Basic earnings (loss) per share of common stock at December 31, 2007, 2006, 2005, 2004, and 2003 are computed using the weighted average number of common shares outstanding during the year of 9,569,859, 9,524,570, 9,455,391, 9,387,556, and 9,352,070, respectively. Diluted earnings per share of common stock at December 31, 2007, 2005, 2004, 2003 and 2002 are computed using the weighted average number of common shares outstanding during the year of 9,866,187, 9,657,059, 9,549,353, 9,387,556, and 9,352,070 respectively. For further discussion of basic earnings per share and diluted earnings per share, see “Note 10 to Consolidated Financial Statements.”
Because the reserve establishment process is by definition an estimate, actual results will vary from amounts established in earlier periods. The Company recognizes such differences in the periods they are determined. Since reserves accumulate on the balance sheet over several years until all claims are settled, a determination of inadequacy or redundancy could easily have a significant impact on earnings and therefore stockholders’ equity. The Company has established net reserves of $348.1 million and gross reserves of $378.4 million as of December 31, 2007 respectively, not including the retrospective reserves ceded under the Rosemont Re treaty. Reserves attributable to the operating segments of the Company are as follows:
For medical malpractice and other long tail liability lines of business, Bulk and IBNR reserves (which include loss adjustment expense reserves not allocated to specific cases) are the mathematical result of subtracting tabular case reserves from projected ultimate losses derived by the actuarial process. Bulk and IBNR reserves in the case of medical malpractice insurance written on a claims-made reporting policy do not generally represent late reported claims but rather expected upward case reserve movement which will be recognized as additional information develops on individual cases.
The Company’s operations, both currently and in the past, have been in areas of insurance considered long-tail lines of business. The long-tail reference relates to both the length of time it takes for claims to become known to an insurer and to be ultimately resolved. As a result of this extended length of time, an actuarial analysis of medical malpractice liability reserves and assumed reinsurance reserves is especially difficult. Small changes in the length of reporting or settlement patterns as well as in the average settlement amount caused by judicial decisions, inflation, catastrophes and foreign exchange rates can result in significant variability in projected reserve levels. In general, for these lines of business, the Company believes that a range plus or minus 10% from expected results is not considered an abnormality. This range reflects the uncertainly of the claim environment as well as the limited predicting power of past data. These uncertainties and limitations are not specific to the Company. A plus or minus 10% range around the Company’s net reserves held as of December 31, 2007 is a range of plus or minus $34.8 million. Such a range does not include all possible scenarios from a statistical distribution standpoint. The range represents a reasonable estimate of possible outcomes and should not be confused with a range of best estimates. The reserve selections represent the Company’s estimate of what it believes is the most probable outcome (best estimate) albeit the probability of any specific selection being exactly the ultimate result when all claims are paid and settled is very small.
The examples selected for inclusion in the preceding table are considered reasonably possible because
for the Core Healthcare Business, the primary decline in pure loss cost trend over the past several years has been driven primarily by decreases in the frequency of claims. Since the decrease in claim frequency is not attributable to any specific cause, this trend is not readily predictable and may be offset by increased severity if frequency declines relate primarily to historically smaller claims. The Company considers a 2 percentage point movement either up or down reasonably possible.
for the Non-Core Healthcare Reserves, the accuracy of the reserves is primarily dependent on the future settlement value of claims now known. Any particular legal award may be larger than current case reserves or, if the Company is successful in defense of the claim, less than current reserves. The Company believes there is a reasonable possibility further uncertainties of settlement could cause the average settlement value to increase or decrease 10%.
The net reserves for non-core healthcare operations as of December 31, 2007 consist of the following:
The accuracy and sensitivity of the Company’s reserves for Assumed Reinsurance is impacted primarily by three factors: the accuracy of case and IBNR reserves reported by the ceding companies on particular contracts; the timeliness of the reporting of losses from ceding companies; and the ultimate severity of large excess of loss claims.
The Occupational Accident reserves are provided to the Company by the internal actuary for the managing general agent in charge of the programs. The Company and its independent actuaries periodically review the resulting estimates of the managing general agent’s actuary for concurrence with his estimates. The remaining reserves involve approximately 33 separate contracts primarily involving high level excess of loss contracts, both property and casualty. These contracts are subject to periodic review by the Company’s internal and independent actuaries.
During 2008, the Company will continue to concentrate its efforts on its core physician and medical group business in California and Delaware and settling outstanding claims in the non-core business.
Premiums written for the core direct healthcare liability insurance business decreased 1.7% and 2.8% in 2007 and 2006 and premiums earned decreased 1.0% in 2007 and 3.4% in 2006, respectively. The decrease in written and earned premium for 2007 and 2006 was primarily the result of decreases in premium related to loss rated policies as loss experience improved.
The Company has historically had a high renewal rate in its core business. The renewal rates of insureds who were offered renewal was 92% for 2007, 96% for 2006, and 95% for 2005. The deterioration in the renewal rate in 2007 was principally attributable to a chiropractors program that the Company insured for a number of years successfully. The program was controlled by a single agency who moved the business to a national competitor. Although the program represented a significant number of policies, total net annual premiums associated with the program was less than $1.5 million. The Company routinely loses insureds due to underwriting actions taken by the Company, or by insureds moving to competitors, leaving their practice, retiring or joining a health facility that provides for their insurance. These losses are offset by new sales activities. New policies written in 2007, 2006, and 2005, were 860, 868, and 1,077, respectively. The core business policies inforce at year end 2007, 2006, and 2005 were 9,767, 10,289, and 10,397 policies, respectively.
No adjustments were made to overall reserve levels in 2007 and 2006 because experience related to new claims and average settlement amounts was consistent with actuarial expectations.
The Company has made significant progress in 2007 and 2006 in settling claims related to non-core healthcare liability business in run-off. Total net reserves declined from $60.6 million at December 31, 2005, to $37.7 million at December 31, 2006, and $23.9 million at December 31, 2007. Outstanding claims decreased from 229 at December 31, 2005, to 136 at December 31, 2006, and 75 at December 31, 2007. Six new claims were reported in 2007 compared to 11 in 2006 and 16 in 2005.
The underwriting loss in 2007 related primarily to upward development on certain contracts and provisions for potential contract disputes.
Net investment income increased to $21.9 million in 2007 from $20.4 million for 2006 and from $17.8 million in 2005. The changes in net investment income are primarily related to changes in short-term interest rates between periods, as the portfolio is very short in duration.
In 2007 the Company incurred $5.6 million in transaction expenses associated with the auction process and subsequent merger agreement executed with The Doctors Company.
The Company currently has a net deferred tax asset of $31.9 million as of December 31, 2007, of which $10.9 million relates to a $31.1 million net operating loss carryforward which begins to expire in 2024. The Company will be able to utilize this carryforward to reduce taxes in future periods. The losses which gave rise to the operating loss carryforward were primarily generated by underwriting losses in the non-core direct healthcare liability and assumed reinsurance businesses. Since these operations are now in run-off and the core business has historically been profitable on both a GAAP and tax basis, after consideration of investment income, the Company’s projections indicate that it is more likely than not that the net operating loss carryforward will be fully utilized within the carryforward period.
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. The Company had positive cash flow from operations of $11.8 million in 2007 and $7.6 million in 2006 compared to 2005, when the Company had negative cash flow from operations of $30.2 million. The positive cash flow during 2007 is primarily related to core premium receipts and the decreasing claims payments associated with the non-core healthcare liability and assumed reinsurance programs, which are now in run-off. As the Company continues to pay-off non-core healthcare liability and assumed reinsurance reserves generated by prior years written premiums, the Company may again have negative cash flow from operations.
The Company maintains a significant portion of its investment portfolio in high-quality, short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and LAE. Cash and cash equivalents totaled $217.3 million, or 39.0% of invested assets, at December 31, 2007. The Company believes that all of its short-term and fixed-maturity securities are readily marketable. In addition, available current investment yields relative to available long-term yields have caused the Company to build up its short-term investments.
The Company’s capital adequacy position was weakened in the past by the losses in the non-core businesses. The Company’s current rating from A.M. Best is B+ (Good). In October 2007, following the Company’s announcement to be acquired by The Doctors Company, A.M. Best Co. placed the financial strength rating (FSR) of B+ (Good) under review with developing implications. In the year prior to the announcement, A.M. Best’s outlook for the Company was stable. A.M. Best assigns this rating to companies that have, in its opinion, a good ability to meet their current obligations to policyholders. The Company believes that it has strengthened its capital adequacy position at December 31, 2007, under the methodology followed by A.M. Best, but does not know whether this will result in a further rating change. The NAIC has developed a different methodology for measuring the adequacy of an insurer’s surplus which includes a risk-based capital (RBC) formula designed to measure state statutory capital and surplus needs. The RBC rules provide for different levels of regulatory attention based on four thresholds determined under the formula. At December 31, 2007, the RBC level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2007, SCPIE Indemnity’s adjusted surplus level of $195.8 million was 466% of this threshold.
The Company has a letter of credit facility in the amount of $25 million with Union Bank of California. Letters of credit issued under the facility collateralize loss reserves under reinsurance contracts. As of December 31, 2007, letter of credit issuance under the facility was approximately $16.1 million. Securities of $16.1 million are pledged as collateral under the facility.