurred in the 2000 policy year as a percentage of premiums earned. The Company experienced a net favorable development in loss and LAE reserves established for prior policy years in 2000 of $42.6 million compared to a favorable development of $61.8 million in 1999.
The Company has experienced favorable development in loss reserves for many years, which has accounted for substantial portions of the Company's net income. During 2000, the Company encountered increases in loss severity relating to its prior policy years, particularly in its hospital policies, which resulted in the reduction in favorable loss and LAE reserve development. The Company does not expect any material favorable development during 2001 in loss reserves established for prior years. However, the Company is anticipating an improved 2001 policy year loss experience based on rate increases instituted by the Company for 2001.
Other Operating Expenses Other operating expenses for the assumed ------------------------ reinsurance segment were $4.2 million in 2000, or an expense ratio of 15.3%. No allocation of operating expenses was made for 1999. Operating expenses consist primarily of commissions and employee-related expenses.
Year Ended December 31, 1999, Compared to Year Ended December 31, 1998 ----------------------------------------------------------------------
Net Investment Income. Net investment income decreased approximately $2.7 ---------------------- million, or 6.7%, to $37.7 million in 1999 from $40.4 million in 1998. Invested assets decreased $138.2 million to $655.4 million at December 31, 1999, from $793.6 million at December 31, 1998, due principally to the sale of securities to fund the Company's repurchase of approximately 2.0 million shares of its common stock from its public stockholders in November 1999. The investment portfolio also contained a larger percentage of higher-yielding bonds during 1999 than in 1998.
Realized Investment Gains (Losses). Realized investment losses were ----------------------------------- approximately $0.3 million in 1999 compared to realized gains of $11.1 million in 1998. Through the nine months ended September 30, 1999, the Company had net realized gains of $5.3 million. The Company recorded a realized loss in the 1999 fourth quarter related to the sale of securities to fund the repurchase of its common stock and to reposition the Company's investment portfolio.
Other Operating Expenses. Other operating expenses increased $1.1 million, ------------------------- or 3.9%, to $29.3 million in 1999 from $28.2 million in 1998. The expense ratio increased to 19.1% in 1999 from 17.9% in 1998. This increase reflected a decrease in premiums earned and higher commission expenses associated with the greater proportion of broker-produced premiums in 1999 compared to 1998.
The Company has entered into a Credit Agreement with Union Bank of California, N. A., First Union Bank and Dresdner Bank AG, as lenders. Under the Credit Agreement, the Company may borrow up to $40.0 million from time to time, subject to certain conditions. The proceeds from the Credit Agreement may be used by the company for general corporate purposes and certain other permitted uses. As of December 31, 2000, borrowings under the Credit Agreement totaled $27.0 million. All amounts outstanding under the Credit Agreement on May 27, 2002 will automatically become payable in twelve equal quarterly installments beginning August 30, 2002.
The Company invests its assets primarily in fixed-maturity securities, which at December 31, 2000, comprised 84% of total investments at market value. U.S. government and tax-exempt bonds represent 65% of the fixed-maturity investments, with the remainder consisting almost entirely of mortgage-backed securities and corporate bonds. Equity securities, consisting primarily of common stocks, account for 4% of total investments at market value. The remaining 12% of the investment portfolio consists of highly liquid short-term money market funds.
The estimated fair values at current market rates for financial instruments subject to interest rate risk in the table above are the same as those disclosed in Note 2 (Investments) to the consolidated financial statements. The estimated fair values at the adjusted market rates (assuming a 100-basis-point increase in market interest rates) are calculated using discounted cash flow analysis and duration modeling where appropriate. The estimated values do not consider the effect that changing interest rates could have on prepayment activity (e.g., mortgages underlying mortgage-backed securities).