The Company is the owner of two office buildings that were previously occupied by the Company’s headquarters, both located in Beverly Hills, California. One building contains approximately 25,000 square feet of office space and the other office building contains approximately 24,000 square feet. Both office buildings are currently unencumbered and are fully leased to unaffiliated parties.
Certain statements in the following discussion that are not historical 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 in “Business-Risk Factors” and in periodic filings with the Securities and Exchange Commission.
The Company conducts its insurance business in two business segments: direct healthcare liability insurance and assumed reinsurance operations. Direct healthcare liability insurance represents professional liability insurance for physicians, oral and maxillofacial surgeons and dentists, healthcare facilities and other healthcare providers. The direct healthcare liability includes premiums assumed under fronting arrangements related to the Brown & Brown dental program. Assumed reinsurance represents the book of assumed worldwide reinsurance of professional, commercial and personal liability coverages, commercial and residential property risks, accident and health and workers’ compensation coverages and marine coverages.
The Company has been a leading writer of medical malpractice insurance for physicians and healthcare providers in California for many years. In 1996, the Company began expansion into other professional liability products and into other geographical markets. The principal product expansion was into professional liability insurance for hospitals. From 1997 through 1999, the Company added more than 75 hospitals to its program. These policies were written through national
In December 2002, the Company entered a 100% quota share reinsurance agreement with GoshawK that divested substantially all of the Company’s ongoing assumed reinsurance operations.
The cession under the GoshawK reinsurance treaty impacted 2002 assumed reinsurance results negatively by $36.9 million.
Premiums written for the core business increased 4.8% and 15.0%, in 2002 and 2001, respectively, as average rate increases of 8.4% and 10.6% in 2002 and 2001, respectively, were partially offset by a decline in the number of insureds. Premiums earned in the core direct healthcare liability insurance business increased 9.0% and 11.3% in 2002 and 2001, respectively, primarily due to rate increases.
The loss ratio for 2002 was 91.2% compared to a loss ratio of 105.2% for 2001. The change in loss ratio reflected increases in average claim costs offset by a decline in the frequency of claims and the effect of the average rate increases on earned premiums. Losses and LAE increased significantly in 2001 from 2000 primarily due to smaller favorable developments in 2001 on prior-year reserves.
The expense ratio decreased from 20.4% in 2001 to 19.6% in 2002. The primary reason for the change was staff reductions implemented in April and November 2002. The underwriting expense ratio increased in 2001 primarily due to a larger proportion of the core business being written through general agencies, thus increasing commission expenses.
The lower loss ratio in 2002 of 193.3% compared to 217.1% in 2001 is the result of the significant rate increases being offset by additional upward development in loss reserves for prior years of $16.4 million in 2002. Despite the significant rate increases taken in 2001, the loss ratio deteriorated significantly in 2001 from 2000 as adverse development of $21.2 million in 2001 from prior years began to emerge. This development related primarily to programs administered by the Brown & Brown agency. In addition, general increases in average claim costs continued to rise for the non-core business.
The Assumed Reinsurance Segment continued to expand in 2002. Premiums written increased 267% in 2001 as more and larger treaties were added to the portfolio. The 2002 written premium for the assumed reinsurance segment was essentially unchanged from 2001 as premiums were ceded under the GoshawK treaty in the fourth quarter 2002. Premiums earned increased to $122.5 million in 2002 from $79.5 million in 2001 and $27.1 million in 2000. The increase in earned premiums is primarily attributable to the increase in premiums written in 2001 and the beginning of 2002.
The underwriting and other operating expense ratio was 38.6% in 2002 and 23.8% in 2001 and 15.3% in 2000. The underwriting and other operating expense ratio increased in 2001 over 2000 as commission rates rose as proportionately more business was written from Lloyd’s syndicates which generally have higher expense ratios. The underwriting and other operating expense ratio increased in 2002, primarily because of the GoshawK transaction expenses discussed below.
The retroactive accounting treatment required under FASB 113 requires that a charge to income be recorded to the extent premiums ceded under the contract are in excess of the estimated losses and expenses ceded under the contract. The charge related to the cession of the unearned premium as of July 1, 2002, and ceded premium written in the third quarter is included in operating expenses in the Assumed Reinsurance Segment. The charge and placement fees amounted to $18.4 million and was recorded in the fourth quarter 2002. The assumed reinsurance premiums written in the fourth quarter 2002 ceded to GoshawK has reduced premiums written for the segment with a corresponding reduction in premiums earned and net incurred losses.
The Company had an income tax benefit of $22.6 million in 2002 compared to a benefit of $32.9 million in 2001 and expense of $5.1 million in 2000.
The primary sources of the Company’s liquidity are insurance premiums, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. Funds are used to pay losses, LAE, operating expenses, reinsurance premiums and taxes.
Because of uncertainty related to the timing of the payment of claims, cash from operations for a property and casualty insurance company can vary substantially from period to period. During 2002, the Company had negative cash flow from operations of $24.5 million compared to positive cash flow of $33.4 million in 2001. The negative cash flow in 2002 was principally attributable to decreased premium written and increased loss payments on the non-core healthcare liability business and the GoshawK reinsurance agreement.
The Company maintains a portion of its investment portfolio in high-quality, short-term securities to meet short-term operating liquidity requirements, including the payment of losses and LAE. Short-term investments totaled $105.9 million,
or 14.9% of invested assets, at December 31, 2002. The Company believes that all of its short-term and fixed-maturity securities are readily marketable.
The Company had borrowings of $9.0 million outstanding at December 31, 2001, under a Credit Agreement with three bank lenders. On February 28, 2002, the Company fully repaid the outstanding balance, and the parties terminated the Credit Agreement. See “Note 8 to Consolidated Financial Statements.”
Unpaid losses and loss adjustment expenses are comprised of case reserves for known claims, incurred but not reported reserves for unknown claims and any potential development for known claims, and reserves for the cost of administration and settlement of both known and unknown claims. Such liabilities 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. Establishing appropriate reserves is an inherently uncertain process; the ultimate liability may be in excess of or less than the amount provided. Any increase in the amount of reserves, including reserves for insured events of prior years, could have an adverse effect on the Company’s results for the period in which the adjustments are made. The Company utilizes both its internal actuarial staff and independent actuaries in establishing its reserves. The Company does not discount its loss and loss adjustment expense reserves.
The Company had a growing volume of assumed reinsurance between 1999 and 2002. Assumed reinsurance is a line of business with an inherent volatility. Also in the absence of a historical data base of our own experience due to the newness of the program, greater reliance is placed on underwriting and industry information to estimate the appropriate loss reserves.
The assumed reinsurance business has exposure to losses from the events of September 11, 2001. Estimation of ultimate liabilities for this exposure is unusually difficult and thus subject to significantly greater than normal variation and uncertainty.
The Company’s Consolidated Financial Statements and related notes, including supplementary data, are set forth in the “Index” on page 47 hereof.