The following discussion should be read in conjunction with the consolidated financial statements and notes thereto accompanying this report. Except for historical information contained here, the discussions in this Item 7 contain forward-looking information that involves risks and uncertainties. As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” our actual financial condition and operating results could differ significantly from these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under Item 1A. Risk Factors.
We provide, through our wholly-owned subsidiaries, (1) insurance services, specifically medical professional liability insurance in Texas, Oklahoma and Arkansas and (2) financial services, including brokerage and investment services to institutions and high net worth individuals.
Through our subsidiaries, APS Financial Corporation, or APS Financial, APS Capital Corporation, or APS Capital, and APS Asset Management, Inc., or Asset Management, we provide our brokerage and investment services to institutions and high net worth individuals.
As a result of the acquisition, our Insurance Services segment recognizes revenue in accordance with SFAS No. 60, Accounting and Reporting of Insurance Enterprises. We issue policies written on a claims-made basis. A claims-made policy provides coverage for claims reported during the policy year. We charge both a base premium and a premium maintenance fee. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro rata basis over the term of the policy. Premium maintenance fees are charged to offset the costs incurred by API to issue and maintain policies. Unearned premiums and maintenance fees are determined on a monthly pro rata basis. Upon termination of coverage, policyholders may purchase an extended reporting period, or tail, endorsement for additional periods of time. These extended reporting period coverage endorsement premiums are earned when written.
Our Financial Services revenues are composed primarily of commissions on securities trades and clearing of trade claims and asset management fees. Revenues related to securities transactions are recognized on a trade date basis. Revenues from the clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios are recognized when the transaction is complete and fully funded. Asset management fees are recognized as a percentage of assets under management during the period based upon the terms of agreements with the applicable customers.
Fair Value Measurements. In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 157, Fair Value Measurements. SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts its business. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.
Valuations are developed from unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
When determining the fair value measurements for assets and liabilities required or permitted to be recorded at and/or marked to fair value, we consider the principal or most advantageous market in which it would trade and consider assumptions that market participants would use when pricing the asset or liability. When possible, we look to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, we look to market observable data for similar assets and liabilities, independent industry-standard models such as matrix pricing and independent, third-party dealer quotes whose inputs may be less observable than Level 1 pricing. When market observable data is not as readily available, the valuation of financial instruments becomes more subjective and could involve substantial judgment. Certain assets and liabilities are not actively traded in observable markets and the Company must use alternative valuation techniques to derive a fair value measurement. For additional disclosures, see Note 23, Fair Value Disclosures, to the unaudited financial statements included herein.
In September 2008, the SEC and FASB issued joint guidance providing clarification of issues surrounding the determination of fair value measurements under the provisions of SFAS 157 in the current market environment. In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which amended SFAS 157 to provide an illustrative example of how to determine the fair value of a financial asset when the market for that asset is not active.
Fair value is used on a recurring basis for our equity and fixed maturity, available for sale securities in which fair value is the primary basis of accounting. Fair value for these securities is the market value based on quoted market prices, when available (Level 1) or quoted prices for similar assets or liabilities in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Certain assets and liabilities are not actively traded in observable markets with listed prices or quotes and we must use alternative valuation techniques based on independent dealer quotes on the security and our own assumptions and professional judgment to derive a fair value measurement (Level 3). In these instances when significant valuation assumptions are not readily observable in the market, instruments are valued based on the best available data to approximate fair value. This data would consider a risk premium that a market participant would require. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. Typically, during periods of market dislocation, the observability of prices and inputs may be reduced for the instruments we hold. This condition could cause an instrument to be reclassified to a lower level during any given period.
The following table presents the estimated fair value of our financial instruments on a recurring basis as of December 31, 2008:
A reconciliation of the beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3) follows (in thousands):
Through our Asset Manager, we review the estimates and assumptions of fair value of each security provided by the pricing service for Level 1 and Level 2 pricing and compare these estimates to our custodial bank statement, which also provides a fair market value for the securities we hold to determine if the estimates are representative of the prices in the market. Comparing our fair value pricing obtained from our custodial bank statement serves as a cross-check to the validity of the information provided from the pricing service. Valuations are reviewed for reasonableness based upon the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. We may adjust the valuation of securities from the independent pricing service when we believe its pricing does not fairly represent the market value of the investment. For example, when market observable data is not as readily available or if the security trades in an inactive market, the valuation of financial instruments becomes more subjective and could involve substantial judgment resulting in Level 3 pricing. We generally consider a market to be inactive if the following conditions exist: (1) there are very few transactions for the financial instrument; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly over time or among independent pricing services or dealers; and (4) there is a limited availability of public market information.
In the third quarter of 2007, the market for non-agency collateralized debt obligations, specifically the market for Alt-A’s, became increasingly inactive based on the limited number of transactions, varying market prices provided by dealers and the limited availability of market data for these securities. The inactivity was evidenced by a significant widening of the bid and ask spread in the dealer markets in which these securities trade and a significant decrease in the volume of trades relative to historical levels. As of December 31, 2008, our portfolio contained seven CMO securities classified as Alt-A of which five of these securities, or $2,659,000 representing 1.3% of our investment portfolio, are classified as Level 3 pricing. The remaining non-agency CMO’s in our investment portfolio have underlying mortgages categorized as “Prime” quality loans with no adjustable features, and none of our CMO’s have underlying mortgages classified as “Subprime.” All of our CMO’s, including our Alt-A securities have underlying mortgages with fixed interest rates and all but one Alt-A security is investment grade, currently rated either AA or A. During the quarter ended December 31, 2008, one of the Alt-A securities with a fair market value of $27,000 at December 31, 2008 was downgraded to a “C” rating.
As noted in the table above (reconciliation of beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3)), $3,660,000 was transferred out of Level 3 to Level 2 during the twelve months ended December 31, 2008 as the pricing from dealer indications we received was comparable to the independent pricing service. We attempt to apply consistent methods and techniques utilized in previous evaluation periods to determine the appropriate level within the fair value hierarchy. Changes in pricing based on Level 3 pricing assumptions of our lowest rated Alt-A securities can have a material effect on our results of operations and financial position as evidenced by the recognition of realized losses of $1,220,100 and $5,818,600, respectively for the three and the twelve months ended December 31, 2008 on these Alt-A securities. If we would have selected pricing based on Level 2 assumptions provided by the pricing service, we would have recognized realized losses of only $693,900 and $3,194,400, respectively, or a $526,100 and $2,624,200 difference for the three and the twelve months ended December 31, 2008. Additionally, our financial position would have been higher since our fixed maturities, available for sale and accumulated, other comprehensive income would have been increased by $1,387,500 as of December 31, 2008 based on different pricing assumptions.
In accordance with SFAS No. 115, we evaluate our investment securities on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other than temporary declines. A decline in the fair value of a security below cost judged to be other than temporary is recognized as a loss in the current period and its fair value becomes the new cost basis of the security. The following factors are considered in determining whether an investment decline is “other than temporary”:
The extent to which we believe market assessments of credit risk for a specific investment or category of investments are either well founded or are speculative;
Reserve for Loss and Loss Adjustment Expense. These reserves represent our best estimate of the ultimate cost of all remaining reported and unreported claims for which we provide insurance coverage to our policyholders. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses (LAE) is an inherently uncertain process, does not represent an exact calculation of the liability and may not represent the ultimate cost of settling our claim obligations. For comparative purposes, we have included detailed claim and loss reserve data and analysis on a “pro forma basis” since we did not acquire API until April 1, 2007. This information is provided to highlight the development of claim and loss reserve data prior to our acquisition of API. Any reference in this Item 7 below to “pro forma” purports to show the impact to us had we acquired API as of January 1 of the year indicated.
The estimate of reserves for losses and LAE is reflective of the types of insurance policies written by us. We write our medical professional liability insurance policies predominantly on a claims-made basis. Claims-made insurance policies provide coverage for claims made and reported to the company during the period covered under the policy. We also write a small percentage of policies on an occurrence basis. Occurrence basis insurance policies provide coverage for losses that occur during the term of the policy, regardless of when the claim is reported. These occurrence policies also cover policyholders that purchase or earn, according to the terms of contract provisions, an extended reporting period, or tail endorsement, upon termination of coverage.
When a claim is reported to us, our claims adjusters establish a case reserve for the estimated amount of the ultimate payment including legal costs associated with defending the claim. The process of estimating case reserves reflects an informed judgment based upon the experience and knowledge of the claims adjuster regarding the nature and value of the specific claim, the severity of injury or damage, the judicial climate where the insured event occurred and the policy provisions relating to the type of loss. With lines of insurance like medical professional liability that often have claims with complex and technical facts and circumstances that take many years to investigate and close, the lack of information available to the claims adjusters when a claim is first reported often makes establishing case reserves difficult. As the discovery phase of the claim proceeds, better information regarding the nature and severity of the claim becomes available enabling us to establish a more appropriate case reserve for the claim. Case reserves on severe claims are also reviewed for adequacy at least quarterly by our claims committee, which includes our Medical Director, physicians with specific expertise in the specialty of the claims being reviewed, and senior management. This process of periodically evaluating and adjusting case reserves is one of the factors we consider when establishing our ultimate loss and LAE expenses. However, case reserves alone are insufficient in measuring our ultimate cost for losses and loss adjustment expenses.
We consider many factors, not just the actuarial point estimates, in determining ultimate expected losses and the level of reserves required and recorded. Recorded (carried) reserves are based upon the judgment of management and are not entirely driven by formulaic determinations produced by various actuarial methods. In addition to considering the point estimate and ranges calculated by the independent consulting actuaries, management also utilizes expected loss ratios in determining its best estimate, which it selects based on the following: (1) information used to price the applicable policies, (2) historical loss information, (3) any public data for medical professional liability insurance for the Texas, Arkansas and Oklahoma blocks of business, and (4) an assessment of the current market conditions. Additionally, we select a best estimate with due regard for the age, characteristics and volatility of medical professional liability insurance, the volume of data available for review and past experience with respect to the accuracy of estimates. Other external factors such as economic inflation, judicial trends and legislative and regulatory changes can also have a substantial impact on our reserve estimation assumptions. For example, when tort reform is passed in a state, as was the case in Texas, we will estimate the impact of reform on both frequency and severity of losses. In addition, we evaluate whether or not the legislation will stand if it is legally challenged in the courts. We also consider the effects of various reinsurance treaties and the varying retention levels and co-participations we have on any given year as these will have an impact on the loss reserves we cede to our reinsurers. We also consider input from our underwriting, claims, and senior management personnel and our claims committee.
We continually review and update the data underlying the estimation of the loss and loss adjustment expense reserves and make adjustments that we believe the emerging data supports. If reserves ultimately prove to be too high, then the excess amount will be recognized as a reduction to loss and loss adjustment expenses in the current period of operations that the change in estimate is made. If reserves prove to be inadequate in the future, we would have to increase such reserves and incur a charge to earnings in the period that such reserves are increased, which could have a material adverse affect on our results of operations and financial condition. These specific risks described above, combined with the variability that is inherent in any reserve estimate, could result in significant positive or negative deviation from our recorded net reserve amounts, and could positively or adversely impact our business, results of operations and cash flows.
We considered the following factors in establishing our best estimate as of December 31, 2008. First, as highlighted in the 10-year reserve development herein, API’s reserve estimates for the years 1999 through 2004 were significantly deficient. Not until recently, 2005 through 2008, have reserves trended favorably from the originally reported net liability. In addition, API has increased the number of policyholders it insures from 2,992 at January 1, 2004 to 5,336 at December 31, 2008 resulting in an approximately 78% increase in policyholder exposure over the last several years. We also recently began writing medical liability policies in Oklahoma. The significant adverse development patterns of API coupled with the uncertainty as to how our significant increase in policyholders and new business in Oklahoma will perform over time warrants a conservative position. Also, API began co-participating in the 2006, 2007, and 2008 reinsurance treaties on claims in excess of the retention of $250,000 on individual claims and $350,000 on multiple insured claims related to a single occurrence. The 2006, 2007, and 2008 reinsurance treaties provide for API retaining an additional 10% of the retention levels for 2006, 20% for 2007, and 40% for 2008. Uncertainty in regards to how these increased participation levels would impact our recorded reserves should API be exposed to considerable losses resulting from a significant liability event or the occurrence of an unusually high number of liability losses in one reporting period, were considered in determining our best estimate as of December 31, 2008.
In considering the potential sensitivity of the factors and assumptions underlying management’s best estimate of recorded loss and loss adjustment reserves, as previously mentioned, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a relatively large average cost per claim. For example, at December 31, 2008, we had 5,336 policyholders and during the calendar year ended 2008 API paid a total of $ 10,815,000 in gross paid damages on 85 claims. Even a small change in the number of claims expected to be paid (i.e. frequency) or a small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, our financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, API has closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the high average cost per claim, any change in the trends of key assumptions used in estimating the ultimate values could result in a significant change in the reserve estimate.
Claims severity is often measured on a paid, reported and ultimate basis. Paid severity represents the cost of payments associated with loss settlements and is typically measured as an average of paid losses per claim closed, per claim closed with no payment and per claim closed with an indemnity payment. Reported severity is usually measured as our average case reserve per open claim. Ultimate severity takes into account not only the severity of losses currently being paid and the losses in our open claims inventory, but also incurred but unreported claims and all remaining costs to settle these claims. One such factor we consider with low-frequency, high-severity lines of business like medical professional liability insurance is the premise that if fewer claims are reported to us, those claims are likely to have higher average severity than the average severity associated with a large population of claims. Implicit in this assumption is that claims that are still being reported are those of greater merit and potential severity while claims no longer being reported are assumed to be non-meritorious in nature and could be closed at little or no cost.
The following table shows net case, IBNR and total reserves and various claim statistics and reserve averages for the years ended December 31, 2008, 2007 and 2006.
Our open claim counts of 585 at December 31, 2008 decreased significantly by 21% from 740 open claims at December 31, 2007. In 2008, our claims settled (with and without indemnity) of 536 outpaced the number of reported claims of 381 which continued the claims trend that we saw in 2007 in which our open claim counts decreased by 8.5% from 809 at December 31, 2006 to 740 at December 31, 2007, the result of a relatively low 402 claims being reported in 2007 combined with total claims closed (with and without indemnity) of 471 outpacing reported claims. However, in 2006 our open claims increased by 15.2% from 702 at January 1, 2006 to 809 at December 31, 2006, the result of reported claim counts of 507 outpacing the number of closed claims (with and without indemnity) in 2006. Our assumption was that the increase in reported claim counts in 2006 was attributable to the significant increase in policyholder count beginning in 2004 through December 31, 2007. We also believed these elevated claim counts represented a more reasonable, normalized claim count in a post-tort reform environment in Texas as compared to the historically low reported claim counts of 335 and 385 in 2005 and 2004, respectively, after the passage of tort reform. From a historical perspective it is important to note that we had 1,372 open claims (the highest number of claims in the history of API) at December 31, 2003, the year in which tort reform legislation passed in Texas. Our open claim counts have declined dramatically since the end of 2003 as the number of reported claims has decreased and as we continue to settle or close claims at an accelerated pace.
Net case reserves were relatively flat in 2008 (up .7%) as compared to 2007; however, the average net case reserves continued to increase by 27.4% as the number of open cases continued to decrease. Net case reserves decreased by 5.4% from December 31, 2006 to December 31, 2007 as the number of open claims continued to decrease over this period. During 2008 our IBNR reserve decreased by 9.4% from $38,039,000 in 2007 to $34,473,000 in 2008. While our number of policyholders continues to increase from 4,930 in 2007 to 5,336 in 2008 the number of reported claims has dropped to 381 in 2008 from 402 in 2007, and the number of remaining open claims has decreased to 585 at December 31, 2008 from 740 at December 31, 2007. Furthermore, claim severity has stabilized and continues to emerge favorably for the post-tort reform years. The combination of declining reported claims and open claims resulted in the decrease in IBNR year over year. Reflected in our net IBNR reserve increase of 8.0% from $35,212,000 at December 31, 2006 to $38,039,000 December 31, 2007 is due to a significant increase in our total number of policyholders, which has risen from 3,919 at the beginning of 2006 to 4,930 at December 31, 2007. Our higher average paid loss per claim in 2008 of $122,602 as compared to $92,555 in 2006, respectively, supports the assumption previously mentioned above that if fewer claims are reported in a given year; those claims are likely to have higher severity than those claims associated with a larger population. Implicit in this assumption is that claims reported post-tort reform, while fewer in number, are of greater merit and potential severity and claims that are no longer reported were non-meritorious in nature and were closed at little or cost.
The following table reflects the activity in the liability for reserve for losses and loss adjustment expenses since January 1, 2006 through the year ended December 31, 2008 (in thousands):
During 2006, API recorded favorable prior year development of $4,786,000, the result of 2004 and 2005 report year loss severity falling below expectations. We continue to see beneficial trends in claims frequency and relative stability in average paid loss severity as compared to pre-tort reform years. For instance, the average number of claims reported and the average net claim paid with indemnity (net paid loss severity) over the last four years (2005-2008) since the passage of tort reform has averaged 406 and approximately $102,000 as compared to the previous four years (2000-2003) prior the passage of reform in which claims reported averaged 773 and paid loss severity averaged $144,000. The effect of significant changes in claim frequency introduces a great deal of variability into our reserve estimation process. We are traditionally cautious with our assumptions concerning emerging trends in claims frequency and severity loss trends and consequently we do not immediately place much weight on the impact that any short-term declines in frequency and severity may have on our ultimate losses. However, actual frequency and severity loss trends have developed more favorably than originally anticipated. We utilize historical claims data to project future expected results. As a result, the impact of recent claims trends is moderated by historical data. We have recently experienced favorable trends of declining frequency and stable paid loss severity and the results of these trends are reflected in our reserve estimations. The impact of recent favorable trends is the main reason for the increase in favorable development from $4,786,000 in 2006, $16,023,000 in 2007, and $20,565,000 in 2008.
We attempt to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherently uncertain process involving loss and loss adjustment expense reserve estimates, the final resolution of the ultimate liability may be different from that anticipated at the reporting date. Therefore, actual paid damages in the future may yield a materially different favorable or unfavorable amount than currently reserved. While we believe that the estimates for loss and loss adjustment expense reserves are adequate as of December 31, 2008, there can be no assurance that our estimates will not change in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge
For comparative purposes, we have included detailed claim and loss reserve data and analysis on a “pro forma basis” since we did not acquire API until April 1, 2007. This information is provided to highlight the development of claim and loss reserve data prior to our acquisition of API on April 1, 2007.
The above tables do not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on these tables.
During 2006, 2007 and 2008, due to improved underwriting practices coupled with tort reform in Texas, API has recognized favorable development related to previously established reserves for accident years 2004 through 2007. Ultimately, as actual results have proven better than suggested historical trends, redundancies have developed, as evident from the favorable trend in our loss reserves from the originally reported net liability in 2005 and 2006.
There are several limitations to interpreting reserve ranges. The reserve range represents a statistical distribution of possible outcomes and while from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate. There are also many macroeconomic effects that may impact the development of reserves such as, tort reforms, changes in the tort common law or the litigiousness of jurisdictions in which we issue policies, the influence of legislative actions and changes in political philosophy. As a result of these factors, as well as the many other quantitative and qualitative factors described herein, there can be no assurance that reserves will develop within these ranges.
We have modeled a statistical distribution along various confidence levels to calculate the potential variability inherent in our loss reserves and the corresponding impact on pre-tax income. Due to the correlation between reserving variables and how they can inter-relate to one another, it is neither practical nor meaningful to isolate and demonstrate the impact of changes in a particular assumption such as claims frequency or severity or other specific parameters such as the effect of tort reform in calculating the reserve estimate. However, a statistical distribution shows the impact if actual claims experience were to emerge more favorably or unfavorably from our recorded reserves at the 78% confidence level to the actuarial point estimate, or approximately ­­18% or more than our recorded reserves. In regards to trending downward to the actuarial point estimate, we believe this reflects a more likely than not scenario as the confidence level is approximately 50%, represents the mean of the distribution and is the most likely amount to be paid. In regards to trending 12% higher than recorded reserves, the confidence level rises to 90% and shows the wide dispersion of possible outcomes given the inherent uncertainty of loss reserves in the medical professional liability line of insurance in relation to other shorter tail lines of insurance. We believe this scenario is reasonably conceivable due to a significant liability event, such as an unexpected adverse court decision that impacts many open claims or multiple insureds or the occurrence of an unusually high number of liability losses in one reporting period. The following table shows the effects on pre-tax income if the recorded reserves as of December 31, 2008 develop under these scenarios:
Reinsurance Premiums Ceded. We enter into reinsurance agreements whereby other insurance entities agree to assume a portion of the risk associated with the policies issued by API. In return, we agree to pay a premium to the reinsurers. We utilize reinsurance to control exposure to potential losses arising from large risks, and to have additional capacity for growth. We remain responsible for the ultimate risk on its policies and would be responsible for losses and loss adjustment expenses should a reinsurer fail to pay its obligations. Reinsurance agreements are also subject to risk transfer analysis in order to be recognized as traditional reinsurance for GAAP or statutory accounting purposes. Risk transfer standards require that (a) the reinsurer assumes significant insurance risk (underwriting and timing risk) under the reinsured portions of the underlying insurance agreements; and (b) it is reasonably possible that the reinsurer may realize a significant loss from the transaction. Whether a reinsurance agreement involves risk transfer is determined by management, with assistance from our outside consulting actuaries, utilizing a comprehensive set of standards. We believe that all of our reinsurance agreements contain the appropriate risk transfer requirements.
In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis give rise to a balance sheet asset classified as “Other amounts receivable under reinsurance contracts” or a balance sheet liability classified as “Funds held under reinsurance treaties.” Furthermore, each retrospective treaty requires a 24- or 36-month holding period before any premium adjustments or cash can be returned or paid. The ultimate settlement amount will not be determined until all losses have been settled under the respective treaties. As of December 31, 2008, we had recorded a balance sheet asset, “Other amounts receivable under reinsurance contracts” of $1,497,000 and a balance sheet liability, “Funds held under reinsurance treaties” of $3,978,000, which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2007 treaty years as compared to the amounts paid on a provisional basis.
The effect of reinsurance on premiums written and earned for the year ended December 31, 2008 is as follows (in thousands):
The effect of reinsurance on premiums written and earned since the acquisition of API on April 1, 2007 through December 31, 2007 is as follows (in thousands):
For the twelve months ended December 31, 2008, we recorded favorable development to ceded premiums of $6,802,000 primarily related to prior year variable premium reinsurance treaties as a result of lower estimated ultimate loss and loss adjustment expenses for treaty years 2002 through 2007. Since the acquisition of API on April 1, 2007, for the year ended December 31, 2007, we recorded favorable development to ceded premiums of $10,888,000 primarily related to prior year variable premium reinsurance treaties as a result of lower estimated ultimate loss and loss adjustment expenses for treaty years 2002 through 2006.
Unsecured reinsurance recoverables at December 31, 2008, that exceeded 10% of total reinsurance paid and unpaid loss and loss adjustment expenses are summarized as follows (in thousands):
We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer defaults. Any amount found to be uncollectible would be written off in the period in which the uncollectible amount is identified. We require letters of credit from any reinsurance company that does not meet certain regulatory requirements, and/or credit ratings. As of December 31, 2008, our reinsurance contracts were with companies in adequate financial condition, and we believe there is not a need to establish an allowance for uncollectible reinsurance recoverable. We have not experienced any material problems collecting from our reinsurers. However, the ultimate effects of the recent financial and market crisis and overall economic downturn may have negative consequences on the credit quality, liquidity and financial stability of the reinsurers with which we do business. As recent market experience indicates, such deteriorations in financial condition can occur rapidly, leaving us unable to react to such a scenario in a manner consistent with orderly markets. This in turn could adversely and negatively affect our financial condition and results of operations.
Stock-Based Compensation. On January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all stock-based compensation awards made to employees and directors, including employee stock options and employee stock purchase plans. The Securities and Exchange Commission also issued Staff Accounting Bulletin No. 107 (“SAB 107”) which provides interpretative guidance in applying the provisions of SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.
SFAS 123R requires companies to estimate the fair value of stock-based awards on the date of grant using an option-pricing model. The portion of the value that is ultimately expected to vest is recognized as expense over the requisite service period. As stock-based compensation expense recognized in our consolidated statements of income for fiscal years 2008, 2007 and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
In addition, SFAS 123R requires that the benefits of realized tax deductions in excess of tax benefits on compensation expense be reported as a component of cash flows from financing activities rather than as an operating cash flow, as previously required. In accordance with SAB 107, we classify stock-based compensation within general and administrative expenses to correspond with the financial statement components in which cash compensation paid to employees and directors is recorded.
Consolidated Financial Statements for the years ended December 31, 2007 and December 31, 2006
At the effective time of the acquisition, April 1, 2007, each share of common stock of API was converted into, and exchanged for, the right to receive the number of shares of our common stock based upon an exchange ratio equal to a purchase price of $39 million minus the $9,179,000 agreed-upon present value of the payments authorized by the Texas Department of Insurance that must be made by us to comply with the mandatory redemption features of the API Series A redeemable preferred stock in exchange for the API refundable deposit certificates, divided by $17.28, divided by the 10,000,000 shares of API common stock. The $17.28 price was the average closing price of our common shares for the twenty trading days immediately preceding the closing. According to the terms of the merger agreement for the acquisition, the value of our common stock issued in the acquisition was subject to adjustment upwards or downwards by up to 15% based on the closing price of our common shares for the twenty trading days immediately preceding the effective date of the acquisition.
Records the elimination of the revenue component of management fee and sub-producer commissions by the Company, the management fee expense by API and the sub-producer expenses by the Company for the three months ended March 31, 2007 and the year ended December 31, 2006.
With the acquisition of API on April 1, 2007, our consolidated revenue and earnings will be predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on API’s earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of API’s earned premiums. In addition, any pre-tax profits of API were shared equally with us so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, the management agreement was terminated and our consolidated results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
Despite continued lower premiums in our Insurance Services segment in 2008, improvements in the terms on our reinsurance contracts coupled with favorable reserve development allowed us to deliver strong results from our operations from this operating segment. As a result of favorable development in both claim counts and claim severity post-tort reform and increased competition, we lowered our rates on average approximately 6% in 2008. We have seen an increase in competition by both existing professional liability carriers as well as new entrants into the marketplace. As a result of this increased competition, we continue to be faced with price pressure on both existing renewals and new business. Many of the new entrants have been aggressive in seeking new business and are willing to compete on price. We will continue to monitor frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted. As a result of these market forces, we will face increased competition throughout 2009, but will continue to price insurance products at rates believed to be adequate for the risks assumed.
(3) Combined ratio is the sum of the loss ratio and the expense ratio.
(5) Ratios for the 2006 actual results are not applicable as the acquisition of API occurred in 2007.
Premium related income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
Net premiums and maintenance fees earned increased to $64,081,000 from $56,039,000 for the year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
Realized capital losses were $7,749,000 for the year ended December 31, 2008 as compared to a $5,256,000 for the year ended December 31, 2007 primarily as a result of “other than temporary” impairment losses incurred in our investment in Alt-A collateralized mortgage-backed securities of $5,819,000 in 2008 as compared to $4,566,000 in 2007, resulting from fair market value declines. In addition, we incurred additional “other than temporary” charges in 2008 on two other non-agency CMO securities in the amount of $1,070,000 for CMO securities as noted above and realized losses due to the selective sale of equity and fixed income securities of $1,679,000 to offset prior year capital gain carry forwards.
The following table reflects the composition of our Alt-A securities as of December 31, 2008 after the other than temporary impairments (dollars in thousands):
We also began to observe an increase in the market-reported delinquency rates for not only our Alt-A CMO’s, but also our non-agency CMO’s backed by prime loans. The delinquency data suggests that continuing home price declines and growth in unemployment are now affecting the behavior by a broader sector of mortgage borrowers, particularly those mortgages with vintage years subsequent to 2005. Rising unemployment, accelerating house price declines, tight credit conditions, volatility in interest rates and weakening consumer confidence not only contributed to rising delinquencies, but also significantly impacted our expectations regarding future performance, both of which are critical to assessing our other-than-temporary impairments. As a result of these factors and a significant decline in market value and the down-rating by outside rating agencies to below investment grade, we recorded write-downs during the three months ended December 31, 2008, on two other non-agency CMO securities in the amount of $1,070,000. We cannot be reasonably assured that the credit support will not continue to weaken for our non-agency CMO’s including our Alt-A securities, particularly in light of the current economic forecasts regarding unemployment, further deterioration of the housing and mortgage markets and continued declines in the value of the collateral underlying these mortgages. While we have the ability to hold all of these securities indefinitely, we continue to closely monitor and evaluate these securities and their underlying collateral. Furthermore, we will continue to consider opportunities to reduce our position in non-agency CMO’s including Alt-A securities if we determine that it prudently reduces our exposure to further declines that may be considered “other-than-temporary.”
In 2003, we acquired 385,000 shares of common stock of Financial Industries Corporation (“FIC”). The total purchase price was approximately $5,647,000. Our policy in regards to our investment in FIC had been that we would record pretax charges to earnings should the common stock price on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. From 2004 through 2007, we wrote down the carrying value of the FIC stock by $3,414,000. In 2008, FIC was acquired. The basis in our investment in FIC common stock at the closing of the merger was $5.80 per share and based on the sale price of $7.25 per share, we recognized a $558,000 realized gain in the third quarter of 2008.
On a pro forma basis, realized capital losses were $7,749,000 for the year ended December 31, 2008 compared to a loss of $5,130,000 for the year ended December 31, 2007. The increase in losses for the current year is primarily due to larger “other than temporary” impairment charges in our investment in Alt-A collateralized mortgage-backed securities of $5,819,000 in 2008 as compared to $4,566,000 in 2007, resulting from fair market value declines. In addition, we incurred additional “other than temporary” charges in 2008 on two other non-agency CMO securities in the amount of $1,070,000 for CMO securities as noted above.
Prior to the acquisition of API, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations. In conjunction with the merger with API on April 1, 2007, our management agreement was terminated as of March 31, 2007 and as such is no longer included in our consolidated results of operations though management fee revenue, including the contingent management fee, were recorded through the quarter ended March 31, 2007. Consequently, management services revenue decreased by $3,715,000 to $88,000 from $3,803,000 for the year ended December 31, 2008 compared to 2007.
Financial services revenue for the years ended December 31, 2008 and 2007 are included in the following table:
Other underwriting expenses and net deferred acquisition costs for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
On a pro forma basis, other underwriting expenses decreased by $561,000 (5%) to $11,074,000 from $11,635,000 for the year ended December 31, 2008 as compared to the same period in 2007. Other underwriting expenses consist primarily of commissions to agents, premium taxes and other general underwriting expenses related to managing our Insurance Services segment. The pro forma decrease of $561,000 is mainly attributable to higher compensation expenses of $1,200,000 incurred with the acquisition of API in 2007. In addition, legal, auditing, actuarial and other professional fees were $287,000 higher in 2007 due to merger related costs offset by higher commission expenses of $205,000 incurred in 2008 as result of increasing commission rates to attract new business. On a pro forma basis, the net change in deferred acquisition costs, which is comprised of the change in deferred and amortized commissions paid to agents on new and renewal business and deferred and amortized premium taxes, decreased for the year ended December 31, 2008 by $17,000 to $14,000 from $31,000 for the comparable period in 2007 due to new costs capitalized exceeding the amortization of prior deferred expenses.
Our extraordinary gain represents the excess of the assets received over the costs to acquire all of the issued and outstanding stock of API. The business combination was accounted for using the purchase method of accounting and, accordingly, the purchase price has been allocated to assets acquired and liabilities assumed based on fair values at April 1, 2007, the date of acquisition. The total purchase price was approximately $45,167,000 and consisted of 1,982,499 shares of the Company’s common stock, valued at a per share price of $17.635, or $34,961,000 in aggregate, $35,000 in cash paid in lieu of fractional shares of common stock, 10,197.95 shares of preferred stock valued at $9,179,000, plus costs to complete the acquisition of $992,000. The net fair value of the assets acquired and the liabilities assumed was $47,431,000. The resulting excess of assets received over costs to acquire was recorded as an extraordinary gain in accordance with SFAS No. 141, “Accounting for Business Combinations.”
Further explanation for the year-to-year variances are described below throughout the remainder of the M,D&A section of this Form 10-K.
Pro forma premium related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
On a pro forma basis, net premiums and maintenance fees earned increased by $1,491,000 (2%) to $72,350,000 from $70,859,000 for the year ended December 31, 2007 as compared to the same period in 2006. While written premiums and maintenance fees were down $9,247,000 year over year primarily due to rate decreases, the aforementioned favorable development for the prior years’ reinsurance treaties contributed to the increase in net earned amounts.
Investment income related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
Realized capital losses were $5,256,000 for the year ended December 31, 2007 as compared to a gain of $155,000 for the year ended December 31, 2006 primarily as a result of “other than temporary” impairment losses incurred during 2007 on Alt-A collateralized mortgage-backed securities and our investment in Financial Industries Corporation.
Financial services revenue data for the years ended December 31, 2008 and 2007 are included in the following table:
Our Financial Services revenue increased $4,206,000 (25%) for the year ended December 31, 2007 compared to 2006. The increases in 2007 was primarily the result of higher commission revenues earned at APS Financial, the broker/dealer, which derives most of its revenue from transactions in the fixed income market, in both investment and non-investment grade securities. Commission revenues increased $4,665,000 (42%) in the year ended December 31, 2007 compared to 2006. Revenue from our trading in distressed corporate and distressed mortgage securities increased in 2007 as a result of trading opportunities brought about by the downturn in the U.S. economy as well as by the well publicized problems in the residential loan market. Some investors in this asset class liquidated positions, while others viewed the current market conditions as an opportunity to invest at distressed price levels. Also, contributing to our increased revenues was the continued growth of transactions in bank debt and trade claims which increased $381,000 (14%) for the year ended December 31, 2007 compared to 2006. Partially offsetting these increases was a decrease in our revenues earned from investment banking activities, which fell $468,000 (16%) in the year ended December 31, 2007 compared to 2006 resulting from lower transaction volumes.
Loss and loss adjustment expenses for the years ended December 31, 2007 and 2006 are included in the following table:
Pro forma loss and loss adjustment expenses for the years ended December 31, 2007 and 2006 are included in the following table:
On a pro forma basis, loss and loss adjustment expenses for the year ended December 31, 2007 decreased by $12,909,000 (34%) to $24,659,000 from $37,568,000 for the year ended December 31, 2006. The decrease of $12,909,000 on a pro forma basis was the result of a lower accident year loss and loss adjustment expense and higher favorable development on prior year losses in 2007 as compared to 2006. For the year ended December 31, 2007, current accident year loss and loss adjustment expenses totaled $40,682,000 based on 402 claims reported and prior year losses developed favorably $16,023,000 as a result of reductions in our estimates of claims severity, principally the 2002 through 2006 report years. For the year ended December 31, 2006, current accident year loss and loss adjustment expenses were $42,344,000 based on 507 claims reported and there was $5,001,000 favorable development on prior years. The positive effects of 2003 tort reform in Texas on average claim severity has resulted in continued favorable development of reserves and improved claim development patterns. API favorably settled a number of post-tort reform claims from the 2004 and 2005 report years at below the reserved amounts. However, even though reported claims have decreased by 103 claims year over year, we continued to accrue our current accident year losses conservatively based on increases in policyholder count from 4,712 as of December 31, 2006 to 4,930 as of December 31, 2007.
Other underwriting expenses and net change in deferred acquisition costs for the years ended December 31, 2007 and 2006 are included in the following table:
On a pro forma basis, other underwriting expenses decreased by $124,000 (1%) to $11,635,000 from $11,759,000 for the year ended December 31, 2007 as compared to the same period in 2006. Other underwriting expenses consist primarily of commissions to agents, premium taxes and other general underwriting expenses related to managing our Insurance Services segment. The pro forma decrease of $124,000 is mainly attributable to compensation expenses of $1,200,000 incurred with the acquisition of API offset by lower commissions of $296,000 due to lower written premiums in 2007 and lower legal, auditing and other costs of $801,000 for merger related expenses that primarily occurred during 2006. On a pro forma basis, the net change in deferred acquisition costs, which is comprised of the change in deferred and amortized commissions paid to agents on new and renewal business and deferred and amortized premium taxes, increased for year ended December 31, 2007 by $70,000 to $31,000 from $(39,000) for the comparable period in 2006 due to the amortization of prior deferred expenses exceeding new costs capitalized.
General and administrative expenses increased $3,353,000 (159%) for the year ended December 31, 2007 compared to 2006. The increase in general and administrative expenses in 2007 includes higher salaries of $389,000 (55%) resulting from our hiring a new Chief Operating Officer in April of 2007 in addition to adding a new Treasurer position in November; higher incentive compensation of $1,075,000 (175%), a formula-driven expense that is higher in 2007 due to the large increase in net earnings resulting primarily from the acquisition of API in April 2007 and from record earnings at our Financial Services segment; higher board fees of $415,000(198%) resulting from deferred compensation awarded as a result of the successful merger as well as due to a greater number of directors and a greater number of board meetings necessitated by the merger with API and the common stock secondary offering; higher legal and professional fees of $401,000 (214%) resulting primarily from internal control expenditures to further our efforts to assess our internal controls consistent with the Sarbanes-Oxley Act of 2002; and higher interest of $429,000 resulting from interest and preferred stock dividends due to our preferred share holders. In addition, there was a decrease in a gain on the sale of assets of $446,000, or 99% in 2007 compared to 2006. These gains were treated as a reduction of rent expense in 2006 and represented the recognition of a deferred gain related to the November 2001 sale and subsequent leaseback of real estate. The monthly recognition of deferred revenue from this sale ended in September 2006 and totaled $422,000 in that year.
Historically, we have maintained a strong working capital position and, as a result, we have been able to satisfy our operational and capital expenditure requirements with cash generated from our operating and investing activities. These same sources of funds have also allowed us to pursue investment and expansion opportunities consistent with our growth plans. Although there can be no assurance our operating activities will provide positive cash flow in the future, we are optimistic that our working capital requirements will be met for the foreseeable future because our current cash position is very strong, with a balance of approximately $22,060,000, and a large portion of our approximate $209,709,000 investment portfolio is in short-term, highly liquid bonds and other fixed income securities.
Restrictions on Dividends by API. In addition to restrictions on dividends and distributions applicable to all Texas stock insurance companies, for so long as any Series A redeemable preferred stock is outstanding, the Texas Department of Insurance prohibits API from paying dividends to us in any calendar year unless and until we have complied with our redemption and dividend payment obligations to the holders of our Series A redeemable preferred stock for that year. Our agreement with the Texas Department of Insurance also provides that, until all of the Series A redeemable preferred stock has been fully redeemed and all dividends have paid, API will not make aggregate annual dividends to us with respect to API’s capital stock in excess of the lesser of 10% of API’s prior year-end policyholder statutory surplus or API’s prior year statutory net income, and in no event may such distributions exceed API’s statutory earned surplus. Accordingly our subsidiaries may not be able to pay funds to us and, even if paid such funds may not be sufficient to enable us to meet our obligations. By way of illustration, if this dividend restriction had been in place in 2006 possible dividends paid by API to us for this year would have been limited to $4,555,000. For calendar year 2007, the dividend restriction was $7,717,000 and through March 1, 2009 total dividends paid to us for 2007 was $7,377,000. For calendar year 2008, the dividend restriction is $8,804,000 and no dividends have yet been paid to us.
Escrow Account. In connection with the API acquisition, the Texas Department of Insurance has required us to place $2,500,000 into an escrow account with a bank, to remain in escrow until the aggregate remaining redemption and dividend obligation relating to our Series A redeemable preferred stock is less than the amount of the escrow balance. No withdrawals may be made from this escrow account without prior approval from the Texas Department of Insurance. To satisfy this condition of the merger, we purchased a fixed income security in March of 2007 in the amount of $2,500,000 paying 5% interest which matured in March of 2008. With proceeds from this maturity we purchased a similar fixed income security in March 2008 paying 2.14% and maturing in April of 2009. This security is included in fixed maturities, available for sale.
Cash and cash equivalents and invested assets totaled $231,769,000 and $223,193,000 at December 31, 2008 and December 31, 2007, respectively. Cash and cash equivalents and invested assets represent 82% and 79% of our total assets for the same respective periods. We believe that a majority of our short-term and fixed-maturity securities are readily marketable, and that our invested assets have scheduled maturities in line with our projected cash needs.
Reinsurance recoverables decreased by $6,233,000 (31%) to $13,796,000 at December 31, 2008 from $20,019,000 primarily as a result of the favorable development in the reinsurance layer of $6,802,000 as discussed in Note 9 to the audited financial statements included herein.
Other amounts receivable under reinsurance contracts decreased $3,038,000 (67%) to $1,497,000 at December 31, 2008 from $4,535,000 at December 31, 2007 due to a net payment of $7,045,000 received from reinsurers primarily for the initial reimbursement for the excess reinsurance premiums paid on a provisional basis for the 2005 treaty year.
Effective January 1, 2008, we adopted SFAS 157, Fair Value Measurements, for our financial assets and financial liabilities, but have not yet adopted SFAS 157 as it relates to non-financial assets and liabilities based on the February 2008 issuance of FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, which permits a one-year deferral of the application of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. The adoption of SFAS 157 as it pertains to financial assets and liabilities did not have a material impact on our results of operations, financial position or liquidity. We will adopt FAS 157 for non-financial assets and non-financial liabilities on January 1, 2009 and do not expect the provisions to have a material effect on our results of operations, financial position or liquidity. For additional disclosures, see Note 23, Fair Value Measurements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure certain financial assets and liabilities at fair value which are otherwise measured on a different basis in existing literature. Additional disclosures are required. It is effective for the Company, if elected, as of January 1, 2008. The adoption of this standard did not have an impact on our financial position, results of operations or cash flows.
In December 2007, the FASB issued Statement of Financial Accounting Standards, or SFAS No. 141 (Revised December 2007) “Business Combinations” (SFAS 141R). SFAS 141R replaces FASB Statement No. 141, “Business Combinations” but retains the fundamental requirement in SFAS 141 that the acquisition method (referred to as the purchase method in SFAS 141) of accounting be used for all business combinations. SFAS 141R provides new and additional guidance with respect to business combinations including: defining the acquirer in a transaction, the valuation of assets and liabilities when non-controlling interests exist, the treatment of contingent consideration, the treatment of costs incurred to effect the acquisition, the treatment of reorganization costs, and the valuation of assets and liabilities when the purchase price is below the net fair value of assets acquired. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption was prohibited. We adopted the Statement on its effective date.
There were no off-balance sheet arrangements as of December 31, 2008 or 2007.
The financial statements and supplementary data of American Physicians Insurance Exchange required to be included in this Item 8 are set forth on the pages indicated in Item 15 of this report.