The Company recorded an 11% or $2,332,960 decrease in total revenues during 1996 as compared to 1995. This decrease was primarily the result of a reduction in premium income of approximately $1,983,000, a decline in investment income of approximately $226,000 and, a decrease in realized investment gains of $123,697. The decline in premium income was primarily the result of an approximate 9% decline in MDA's total policyholders and occurred despite a 14% rate increase which was effective January 1, 1996 on all of MDA's new and renewal business. The decrease in the Company's investment income was primarily the result of a decline in invested assets during 1996 as compared to 1995. This decline in invested assets, which was approximately $8,450,000 at December 31, 1996 compared to the previous year-end, was the result of an increase in claim payments in 1996 compared to 1995. See "Business of Medical Defense Associates - Reserves for Unpaid Losses and Loss Adjustment Expenses." Realized investment gains declined $123,697, when compared to 1995, as fixed-income investment prices were generally higher in 1996 and therefore the opportunity to realize investment gains was not as prevalent as in 1995.
During 1996, total expenses increased $4,437,310 or 23.2% compared to 1995. This increase was almost entirely the result of an increase in claim losses and claim loss adjustment expenses which increased approximately $4.2 million compared to these same expenses in 1995. Due to an increase in the amount of claim loss and loss adjustment expense payments during 1996, Company management retained its actuary to perform additional actuarial analysis and as a result of actuarial analysis, the Company strengthened its loss and loss adjustment expense reserves for accident years prior to 1996 by approximately $4.6 million. The Company will continue to monitor the level of claim severity, and to seek input from actuaries as appropriate. The balance of the increase in total expenses during 1996 compared to 1995 was primarily the result of an increase in amortization of deferred acquisition costs of approximately $315,000, which is entirely related to Missouri premium taxes. The Company was not subject to Missouri premium taxes prior to the completion of MDA's demutualization on June 26, 1995 and therefore, no deferred acquisition costs were recorded or amortized prior to that date.
For the year ended December 31, 1996, the Company experienced a loss (before provision for income taxes) of $4,705,629, compared to income (before provision for income taxes) of $2,064,641 in 1995. The Company's total tax provision increased $547,150 to $795,413 which was primarily the result of an increase in the deferred tax provision of approximately $3.7 million. This increase in the deferred tax provision was due to an increase in the deferred tax asset valuation allowance of approximately $2.4 million, which relates entirely to loss reserve discounting and represents the difference between the total deferred tax asset related to loss reserve discounting required by the Internal Revenue Service and the amount that is more likely than not to be realized. As a result, the Company's net loss for 1996 was $5,501,042 compared to net income of $1,816,378 for 1995.
Total consolidated liabilities of the Company at December 31, 1997 were $67,575,817 a decrease of $7,367,187 from the previous year end. This decrease was the result of the increase in claim payments of approximately $4.5 million discussed earlier, a decline of approximately $1.5 million in the unearned premium reserve which was primarily due to the decrease in policyholders, a decrease in amounts payable to reinsurers on retrospectively rated reinsurance contracts of $857,000, and a decrease in claims drafts outstanding of approximately $420,000 which is included in the decrease in other liabilities of $426,125. Over 86% of the Company's total liabilities at December 31, 1997 relate to reserves for unpaid losses and loss adjustment expenses, which declined approximately $4.5 million from the prior year end. These unpaid loss and loss adjustment expense reserves are established based on actuarially determined estimates and are reviewed regularly by management and the Company's independent actuary.
During 1997, as a result of the cash flow used by operating activities, the Company's net cash flow provided from investing activities was $3,143,946, as fewer fixed maturity investments were purchased to replace those investments sold or matured. Also, during 1996, due to cash flow used by operating activities, the Company's net cash flow provided from investing activities was $6,785,490, again as fewer fixed maturity investments were purchased to replace those investments sold or matured. Due to the positive cash flow provided by operations during 1995, the Company was able to increase net cash flow in investing activities for the year ended December 31, 1995 by $6,812,854.
The Company does not anticipate in the immediate future any major capital expenditures outside the normal course of operations.
As discussed more fully in Note 12, to the financial statements, the Company adopted Statement of Financial Accounting Standard No. 128, Earnings Per Share.
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995
The Company operates as a direct writer of professional liability insurance and thus does not incur sales commissions or other variable sales costs directly related to premium production which are normally associated with deferred acquisition costs. Subsequent to completion of MDA's conversion to a stock insurance company, as discussed in Note 1, all MDA premiums written are subject to Missouri premium taxes. Deferred acquisition costs recorded during 1997 and 1996 relate entirely to Missouri premium taxes. Such deferred costs are amortized over the terms of the underlying policies, written off when policies are canceled and tested for recoverability out of the unearned premium reserve annually.
Losses and loss adjustment expenses incurred, and the liabilities for unpaid losses and loss adjustment expenses are shown gross of any reinsurance recoveries from other companies. In the event that any reinsuring company was unable or unwilling to meet its obligations under existing agreements, MDA would become liable.
F. Investments, continued: The Company has classified all investments in fixed maturities as available for sale and carries such investments at market value as a result of the Company's willingness to sell investments based on market conditions and interest rate changes. Should the Company experience declines in market value that are other than temporary, the difference between amortized cost and market would be recognized through current earnings.
Fair value is defined as market value based on third-party quoted market prices of the securities or when unavailable, on similar securities.
G. Property and Equipment: Property and equipment are carried at cost less accumulated depreciation. Depreciation is computed over the estimated useful lives of the assets using the modified accelerated cost recovery method. Maintenance, repairs and minor renewals are charged to expense as incurred while renewals and betterments are capitalized.
The cost and related allowance for depreciation of assets sold or retired are removed from the related accounts and the resulting gains or losses are reflected in operations.
During 1995 the Company issued 11,999,991 shares of $1.00 par value redeemable convertible preferred stock, with limited voting rights, to the eligible policyholders of MDA in exchange for their mutual policyholders' rights in MDA. Each share of preferred stock is convertible into two shares of Medical Defense Holding Co. Class B Common Stock, at the holder's option, and may be converted at any time prior to redemption. Holders of preferred stock have limited voting rights as set forth in the Company's Articles of Incorporation. Such voting rights primarily deal with a change in control or a sale of a major portion of the Company's assets. Each share of preferred stock is redeemable, at the Company's option, after three years from the date of issuance, at a price per share of $1.00. The preferred stock does not provide a stated dividend; however, no dividends may be paid on any Company common stock while there are preferred stock shares outstanding. In 1997, 6,813 shares of preferred stock were converted to 13,626 shares of Class B common stock. In 1995, 9,802 shares of preferred stock were converted to 19,604 shares of Class B common stock.
The Company has issued shares of $0.50 par value Class A common stock, in accordance with an agreement and plan of conversion dated November 29, 1994, in exchange for cash. Class A common stock is not redeemable and is entitled to fifty votes per share on all matters.
The Company has issued shares of $0.50 par value Class B common stock in accordance with the conversion rights of the convertible preferred stock. Class B common stock is not redeemable and is entitled to one vote per share on all matters.
For purposes of the above, bonds without prepayment characteristics have been included at their stated maturity date. Bonds with prepayment features are included at their estimated maturity date as supplied by the Company's investment adviser. Accordingly, actual maturities may differ from estimates.
To comply with the Missouri Department of Insurance, MDIC had a U.S. Treasury Note with a par value of $850,000 as of December 31, 1997 and 1996, on deposit with the state of Missouri.
Escrow Funds: Pursuant to the settlement agreement for a specific claim, MDA has deposited $400,000 in escrow to guarantee future annuity payments. MDA receives all earnings on the escrowed funds. At December 31, 1997 and 1996, the escrowed funds were invested in a $400,000 par value U.S. Treasury Note with a fair value of $406,248 and $400,876, respectively, which is included with investments on the balance sheet. This U.S. Treasury note matures April 30, 2001.
Realized gains on investments reflected in the results of operations for each of the three years ended December 31, are as follows:
The Company maintains the following assets, at amortized cost, issued by single entities in excess of 10% of stockholders' equity at December 31:
Management evaluates the payout pattern based on advice from its outside actuary concerning trends in claim frequencies and severities and needed changes in future premium rates, industry trends and experience of direct Missouri competitors in these matters.
Projection of future income is inherently uncertain and the achievability of any projection is made more difficult by the length of the discount period. Historical losses cannot be adjusted precisely to future cost levels and the impacts of future emergence of new classes of losses or types of losses which may not be represented sufficiently in the Company's data base or which are not yet quantifiable, cannot be precisely anticipated. Utilizing an outside actuary, management believes that it can reasonably estimate the amount of the loss reserves which will likely settle in future years. Based on this estimate, management can determine how much of the discount will likely reverse and could be recovered, if necessary, from taxes paid in the carryback period. The 1997 Tax Act changed the carryback period for net operating losses from three years to two years effective for tax years beginning after August 5, 1997. This change impacted the amount of taxes recoverable from carrybacks as no taxes were paid in 1996 and 1997.
Management does not believe it can reasonably determine the amount of loss reserve deferred tax benefit which can be recovered from future taxable income arising more than two years beyond the carryback period using a more likely than not standard.
Under employment agreements with certain officers and directors, payments totaling approximately $500,000 are to be made if the number of insureds fall below 913. Such payments are forfeited in whole or part if the individual does not remain employed for a period of 36 months following the payment date.
As discussed in Note 3, on October 16, 1997 and November 15, 1996, the Company purchased 1,721,445 and 2,781,338 shares of its convertible preferred stock. In addition, during December 1997, the Company purchased 44,498 shares of its convertible preferred stock from a small number of shareholders.
Basic and diluted earnings per share for the three years ended December 31, is as follows: