The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this report. The discussion that follows contains certain forward-looking statements relating to our anticipated future financial condition, operating results, cash flows and our current business plans. When we use any of the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward looking statements. These forward-looking statements represent our outlook only as of the date of this report. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are detailed under “Item 1 - Business - Uncertainties Relating to Forward Looking Statements” and elsewhere in this report and from time to time in other reports filed by the Company with the Securities and Exchange Commission. The cross-referenced information is incorporated herein by reference.
Underwriting expenses represent costs associated with issuing new and renewal business as well as ongoing policy maintenance expenses. Some of these costs, such as commissions and premium taxes, as well
To ensure the security of our policyholders, we must maintain assets in excess of total liabilities. This excess, or “surplus,” is the principal measure used by state insurance regulators, and rating agencies such as A.M. Best, to evaluate the Company’s financial strength. Medical professional liability insurers generally attempt to keep this surplus level approximately equal to their annual net premiums written.
The medical professional liability insurance business, like all other property and casualty insurance markets, tends to cycle through what are often referred to as “hard” and “soft” markets. A hard market is generally characterized as a period of rapidly rising premium rates, tightened underwriting standards, narrowed coverage, and the withdrawal of insurers from certain markets. Soft markets, are usually characterized by relatively flat or slow-rising premium rates, less stringent underwriting standards, expanded coverage and strong competition among insurers. In the mid to late 1990’s, the medical professional liability insurance industry was generally viewed as being in a soft market. However, since approximately 2001, the trend in medical professional liability insurance has been towards a harder market. Hard and soft market cycles tend to be more extreme in the medical professional liability business than in other insurance businesses because of the longer period of time required to resolve medical malpractice claims.
Tort reform is another factor that affects our business. Tort reform encompasses a variety of subject matters; however, the one most critical to the medical professional liability insurance market is limits on non-economic damages and punitive damages. Historically tort reform has occurred on a state by state basis. Accordingly, losses can vary dramatically by state depending on the level of tort reform the state has enacted. We monitor state tort reform closely and evaluate any changes for impacts on our current business strategies and estimated loss reserves.
As with other types of property and casualty insurance, medical professional liability insurance policies are subject to policy limits. The limits of liability purchased by our medical professional liability policyholders differ by state. In Michigan and New Mexico, the most common limits purchased are $200,000 of coverage per claim and $600,000 of aggregate coverage per year. In all other states in which we write business, the most common policy limits purchased are $1 million/ $3 million. We may write higher limits and excess coverage in conjunction with special reinsurance arrangements.
The principal agency through which we write medical professional liability insurance is SCW Agency Group, Inc. and its wholly owned subsidiaries. SCW is 91.1% owned by William B. Cheeseman, one of our directors and our former president and chief executive officer. Bridget Cheeseman, Mr. Cheeseman’s adult daughter, is a vice president of SCW and owns approximately 2.5% of SCW. During the three years ended December 31, 2003, Mr. Cheeseman has received no cash or other compensation, dividends or other distributions from SCW and his only benefit from SCW from this relationship is the potential appreciation of his ownership interest in that company. If SCW increases the amount of business it writes for us, SCW will earn more commission revenue from us. To the extent the increase in commission revenue we pay SCW increases SCW’s profits, Mr. Cheeseman’s ownership interest may appreciate.
Based on financial information made available to us, we estimate SCW’s net profits on the commission revenue earned from us in 2003 to be approximately $1.2 million. We have not attempted to independently audit or verify the information SCW has furnished, although we have no reason to believe it is inaccurate. For purposes of this disclosure, we have estimated the net profits that SCW earned on the revenue received from us by calculating the profit percentage that SCW’s net profits bears to its total revenue in 2003 and applying that percentage to the revenue earned from us.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect amounts reported in the accompanying consolidated financial statements and related footnotes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in the Company’s earnings in the period those estimates changed. The following policies are those we believe to be the most sensitive to estimates and judgments. Our significant accounting policies are more fully described in Note 1 to our Consolidated Financial Statements. Such information is incorporated herein by reference.
frequency or severity of claims reported to us can have a significant impact on actuarial estimates of ultimate losses and recorded reserves. Based on these quantitative as well as other qualitative factors, such as a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and the current reserving practices of the Company’s claims department, we select a “best estimate” of ultimate future losses, and then record this best estimate in the Company’s Consolidated Financial Statements. As required by insurance regulatory authorities, we receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves.
The process of estimating the reserves for unpaid losses and loss adjustment expenses involves significant judgment and is complex and imprecise due to the number of variables and assumptions inherent in the estimation process. These variables include the effects on ultimate loss payments of internal factors such as changes in claims handling practices and changes in the mix of our products, as well as external factors such as changes in loss severity trends, economic inflation, judicial trends and legislative and regulatory changes. In addition, medical professional liability claims may take several years to resolve due to typical delays in reporting claims to us, the often lengthy discovery process, and the time necessary to defend the claim. In addition, claims with similar characteristics may result in very different ultimate losses depending on the state or region where the claim occurred. All of these factors contribute to the variability in estimating ultimate loss payments, especially since the affects of many of these variables cannot be directly quantified, particularly on a prospective basis.
During the year ended December 31, 2003, we recorded an impairment charge of $1.3 million on enhanced equipment trust certificates that were issued by Delta Airlines. During the years ended December 31, 2002 and 2001 we recorded an impairment charge of $520,000 and $5.9 million, respectively related to bonds issued by Frontier Corporation, a subsidiary of Global Crossings. At December 31, 2003, the
A portion of the coverage that physicians purchase under claims-made policies is for an additional death, disability and retirement (“DDR”) insurance benefit. This DDR coverage provides coverage to the physician for any prior incidents occurring during the coverage period that are reported after their death, disability or retirement. The loss exposure associated with this product is known as extended reporting period claims. The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of expected future premiums associated with this DDR coverage. The reserves for these claims fluctuate based on the number of physicians who are eligible for this coverage and their age. Any changes in the DDR reserves are reflected as an expense in the period in which we become aware that an adjustment is necessary. At December 31, 2003 and 2002, our recorded DDR reserves were $14.0 million.
In accordance with industry practice, we cede to other insurance companies some of the potential liability under insurance policies we have underwritten. This practice, called reinsurance, helps us reduce our net liability on individual risks, stabilize our underwriting results and increase our underwriting capacity. As payment for sharing a portion of our risk, we are also required to share a part of the premium we receive on the related policies. We determine the amount and scope of reinsurance coverage to purchase each year based upon an evaluation of the risks accepted, consultations with reinsurance brokers and a review of market conditions, including the availability and pricing of reinsurance. Our reinsurance arrangements are generally renegotiated annually.
We annually review the financial stability of all of our reinsurers. This review includes a ratings analysis of each reinsurer participating in a reinsurance contract. On the basis of this review, as of December 31, 2003, we concluded that an allowance for uncollectible reinsurance recoverables was unnecessary. We do, however, have a reinsurance recoverable from Gerling Global (“Gerling”) of approximately $17.5 million ($13.3 million net of ceded premiums payable of $4.2 million), at December 31, 2003. In 2002, Gerling’s parent company put Gerling’s United States subsidiary into run off resulting in a series of A.M. Best rating downgrades for Gerling. We have discussed the possibility of a settlement with Gerling, but have not received an offer that we deem financially adequate. We continue to believe that Gerling has adequate surplus and cash flow to satisfy its obligations to us and we have not experienced any difficulties in collecting amounts due from Gerling; however, there can be no assurance that amounts currently recoverable from Gerling will ultimately
be collected. Because the Company has not experienced any difficulties in collecting amounts from Gerling, and in light of Gerling’s current surplus levels and cash flows, we determined not to accept the settlement offer because we do not believe that it is in the Company’s best long-term economic interest. We will continue to monitor Gerling’s financial strength and liquidity and may pursue a settlement in the future if circumstances change. The periodic analysis of Gerling includes reviews of Gerling’s publicly available financial information, as well as monitoring of trade publications and press releases. Should there be a material change in the financial condition of Gerling, our assessment of its ability to meet its obligations to us may also change. Our assessment of the financial strength and liquidity of Gerling is the primary basis by which we have determined not to record a valuation allowance against this recoverable.
In addition to premiums earned on written premiums, the Company also recognizes premium income for any changes in estimated “earned but unbilled premiums” in connection with future audit premium billings on workers’ compensation insurance policies. Audit premiums are retroactive adjustments made after the policy’s expiration that result in either additional premium billings or premium refunds based on the insured’s actual employee head count and other factors. Earned but unbilled premiums represent the portion of estimated future audit premiums that will be billed in future periods, but have been earned during the period based on the effective dates of the policies that are expected to generate the future audit premium billings. Estimated future audit premium billings are based on historical audit premium billings, adjusted for factors related to the current economic environment. To the extent that there are changes in the classes of businesses that we insure, or that the headcount at insured businesses changes based on the overall economic environment, our use of historical data to estimate future earned but unbilled premiums may result in amounts that differ from actual billings. The estimate for earned but unbilled premiums at December 31, 2003 and 2002 was $339,000 and $945,000, respectively.
Deferred policy acquisition costs (“DAC”) are those costs that vary with and are primarily related to the production of new, or renewal, business and include such costs as commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Under GAAP, the premiums that will be earned in future periods, to which these deferred costs relate, must produce sufficient profits to offset the future expense that will be recognized from the amortization of the DAC, that is, the DAC must be recoverable. In evaluating the recoverability of
This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and operating the insurance segments. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business and improve our loss ratio, and overall profitability.
2003 Compared to 2002. The net loss reported for 2003 was primarily attributable to unfavorable development on prior year loss reserves of $43.4 million and the establishment of a deferred tax valuation allowance of $50.6 million. The unfavorable development on prior year loss reserves was primarily related to our medical professional liability segment, and was the result of an increase in paid loss severity noted during
the third quarter, particularly in our Florida, Ohio and Kentucky markets. We also established the deferred tax valuation allowance in the third quarter of 2003, as there was not adequate support regarding the availability of future taxable income based on our recent loss history. Our net loss in 2002 was primarily the result of a $55.1 million underwriting loss, and a $9.1 million charge, net of tax, for the write-off of goodwill, which was recorded as a cumulative effect of a change in accounting principle, partially offset by $44.8 million of investment income.
The yield on our investment portfolio was 5.55% for 2003 compared to 5.98% for 2002. The lower yield in 2003 was the result of a general decline in interest rates combined with a higher cash balance during the first part of the year, which produces a significantly lower yield than longer-term more productive assets. We delayed investing a portion of the cash flow generated during the first half of 2003 due to the very low interest rate environment and our reluctance to lock-in longer-term interest rates at prevailing levels.
Incurred loss and loss adjustment expenses increased during 2003 as a result of the $43.4 million of unfavorable development on prior year loss reserves mentioned above. Prior year unfavorable loss reserve development in 2002 was $5.6 million. The consolidated calendar year loss ratio for the 2003 year was 112.5%, consisting of 19.3% on prior accident years and 93.2% on the current accident year. In 2002, the current year accident loss ratio was 100.3%, with a prior year loss ratio of 2.4%, for a total calendar year loss ratio of 102.7%. Our incurred loss and loss adjustment expenses are analyzed more fully in the discussions of our individual operating segment results.
Restructuring expenses incurred during 2003 were recorded during the fourth quarter and relate to employee separation costs as a result of terminations in connection with the initiation of our exit from the workers’ compensation segment. As we continue our exit from workers’ compensation in 2004 and beyond, we anticipate incurring approximately $300,000 of additional employee separation costs in future periods in accordance with the guidance given in Statement of Financial Accounting Standards “SFAS” No. 146. See “- Effects of New Accounting Pronouncements” for further discussion of the impact of the adoption of SFAS No. 146.
re-established a pattern of profitability, and can demonstrate the availability of future taxable income, the deferred tax valuation allowance may be reduced, which will create a federal income tax benefit in the period of reduction.
The decline in investment income was primarily the result of a lower interest rate environment in 2002, compared to 2001. In addition, the Company spent $27.5 million to fund its share repurchase program during the year ended December 31, 2002, which reduced the amount of invested assets during 2002 as compared to 2001. The average yield on the Company’s investment portfolio was 5.98% for the year ended December 31, 2002 compared to 6.36% for 2001.
The decrease in net realized losses in 2002 was the result of a charge for other than temporarily impaired securities in 2001 of $5.9 million related to bonds issued by Frontier Corporation. These same bonds were written down an additional $520,000 during 2002.
The decrease in incurred loss and loss adjustment expenses was the result of the $29.0 million of unfavorable development on prior year loss reserves recorded in 2001. Unfavorable development on prior year loss reserves in 2002 was $5.6 million. Our incurred loss and loss adjustment expenses are analyzed more fully in the discussions of our individual operating segments.
Restructuring costs in 2001 were incurred in connection with a reduction of personnel in our Information Systems department and our senior management team as the Company evaluated the impact of recently becoming a publicly traded company and made certain organization changes to obtain expertise in its core lines of business.
The Company recorded $5.5 million in federal income tax benefit for the year ended December 31, 2002, compared to a benefit of $23.5 million during 2001. The income tax benefit recorded was a result of net losses in those periods. The effective tax rate was 37.0% for the year ended December 31, 2002, compared to 34.9% for 2001.
2003 Compared to 2002. Direct premiums written for the medical professional liability segment increased in 2003 primarily as a result of rate increases in virtually all markets, partially offset by our exit from the Florida market. Our insured physician count at December 31, 2003 has decreased approximately 12% from December 31, 2002 due to our exit from the Florida market, the discontinuance of Ohio occurrence-based policies and the elimination of poor risks in other markets. The average premium per policy in-force has increased from approximately $13,400 at December 31, 2002 to approximately $16,300 at December 31, 2003, an increase of 21.6%. The decrease in direct premiums written in Florida, as a result of our exit from that state was partially offset by direct premiums written of approximately $3.8 million by Physicians Insurance Company (“PIC”), a newly consolidated entity. See “- Effects of New Accounting Pronouncements” for further discussion regarding our investment in PIC.
We believe that the current pricing environment for medical professional liability insurance is favorable. We expect medical professional liability direct premiums written to increase moderately in the future as the Company is granted additional rate increases by regulatory authorities. However, this growth may be limited by our ability to allocate appropriate levels of statutory capital and surplus to the medical professional liability segment. The decrease in premiums related to our exit from the Florida and other markets is expected to be offset by rate increases in other states. While we do not anticipate any significant decline in business as a result of our recent A.M. Best downgrades, the downgrades could adversely impact our competitive position within the marketplace, making it more difficult to retain or attract new policyholders.
The loss ratio, on an accident year basis, was 96.5% for the year ended December 31, 2003 compared to 106.1% for the year ended December 31, 2002. The decrease in the accident year loss ratio was primarily the result of rate increases taken in all markets.
The increase in underwriting expenses was the result of increased salaries and employee relations costs as we added to our claims and underwriting personnel. In addition, higher premium volumes resulted in increased commissions and premium taxes. We anticipate that the medical professional liability underwriting ratio may increase in the near future due to the increased allocation of corporate and other overhead expense to this segment as we exit the workers’ compensation and health lines.
The increase in underwriting expenses from 2001 to 2002 was primarily the result of increased commissions and premium taxes on the higher premium volume.
compensation policy renewals under the terms of a previously announced non-binding letter of intent. We are required by various state regulatory authorities to provide a notification period, typically 30 to 90 days, to insureds prior to non-renewing their policies to provide them time to find alternative coverage. We began mailing non-renewal notices in February 2004, which means that additional written premiums may continue into the second quarter of 2004.
Management is continuing to pursue a loss portfolio transfer of our existing workers’ compensation reserves for unpaid losses and loss adjustment expenses. As of December 31, 2003 workers’ compensation reserves totaled $62.3 million, $60.6 million net of reinsurance.
The decrease in the loss ratio from 2001 to 2002 was due to an overall pattern of increasing premium rates and reduced discounts in all markets, as well as a $5.0 million reserve enhancement related to prior accident years in 2001. There was no reserve development related to prior accident years in 2002.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our health insurance operations for the years ended December 31, 2003, 2002 and 2001.
2003 Compared to 2002. Health direct premiums written decreased in 2003 as a result of a reduction in the number of covered lives, partially offset by an increase in the average per member per month premium. The number of covered lives at December 31, 2003 was 6,554 compared to 12,898 at December 31, 2002, a decrease of approximately 49%. Over the same period, the average per member per month premium increased $60 from $188 at December 31, 2002 to $248 at December 31, 2003. We expect to see premiums for this segment continue to decrease due to a further decline in the number of covered lives as we tighten underwriting standards and raise rates during the first half of 2004, after which we will discontinue issuing new health insurance policies.
The increase in underwriting expenses was primarily the result of additional commissions and premium taxes on higher premium volumes. The decrease in the health underwriting ratio was primarily the result of holding underwriting salaries and employee benefit costs relatively constant, while net premiums earned increased 27.6% during the year ended December 31, 2002.
2002 Compared to 2001. Loss before federal income taxes, minority interests and cumulative effect of a change in accounting principle for the year ended December 31, 2002 was $1.0 million compared to $2.8 million for the same period of 2001. The decrease in net loss was primarily attributable to the restructuring charges incurred in 2001.
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. We also enter into financing transactions from time to time to acquire additional capital. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, and the repurchase of the Company’s stock.
At December 31, 2003, we had no material planned expenditures for the acquisition of assets, or other expenditures, other than expenses incurred in the normal course of operations.
In September 2003, the Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439. The Company repurchased 272,800, 1,555,100 and 1,369,170 shares, at a cost of $7.7 million, $27.5 million and $25.2 million, during 2003, 2002 and 2001, respectively, bringing the total number of shares purchased pursuant to these authorizations to 3,197,070, at a total cost of $60,382,000, or an average price per share of $18.89. The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of December 31, 2003, the Company has approximately 418,369 shares of its September 11, 2003 stock repurchase program remaining to be purchased. The Company does not anticipate repurchasing any of its shares in the near future.
Our net cash flow generated by operations was approximately $9.1 million for the year ended December 31, 2003, compared to $52.1 million provided by operations for 2002. The cash generated by operations in 2003 was primarily the result of premiums collected, net of reinsurance premiums paid, of approximately $231.0 million in excess of losses paid of approximately $220.1 million. Premiums collected in excess of losses paid in 2002 were approximately $36.4 million. In general, our investment income offsets cash paid for underwriting and general and administrative expenses. A large portion of our investment expense is related to depreciation on investment in real estate, which is a non-cash charge. Anticipated premium rate increases are expected to have a positive impact on our cash flows from operations in 2004.
Based on historical trends, market conditions and our business plans, we believe that our existing resources and sources of funds will be sufficient to meet our short and long-term liquidity needs. However, economic, market and regulatory conditions may change, and there can be no assurance that our funds will be sufficient to meet these liquidity needs. In addition, in order to support future premium growth as a result of planned rate increases, or to support our A.M. Best rating, our insurance subsidiaries may require additional capital. Accordingly, we are exploring options with respect to raising future capital.
Our statutory capital and surplus (“surplus”) at December 31, 2003 was approximately $150.3 million, which results in a net premiums written to surplus ratio of 1.49:1. Statutory surplus at December 31, 2002 was approximately $190.2 million, for a net premiums written to surplus ratio of 1.25:1. The increase in our ratio of net premiums written to surplus was primarily the result of the third quarter charge for unfavorable development on prior year loss reserves related to our medical professional liability segment, which reduced our statutory surplus by approximately $43 million. The exit from the workers’ compensation and health insurance lines of business in 2004 is expected to make additional surplus available to support future medical professional liability premiums. However, as approximately $35 million of our statutory surplus is related to our APSpecialty and ICA insurance subsidiaries, we are considering alternatives on how to maximize our use of that surplus to support the medical professional liability premium writings in American Physicians. These alternatives include a pooling arrangement between APSpecialty and American Physicians, and/or a statutory merger among our various insurance subsidiaries. In January 2004, APCapital contributed $25 million to American Physicians. We are also considering various options with respect to raising additional capital at the holding company level, which could then be contributed to American Physicians.
Our invested assets consist primarily of fixed maturity and equity securities, which are carried in the Consolidated Balance Sheets, included elsewhere in this report, at their estimated fair value, and investment
real estate and real estate limited partnerships. At December 31, 2003, our investment portfolio included net unrealized gains of approximately $45.5 million, an increase of $7.6 million as compared to December 31, 2002. Net unrealized gains are reported, net of tax, in the shareholders’ equity section of the Consolidated Balance Sheets, included elsewhere in this report, and represented approximately 14.7% and 8.8% of consolidated shareholders’ equity at December 31, 2003 and 2002, respectively. Generally, the estimated fair value of our fixed maturity securities is inversely related to current interest rates. Therefore, as interest rates rise or fall, our net unrealized gains will change accordingly. See “
In our opinion, the consolidated financial statements listed in the accompanying index under Item 15(a)(1) and (2), present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index under Item 15(a)(1) and (2), present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, during 2003 the Company adopted the provisions of Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for goodwill to be in conformity with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets”, which was adopted as of January 1, 2002.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of American Physicians Capital, Inc. (“APCapital”), its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation (“APS”), APConsulting LLC, APDirect Sales, LLC, Alpha Advisors, Inc., APIndemnity (Bermuda) Ltd., APManagement Ltd. and American Physicians Assurance Corporation (“American Physicians”). In accordance with the guidance given in Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN No. 46”), the accounts of two wholly owned subsidiary trusts used to issue mandatorily redeemable trust preferred securities have been included on the equity method in the accompanying Consolidated Financial Statements, and the accounts of Physicians Insurance Company (“PIC”) have been included in the accompanying Consolidated Financial Statements. See Note 2 for further discussion regarding the impact of FIN No. 46. All significant intercompany accounts and transactions are eliminated in consolidation.
All of the Company’s fixed maturity and equity securities are classified as available-for-sale, which are those securities that would be available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates and asset-liability management strategies. Available-for-sale securities are reported at estimated fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income, net of deferred taxes.
During 2003, the Company purchased interest-only certificates that may not allow for the recovery of substantially all of its investment. These certificates pay a variable rate of interest that is inversely related to the London Interbank Offered Rate (“LIBOR”). The Company has determined that these certificates contain an embedded derivative instrument as defined by Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.”
All interest-only certificates with an inverse floating rate of interest are carried on the balance sheet at fair value as a fixed maturity security. These certificates are not linked to specific assets or liabilities on the balance sheet or to a forecasted transaction and, therefore, do not qualify for hedge accounting. In addition, the Company does not feel that it can reliably identify and separately measure the embedded derivative instrument. Accordingly, any changes in the fair value of the interest-only certificates, based on quoted market prices, are recorded in current period earnings as investment income.
At December 31, 2003 the Company had such certificates with a fair value of approximately $7.4 million. The fair value of these certificates increased by approximately $432,000 during the year ended December 31, 2003.
The Company uses these certificates as a part of its overall interest rate risk-management strategy related to its investment portfolio.
Premiums written are earned using the daily pro rata method over the period of risk. Premiums receivable include $58,694,000 at December 31, 2003 and $57,013,000 at December 31, 2002 of premium installments. Receivable balances consist principally of written premiums from physicians and employers in the states of Michigan, Ohio, Illinois, Minnesota and New Mexico. The Company’s exposure to credit risk associated with
Deferred policy acquisition costs (“DAC”) (carried on the accompanying Consolidated Balance Sheets in other assets) include commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Future investment income has been considered in determining the recoverability of deferred costs.
The reserves for unpaid losses and loss adjustment expenses are estimated using the Company’s claim experience. These estimates are subject to the effects of trends in loss severity and frequency. When a claim is reported to the Company, a “case reserve” is established for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon insurance reserving practices appropriate for the relevant type of insurance, and based on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are periodically reviewed and adjusted as necessary as more information becomes available. Reserves for claims “incurred but not reported” provide for the future reporting of claims already incurred, and development on claims already reported. The reserve for claims incurred but not reported is actuarially estimated based on historical loss trends. With the exception of reserves for extended reporting period claims, the Company does not discount reserves to recognize the time value of money.
The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, utilizing the pure-premium approach, in amounts believed to be adequate to pay for estimated future claims reported subsequent to a current policyholder’s death, disability or retirement. The amount of this reserve is $14.0 million at December 31, 2003 and 2002, and is included in unpaid loss and loss adjustment expenses on the balance sheet. Changes in this reserve are charged or credited to income.
The Company also recognizes premium income for any changes in its estimate for “earned but unbilled premiums.” Earned but unbilled premiums represent the portion of estimated future audit premiums, associated with workers’ compensation insurance policies, that will be billed in future periods, but have been earned during the period based on the effective dates of the policies that are expected to generate the future audit premium billings. Earned premiums included approximately $339,000, $945,000 and $0 of earned but unbilled premiums for the years ended December 31, 2003, 2002 and 2001, respectively. Estimated future audit premium billings are based on historical audit premium billings, adjusted for factors related to the current economic environment. Although considerable variability is inherent in such estimates, management believes that its estimate of future audit premium billings and earned but unbilled premiums is reasonable.
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. The Company has reviewed its deferred federal income tax assets for recoverability based on the availability of future taxable income when the deductible temporary differences are expected to reverse, and has determined, based on its recent loss experience, that sufficient taxable income may not exist in the periods of reversal. Accordingly, the Company has recorded a deferred tax asset valuation allowance for the entire net deferred tax asset. The establishment of a valuation allowance in 2003 is recorded as federal income tax expense in the accompanying Consolidated Statements of Income. Once the Company has re-established a pattern of profitability, the deferred tax asset valuation allowance may be reduced upon evaluation of the availability of future taxable income.
Effective January 1, 2002, the Company completed the transitional impairment testing required by SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). Based on the results of the impairment testing, net goodwill of $13.9 million, $9.1 million net of tax, was written off as a cumulative effect of a change in accounting principle. See Note 4 for additional information regarding the effects of the adoption of SFAS No. 142.
Had compensation expense been determined based on the fair value at the grant date, consistent with the provisions of SFAS No. 123, our net loss and net loss per share would have been as follows for the years ended December 31, 2003, 2002 and 2001:
See Note 17 for further information regarding the Company’s stock-based compensation plans.
The most significant estimates that are susceptible to significant change in the near-term relate to the determination of loss and loss adjustment expense reserves, investments, taxes, reinsurance, and the reserve for extended reporting period claims. Although considerable variability is inherent in these estimates, management believes that the current estimates are reasonable in all material respects. The estimates are reviewed regularly and adjusted as necessary. Such adjustments are reflected in current operations.
In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No, 146”). With the adoption of SFAS No. 146, effective for exit or disposal activities initiated after December 31, 2002, a liability for a cost associated with an exit or disposal activity should be recognized and measured initially at fair value only when the liability is incurred. See Note 14 for further discussion regarding costs associated with exit activities and the impact of SFAS No. 146.
The adoption of SFAS No. 142 had a significant impact on the Company’s operating results, as effective January 1, 2002 goodwill is no longer being amortized. The Company’s net loss per share for the years ended December 31, 2003, 2002 and 2001, in the Consolidated Statements of Income, exclusive of amortization expense recognized in those periods related to goodwill, would have been as follows:
For the year ended December 31, 2003, gross unrealized gains include $432,000 of gains that relate to securities that contain an embedded derivative instrument. These gains have been included in investment income for the period in accordance with SFAS No. 133. See Note 1 for further discussion of these securities and the embedded derivative instruments.
The following table shows the Company’s gross unrealized investment losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003.
The components of pretax investment income and net realized investment gains (losses) for the years ended December 31, 2003, 2002 and 2001 were:
Net realized investment gains (losses) above excludes approximately $7,000 in 2003, $293,000 in 2002, and $528,000 in 2001 of realized losses on the sale or disposal of fixed assets.
During the years ended December 31, 2003 and 2002, the Company capitalized approximately $1.6 million and $605,000, respectively, of costs incurred related to computer software obtained and developed for internal use. Accordingly, at December 31, 2003 and 2002, approximately $2.2 million and $605,000, respectively, of costs related to this software package have been capitalized. It is anticipated that the software will be placed in use in the second quarter of 2004, at which time these capitalized costs will begin to be amortized on a straight-line basis over a period of five years.
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2003, 2002, and 2001 was as follows:
The gross proceeds from the trust issuances, and the cash from the equity contribution, were used by the trusts to purchase Debentures issued by APCapital. The TPS issued by the trusts have financial terms similar to the floating rate junior subordinated deferrable interest debentures (the “Debentures”) issued by APCapital. In accordance with FIN No. 46, these trusts are not consolidated in the Company’s Consolidated Financial Statements. See Note 2 for further discussion regarding the impact of FIN No. 46.
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and plus 4.20% for the second trust issuance, payable quarterly. The interest rate is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 12.50%. The weighted average interest rates of 5.31% (Trust I issuance) and 5.40% (Trust II issuance) resulted in interest expense of approximately $1.0 million for the year ended December 31, 2003. At December 31, 2003, accrued interest payable to the trusts was approximately $182,000. The Debentures are callable by APCapital at par beginning in May 2008. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS. As the amounts that could potentially be payable under the guarantees are recorded as liabilities by the Company, no additional liability related to these guarantees has been accrued.
A reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2003, 2002, and 2001 is as follows:
Losses and loss adjustment expenses incurred are net of ceded losses of $33,497,000 for 2003, $31,725,000 for 2002, and $46,721,000 for 2001.
The Company had reinsurance recoverables from the following reinsurers at December 31, 2003 and 2002:
Income taxes incurred do not bear the usual relationship to income before income taxes for the years ended December 31, 2003, 2002, and 2001 due to the following:
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. The Company has reviewed its deferred federal income tax assets for recoverability based on the availability of future taxable income when the deductible temporary differences are expected to reverse, and has determined, based on its recent loss experience, that sufficient taxable income may not exist in the periods of reversal. Accordingly, the Company has recorded a deferred tax asset valuation allowance for the entire net deferred tax asset. The establishment of the valuation allowance during 2003 is recorded as federal income tax expense in the accompanying Consolidated Statements of Income. Once the Company has re-established a pattern of profitability, the deferred tax asset valuation allowance may be reduced upon evaluation of the availability of future taxable income.
In September 2003, the Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439. The following table reflects the number of shares
The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of December 31, 2003, the Company has 418,369 shares of its September 11, 2003 stock repurchase program remaining to be purchased.
Approximately $1.032 billion of consolidated assets represents assets of the Company’s insurance operations that are subject to regulation and may not be transferred to APCapital in the form of dividends, loans or advances. The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding realized gains (losses) on sales of investments, or 10% of surplus as of the preceding year end. As of January 1, 2004, approximately $14.8 million could be paid by the Company’s insurance subsidiaries without prior regulatory approval.
Under SFAS No. 107, the Company’s investment securities, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, long-term debt, and note payable constitute financial instruments. The carrying amounts of all financial instruments approximated their fair values at December 31, 2003 and 2002.
In November, 2001, the Company reduced personnel in its Information Systems department and its management team. A total of eleven people were terminated resulting in $1,891,000 of severance costs and $26,000 of other costs. In December 2001, the Company completed its phase out of the personal and commercial lines and all policies have been non-renewed. A total of nine people were terminated resulting in a charge of $567,000. At December 31, 2002, substantially all activities related to the restructuring initiatives were substantially complete; however, structured severance packages were not completely paid out until 2003.
In the fourth quarter of 2003, the Company began to exit its workers’ compensation line of business. A total of twelve employees were terminated resulting in $808,000 of one-time employee severance costs. Approximately $81,000 of these costs were paid prior to December 31, 2003, with the remaining $727,000 expected to be paid out over the next 10 months in accordance with the structure of the severance packages.
These costs have been included in the loss before taxes reported for the workers’ compensation segment for the year ended December 31, 2003 (Note 21).
The note payable to an officer represents the remaining annual installment payments due to the Company’s former President and CEO in connection with the purchase of Stratton-Cheeseman Management Company in 1999. In accordance with the original purchase agreement, the remaining annual installments have been reduced by $200,000 each because of the half-grade decrease in the Company’s A.M. Best Company rating during the fourth quarter of 2003. The note aggregated $6,000,000 and $6,566,800 at December 31, 2003 and 2002 respectively. As specified in the original purchase agreement, the note was paid in its entirety in January 2004 upon the retirement of the former President and CEO, effective December 31, 2003.
The Company offers benefits under certain defined contribution plans. In 2003, 2002 and 2001, the defined contribution plans provide for Company contributions of 5% of employee compensation, as defined in the plan, and a 100% match of employee contributions on the first 3% of contributions and 50% match on the next 2% of contributions. Employer contributions to the plans were approximately $986,000, $995,000, and $1,672,000, for 2003, 2002, and 2001, respectively.
In December 2000, the Company granted 135,200 restricted shares of APCapital common stock, having a per share market value of $13.50, to certain officers, board members and employees. The restricted shares vest in annual installments of 10%, 15%, 20%, 25% and 30% on the first through fifth anniversaries, respectively, of the date of grant.
The Company is obligated under operating leases, which have various expiration dates through December 2008. Minimum future lease payments are as follows: 2004 - $1,336,000; 2005 - $924,000; 2006 - $726,000, 2007 - $469,000 and 2008 and thereafter - $2,357,000. Rental expense was $1,615,000 in 2003, $1,900,000 in 2002, and $2,177,000 in 2001.
The Company is the first and second guarantor of approximately $1.6 million and $4.9 million, respectively, of debt owed by one of the Company’s real estate partnership investments. The debt matures in 2005, at which time, if the partnership is not able to refinance the loan, the Company has committed to provide temporary financing in an amount not to exceed the amount of the loan that matured for a period not to exceed nine months. Upon the failure to perform of the other parties to the guarantee, the Company has certain remedies that include suing to seek enforcement of the Company’s right of contribution to the partnership, remove the other parties as managers of the partnership, or force the sale of the partnership to recover damages. At December 31, 2003 and 2002, the Company has not recorded any liability related to these guarantees, as the probability of being called upon to make payment under the guarantees is considered by management to be remote.
With the exception of the following, the Company is not currently subject to any material litigation. Though routine litigation matters may arise in the ordinary course of the Company’s insurance business, management does not expect these cases to have a material adverse effect on the Company’s financial condition or results of operations.
The following is statutory surplus at December 31, 2003, 2002, and 2001 and net (loss) income for the years then ended.