Management's Discussion & Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------------ The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements appearing elsewhere in this report. The consolidated financial statements include the results of all of the Company's wholly owned and majority owned subsidiaries.
willingness of credit institutions to provide financing and the availability of credit generally and, (xiii) developments in reinsurance markets that could affect the Company's reinsurance program.
Critical Accounting Policies - ---------------------------- The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to income taxes, loss and loss adjustment expenses ("LAE") reserves, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Income Taxes. The Company accounts for income taxes in accordance with Financial Accounting Standard ("FAS") No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not, that all or some portion of the benefits related to the deferred tax assets will not be realized. Valuation allowances are based on estimates of taxable income and the period over which deferred tax assets will be recoverable. In the event that actual results differ from these estimates or these estimates are adjusted in future periods, the Company may need to establish a valuation allowance, which would impact our financial position and results of operations. No such valuation allowance has been established to date as the Company believes it is more likely than not that its deferred tax assets will be fully realized.
In the event goodwill or another intangible asset is impaired, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the respective asset. Fair value is determined primarily using anticipated cash flows at a rate commensurate with the risk involved. Losses on assets to be disposed of are determined in a similar manner, except that fair values are reduced for the cost of disposal.
The liabilities for losses and LAE and the related estimation methods are continually reviewed and revised to reflect current conditions and trends. The resulting adjustments are reflected in the operating results of the current year. While management believes the liabilities for losses and LAE are adequate to cover the ultimate liability, the actual ultimate loss costs may vary from the amounts presently provided and such differences may be material.
The Company also has direct and assumed liabilities under covered extended reporting endorsements associated with claims-made MPL policy forms, which generally provide, at no additional charge, continuing MPL coverage for claims-made insureds in the event of death, disability or retirement. These liabilities are carried within unearned premium reserves and are estimated using techniques, which possess elements of both loss reserves and pension liabilities, and thus, include additional assumptions for mortality, morbidity, retirement, interest and inflation.
In performing its tests of the liability for losses and LAE as of December 31, 2001, the Company's independent actuarial firm utilized multiple methods and developed a range of reasonable estimates. The Company's liability for losses and LAE, net of reinsurance, as of December 31, 2001 is $238.1 million, which corresponds with the point estimate of its independent actuarial firm's consolidated range of estimates of $223.2 million (minus $11.8 million, or 6%) to $255.5 million (plus $12.3 million, or 7%). For each 1% increase or decrease in the Company's estimated liability for losses and LAE as of December 31, 2001, that could occur in one or more future periods, a corresponding charge or credit to income in the amount of approximately $2.4 million ($1.8 million, after tax effects) would occur.
five shares of the Company's common stock for each of their shares of Florida Physicians common stock. In May 2001, the Company changed the name of Florida Physicians to First Professionals Insurance Company, Inc. ("First Professionals"). Effective January 1, 2002, McCreary and its subsidiary, Employers Mutual, Inc. ("EMI") were consolidated by legal entity merger, with EMI continuing as the surviving entity.
The Company has three main operating segments as follows: insurance, reciprocal management and third party administration ("TPA"). The Company's primary sources of revenue are management fees and dividends received from its subsidiaries. The primary sources of revenue for these amounts are premiums earned and investment income derived from the insurance segment and fee and commission income from the reciprocal management and TPA segments.
Through the insurance segment, the Company specializes in professional liability insurance products and services for physicians, dentists, other healthcare providers and attorneys. The Company's medical professional liability ("MPL") insurance is written substantially on a "claims-made" basis (as opposed to an "occurrence" basis) providing protection to the insured only for those claims that arise out of incidents occurring, and of which notice to the insurer is given, while coverage is in effect. The Company also offers "tail coverage" for claims reported after the expiration of the policy for occurrences during the coverage period. The price of tail coverage is based on the length of time the insured has been covered under the Company's claims-made form. The Company provides free tail coverage for insured physicians who die or become disabled during the coverage period of the policy and for those who have been insured by the Company for at least five consecutive years and retire completely from the practice of medicine. Through the reciprocal management segment, the Company provides brokerage and administration services for reinsurance programs and brokerage services for the placement of annuities in structured settlements. The Company's TPA markets and administers self-insured and fully insured plans for both large and small employers, including group accident and health, workers' compensation and general liability and property insurance.
The Company also accomplished a number of significant strategic initiatives during 2001, including: a) its 2002 reinsurance program at acceptable rates; b) completion of a new credit facility with a syndicate of banks, reducing outstanding debt by approximately $14 million, or 21%; c) completion of the Company's exit from the small group accident and health ("A&H") business; d) consolidation of the Company's third party administration operations; and e) implementation of an integrated investment program engaging outside professional investment managers.
Net income for the year ended December 31, 2001, totaled $2.9 million, or $0.31 per diluted share, compared with net income of $0.6 million, or $0.06 per diluted share, for the year ended December 31, 2000. The 2001 results include the after-tax effects of $5.4 million for an adjustment made to increase reserves on prior years'
Total revenues for the year ended December 31, 2001 increased 8%, to $197.5 million, from $182.3 million for the year ended December 31, 2000. Annual revenue growth was driven primarily by growth in earned premiums, which contributed $10.6 million to such growth. Strong improvements in pricing and the addition of MPL policyholders, primarily in Florida and Missouri, were the primary source of premium growth. Commission income and claims administration and management fees earned by the Company's non-insurance subsidiaries in New York and Florida also grew, contributing $7.1 million to the growth in total revenues. The growth in total revenues during 2001 was offset by a $1.7 million decline in investment income as a result of lower market yields.
Insurance Segment - ----------------- The Company's insurance segment is made up of its four insurance subsidiaries, First Professionals, Anesthesiologists Professional Assurance Company ("APAC") and The Tenere Group, Inc. ("Tenere") companies of Intermed Insurance Company and Interlex Insurance Company. Holding company operations are included within the insurance segment due to its size and prominence and the substantial attention devoted to the segment. Financial data for the Company's insurance segment for the years ended December 31, 2001, 2000 and 1999 are summarized in the table below. Dollar amounts are in thousands.
Net investment income decreased 7%, to $22.8 million for the year ended December 31, 2001 from $24.5 million for the year ended December 31, 2000. The decrease in net investment income is primarily the result of lower investment returns on the Company's investment portfolio during 2001 caused by lower prevailing interest rates in fixed income securities. The effects of lower yields have been offset to some degree by growth in cash and invested assets resulting from growth in insurance premiums. On a consolidated basis, the Company's total investment portfolio grew to $ 424.2 million in 2001, up $19.2 million or 5%, from $405.0 million in 2000.
consolidated basis, the Company's total investment portfolio grew to $ 405.0 million in 2000, up $58.4 million or 17%, from $346.6 million in 1999.
Finance charge and other income decreased 52%, to $0.7 million for the year ended December 31, 2001 from $1.5 million for the year ended December 31, 2000. The decline in finance charge and other income is due to the Company's decision to include a provision for finance charges within its Florida MPL policy premiums, rather than assessing finance charges separately.
The liability for losses and LAE represents management's best estimate of the ultimate cost of all losses incurred but unpaid and considers prior loss experience, loss trends, the Company's loss retention levels and changes in the frequency and severity of claims. The process of establishing reserves for property and casualty claims is a complex and uncertain process, requiring the use of informed estimates and judgments. The Company's estimates and judgments may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Any such revisions could result in future changes in the estimates of losses or reinsurance recoverables, and would be reflected in the Company's results of operations when the change occurs. The Company believes its liability for losses and LAE is adequate; however, given the inherent uncertainty in reserve estimates, there can be no assurance that the ultimate amount of actual losses will not exceed the related amounts currently estimated. Furthermore, any such difference, either positive or negative, could have a material effect on the Company's results of operations and financial position.
Net losses and LAE incurred increased 52%, to $122.8 million for the year ended December 31, 2000 from $81.0 million for the year ended December 31, 1999. The loss ratios for such periods were 102% and 69%, respectively. The increase in net losses and LAE incurred is primarily due to an increase in the loss and LAE provision during 2000 resulting from a reserve strengthening of $21.0 million, pre-tax. In addition, the 1999 results included reserve releases of approximately $17.0 million resulting from favorable development in loss experience on business written in years prior to 1999, which did not recur during the year 2000.
Other expenses declined 64%, to $1.0 million for the year ended December 31, 2001 from $2.8 million for the year ended December 31, 2000. Other expenses for the year 2000 included a non-recurring pre-tax severance charge of $1.8 million, which did not recur in 2001.
In accordance with the management agreement between AFP and PRI, AFP receives a management fee equal to 13% of PRI's direct premiums written, with an adjust- ment for expected return premiums. AFP's claims administration and management fees are entirely comprised of these fees. Claims administration and manage- ment fees increased 35%, to $23.0 million for the year ended December 31, 2001, from $17.0 million for the year ended December 31, 2000. The increase in claims administration and management fees is due to an increase in the premiums written by PRI. The Company's revenues and results of operations are financially sensitive to the revenues and results of operations of PRI. In addition, PRI, as an MPL insurer, is subject to many of the same types of risks as those of the Company's insurance subsidiaries, which are described throughout this document.
Commission income increased 107%, to $2.5 million for the year ended December 31, 2001 from $1.2 million for the year ended December 31, 2000. The increase in commission income corresponds with the increase in the amount of reinsurance brokered by Intermediaries in 2001.
Other income decreased 76%, to $0.4 million for the year ended December 31, 2001 from $1.7 million for the year ended December 31, 2000. The decrease in other income is the result of lower statutory net income at PRI compared to the year 2000. The income received by AFP related to PRI's statutory net income for the years ended December 31, 2001, 2000 and 1999 was $0.3 million, $1.6 million and $1.7 million, respectively. In accordance with the management agreement between AFP and PRI, AFP receives or pays an amount equal to 10% of PRI's statutory net income or loss.
Third Party Administration - -------------------------- The Company's TPA segment is made up of McCreary and its subsidiary EMI. Effective January 1, 2002, McCreary and EMI were consolidated by legal entity merger, with EMI continuing as the surviving entity. Financial data for the Company's TPA segment for the years ended December 31, 2001, 2000 and 1999 are summarized in the table below. Dollar amounts are in thousands.
During the fourth quarter 2001, the Company incurred a pre-tax charge of approximately $0.6 million in connection with the disposition of the Brokerage Services, Inc. ("BSI") division of EMI in Albuquerque, New Mexico. Under the plan, the Company sold the division's assets and cancelled its service agreements with self-insured customers. Certain other contracts were retained and will be serviced by the Company's Jacksonville, Florida division. The 2001 restructuring activity was a continuation of the Company's consolidation of the TPA operations and brings to an end the restructuring activities of the Albuquerque division that began during the fourth quarter of 2000 when the Company incurred a pre-tax charge of $0.5 million. Excluding the effects of the restructuring charges, the TPA segment incurred a net loss of approximately $0.2 million and $0.5 million for the years 2001 and 2000, respectively.
Net realized investment losses for the year ended December 31, 2000 were $0.4 million, largely due to the write down of the Company's investment in a joint venture, Bexar Credentials, Inc. ("Bexar") in the fourth quarter of 2000. The Company's stock in Bexar was redeemed for $70 thousand in cash and notes receivable in January 2001. All amounts receivable by the Company from the sale have been collected.
Claims administration and management fees declined 3%, to $12.5 million for the year ended December 31, 2001 from $13.0 million for the year ended December 31, 2000. The decline in claims administration and management fees is due to the termination of certain non-profitable contracts at the Company's Albuquerque division.
Commission income increased 19%, to $2.5 million for the year ended December 31, 2001 from $2.1 million for the year ended December 31, 2000. The increase in commission income corresponds with increases in the underlying rates paid by customers for reinsurance being placed by the TPA segment under alternative market arrangements.
Commission income increased 21%, to $2.1 million for the year ended December 31, 2000 from $1.7 million for the year ended December 31, 1999. The increase in commission income is the result of growth in the placement of insurance and reinsurance by McCreary with external parties on behalf of its self-insured customers during 2000.
Claims administration and management expenses increased 33%, to $15.7 million for the year ended December 31, 2000 from $11.8 million for the year ended December 31, 1999. The growth in claims administration and management expenses is primarily attributable to the acquisition of assets by EMI during the third quarter of 1999.
For the year ended December 31, 2001, other expenses decreased 28%, to $1.3 million from $1.8 million for the year ended December 31, 2000. Excluding the restructuring charges taken during the fourth quarter of 2001 and 2000 mentioned above, other expenses declined 46%, to $0.7 million for the year ended December 31, 2001, from $1.3 million for the year ended December 31, 2000. The decrease in other expenses represents savings from the Company's disposition of non-core businesses during 2000.
Accrued investment income decreased $1.3 million, to $4.6 million as of December 31, 2001 from $5.9 million as of December 31, 2000. The decrease in accrued investment income is due to lower investment returns on the Company's investment portfolio associated with lower interest rates on fixed income securities.
Due from reinsurers on unpaid losses and advance premiums increased $22.7 million, to $80.4 million as of December 31, 2001 from $57.7 million as of December 31, 2000. Ceded unearned premiums increased $30.7 million, to $40.8 million as of December 31, 2001, from $10.1 million as of December 31, 2000. The increases in these assets are related to the increase in the underlying reserves and unearned premiums resulting from growth in premiums written and earned on the Company's core MPL business and the increase in premiums written under fronting arrangements whereby the Company cedes substantially all of the business to other insurance carriers.
Goodwill and intangible assets decreased $2.4 million, to $58.5 as of December 31, 2001 from $60.9 million as of December 31, 2000. The decrease in goodwill and intangible assets is due to amortization.
Federal income tax receivable decreased $3.2 million, to $5.3 million as of December 31, 2001 from $8.5 million as of December 31, 2000. The decrease in federal income tax receivable corresponds with the related decrease in the current benefit recognized in 2001, and the receipt of a federal tax refund related to the overpayment of estimated taxes for the year 2000.
The Company's liability for loss and LAE increased $37.2 million, to $318.5 million as of December 31, 2001 from $281.3 million as of December 31, 2000. The increase in the liability for loss and LAE is attributable to increases in premiums earned and the establishment of reserves for the current book of business, taking into consideration expected loss trends and an appropriately conservative loss ratio. In addition, the Company recorded a pre-tax reserve adjustment of $8.8 million in the fourth quarter of 2001 to strengthen reserves established for prior coverage years. The adjustment to reserves reflects the soft market conditions that prevailed for coverage years 2000 and prior.
Unearned premiums increased $46.7 million, to $146.8 million as of December 31, 2001 from $100.1 million as of December 31, 2000. The increase in unearned premiums is primarily related to growth in premiums written at the Company's insurance subsidiaries.
Premiums paid in advance and unprocessed premiums increased $3.8 million, to $9.9 million as of December 31, 2001 from $6.1 million as of December 31, 2000. The increase in paid in advance and unprocessed premiums reflects the policy renewal cycle at the Company's largest insurance subsidiary whereby the majority of policies are renewed with an effective date of January 1 or July 1 of each year. In addition, the Company instituted a rate increase at its largest insurance subsidiary in December 2001.
The Company's revolving credit facility and term loan decreased $14.2 million, to $53.0 million as of December 31, 2001 from $67.2 million as of December 31, 2000. On August 31, 2001, the Company entered into a revolving Credit and Term Loan Agreement (the "credit facility") with five financial institutions. The initial aggregate principal amount of the new credit facility was $55 million, including (i) a $37.5 million revolving credit facility (with a $15 million letter of credit sub-facility), which matures on August 31, 2004, and (ii) a $17.5 million term loan facility, repayable in twelve equal quarterly installments of approximately $1.5 million each commencing on December 31, 2001. The credit facility replaced a $75 million revolving credit facility (the "prior
facility") that was entered into by the Company in January 1999, which would have matured on January 4, 2002. Approximately $67.2 million of principal was outstanding under the prior facility. The Company used available funds to pay down the difference between the outstanding principal amount of the prior facility and the initial amount of the new facility.
Stock Repurchase Plans - ---------------------- During 2001, the Company repurchased 21,500 shares of its stock on the open market under its previously announced stock repurchase program at an average price of $10.84 per share. Under the Company's stock repurchase programs, shares may be repurchased at such times, and in such amounts, as management deems appropriate, and subject to the requirements of its credit facility under which the Company may repurchase shares up to an amount not to exceed 50% of net income of the immediately preceding year. A decision whether or not to make additional repurchases is based upon an analysis of the best use of the Company's capital. Since the commencement of these repurchase programs, the Company has repurchased 875,000 of its shares at a cost of approximately $16.2 million. A total of 365,500 shares remain available to be repurchased under the programs.
The Company maintains a $55 million credit facility with five banks. The credit facility replaced a $75 million prior facility that was entered into by the Company in January 1999, which would have matured on January 4, 2002. Approximately $67.2 million of principal was outstanding under the prior facility. The Company used available funds to pay down the difference between the outstanding principal amount of the prior facility and the initial amount of the new credit facility.
At December 31, 2001, the Company did not meet its fixed charge coverage ratio loan covenant, primarily as a result of the reserve strengthening charge in the fourth quarter described above. The Company's lenders have waived this violation bringing the Company into compliance with its loan covenants. In addition, the Company and its lenders have re-negotiated a modification to the fixed charge coverage ratio loan covenant from 2.5:1, to 2.0:1 for the year 2002; and to 2.25:1 beginning in the first quarter of 2003. In connection with the waiver and modification, the applicable margin charged by the lenders as part of interest costs will increase 25 basis points, or 1/4 of 1 percent beginning in 2002.
The National Association of Insurance Commissioners has developed risk-based capital ("RBC") measurements for insurers, which have been adopted by the Florida and Missouri Departments of Insurance. RBC measurements provide state regulators with varying levels of authority based on the adequacy of an insurer's adjusted surplus. At December 31, 2001, the Company's insurance subsidiaries maintained adjusted surplus in excess of their required RBC thresholds.
Accounting Pronouncements - ------------------------- Effective January 1, 2001, the Company adopted FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" and FAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment to FAS No. 133". FAS No. 133 requires all derivative financial instruments, such as interest rate swaps, to be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. Changes in the fair market value of derivative financial instruments are either recognized periodically in income or shareholders' equity (as a component of accumulated other comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. FAS No. 138 amended the accounting and reporting standards for certain derivative instruments and hedging activities under FAS No. 133. The adoption of FAS No. 133 did not have a material effect on the Company's consolidated financial statements, but did increase total shareholders' equity by $124 thousand at January 1, 2001 as a cumulative effect of a change in accounting principle.
In June 2001, the Financial Accounting Standards Board ("FASB") issued FAS No. 141 "Business Combinations." FAS No. 141 addresses financial accounting and reporting for business combinations and supersedes Accounting Principles Board ("APB") Opinion No. 16, "Business Combinations," and FAS No. 38, "Accounting for Preacquisition Contingencies of Purchased Enterprises." The standard eliminates the pooling of interests method of accounting for business combinations except for qualifying business combinations initiated prior to July 1, 2001 and requires that all intangible assets be accounted for separately from goodwill, for acquisitions after July 1, 2001. Management believes the adoption of FAS No. 141 will not have a significant impact on the Company's consolidated financial statements.
In June 2001, the FASB issued FAS No. 143, "Accounting for Asset Retirement Obligations." FAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Although earlier application is encouraged, FAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002. Management believes the adoption of FAS No. 143 will not have a significant impact on the Company's consolidated financial statements.
In August 2001, the FASB issued FAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The proposed standard provides a unified model for all assets to be disposed of, including the disposal of segments of a business currently accounted for under APB Opinion No. 30. FAS No. 144 also resolves the implementation issues and inconsistencies in accounting for assets to be disposed of raised by FAS No. 121 and covers the reporting of discontinued operations. The standard supersedes FAS No. 121, while retaining the
recognition and measurement provisions of FAS No. 121 for long-lived assets to be held and used and the measurement of long-lived assets to be disposed of by sale. Management believes the adoption of FAS No. 144 will not have a significant impact on the Company's consolidated financial statements.