Premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Premiums written is a statutory measure of production levels. Premiums earned, the most directly comparable GAAP measure, represents the portion of premiums written that is earned, on a pro-rata basis, as income in the financial statements for the periods presented. The change in unearned premium reconciles the difference between the two measures.
Basic earnings (loss) per share of common stock at December 31, 2005, 2004, 2003, 2002, and 2001 are computed using the weighted average number of common shares outstanding during the year of 9,455,391, 9,387,556, 9,352,070, 9,322,249, and 9,333,425 respectively. Diluted earnings per share of common stock at December 31, 2005, 2004, 2003, 2002, and 2001 are computed using the weighted average number of common shares outstanding during the year of 9,549,353, 9,387,556, 9,352,070, 9,322,249, and 9,333,425 respectively. For further discussion of basic earnings per share and diluted earnings per share, see the “Note 10 to Consolidated Financial Statements.”
Certain statements in this report on Form 10-K that are not historical in fact constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA provides certain “safe harbor” provisions for forward-looking statements. All forward-looking statements made in this annual report on Form 10-K are made pursuant to the PSLRA. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” and similar expressions are intended to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors based on the Company’s estimates and expectations concerning future events that may cause the actual results of the Company to be materially different from historical results or from any results expressed or implied by such forward-looking statements. These risks and uncertainties, as well as the Company’s critical accounting policies, are discussed in more detail under “Business-Risk Factors,” “Management’s Discussion and Analysis-Overview,” and “Management’s Discussion and Analysis-Critical Accounting Policies” and in periodic filings with the Securities and Exchange Commission. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.
SCPIE Holdings is a holding company owning subsidiaries engaged in providing insurance and reinsurance products. The Company is primarily a provider of medical malpractice insurance and related liability insurance products to physicians, healthcare facilities and others engaged in the healthcare industry in California and Delaware. Previously, the Company had also been actively engaged in the medical malpractice insurance business and related products in other states and in the assumed reinsurance business. During 2002 and 2003, the Company largely completed its withdrawal from the assumed reinsurance market and medical malpractice insurance outside of California and Delaware.
The Company’s insurance business is organized into two reportable business segments: direct healthcare liability insurance and assumed reinsurance operations. Primarily due to significant losses on medical malpractice insurance outside of the state of California and assumed reinsurance business losses arising out of the September 11, 2001 World Trade Center terrorist attack, the Company incurred significant losses from 2001 to 2004. The resulting reductions in surplus and corresponding decrease in capital adequacy ratios under both the A.M. Best Company (A.M. Best) and National Association of Insurance Commissioners (NAIC) capital adequacy models required the Company to take actions to improve its long-term capital adequacy position. The primary actions taken by the Company were to effect an orderly withdrawal from healthcare liability insurance markets outside of California and Delaware and from the assumed reinsurance market in its entirety. At December 31, 2003, the Company had only 379 healthcare liability insurance policies remaining in force in these other markets, all of which expired during the first quarter of 2004. In December 2002, the Company entered into a 100% quota share reinsurance agreement to retrocede to another insurer the majority of reinsurance business written in 2002 and 2001. During 2003, the Company participated in only one ongoing reinsurance syndicate and had no ongoing reinsurance participation in 2004. The Company continues to settle and pay claims incurred in the non-core healthcare and assumed reinsurance operations.
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 $383.8 million and gross reserves of $429.3 million as of December 31, 2005 respectively, not including the retrospective reserves ceded under the Rosemont Re treaty. Reserves attributable to the operating segments of the Company are as follows:
The relationship between Bulk and IBNR reserves and case reserves can be significantly different between lines of insurance as well as between individual companies. These differences may result from the length of time required to adequately investigate and evaluate individual cases, a company’s individual case reserving philosophy or other reasons.
The sensitivity of the Company’s reserves for non-core healthcare operations is impacted by two factors: frequency and severity. Because the non-core healthcare operations are comprised of claims-made policies that are in run-off, no significant number of new claims are expected. The severity of existing reported claims will be the principal determinant of ultimate reported losses. A change in the average severity of existing claims will have a proportional increase or decrease in reported reserves.
Additional net liabilities of $3.9 million representing payment requests made to the Company are included in other liabilities on the Company’s balance sheet. These net liabilities are being contested in pending arbitrations. (See “Legal Proceedings-Bail and Immigration Bond Proceedings.”)
The Occupational and 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 40 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.
At December 31, 2005, the Company had $51.2 million of net deferred income tax assets. Net deferred income tax assets consist of the net temporary differences created as a result of amounts deductible or revenue recognized in periods different for tax return purposes than for accounting purposes. These deferred income tax assets include an asset of $24.9 million for a net operating loss carryforward that will begin to expire in 2021. A net operating loss carryforward is a tax loss that may be carried forward into future years. It reduces taxable income in future years and the tax liability that would otherwise be incurred.
The Company has been a leading writer of medical malpractice insurance for physicians and healthcare providers in California for many years. In 1996, the Company began expansion into other professional liability products and into other geographical markets. The principal product expansion was into professional liability insurance for hospitals. From 1997 through 1999, the Company added more than 75 hospitals to its program. These policies were written through national and regional brokers and covered facilities in four states outside California. At approximately the same time, the Company undertook a major geographic expansion in the physician and small medical group market through an arrangement with Brown & Brown, a leading publicly held insurance broker. This arrangement commenced in 1998, eventually encompassed nine states and in 2000 was expanded to include dentists in two states. During the same period, the Company also expanded into underwriting greater risk nonstandard physicians in a number of states outside California.
The Company and Brown & Brown agreed in early 2002 to terminate both the physician and dental programs no later than March 6, 2003. During 2002, the Company continued to issue and renew those policies under the Brown & Brown programs that satisfied the stringent underwriting standards. The Company applied these same standards to the nonstandard physician policies renewed outside California. As of December 31, 2002, 813 policies were in force related to the Brown & Brown program. That number was reduced to 379 policies as of December 31, 2003. All claims-made policies in force for the non-core healthcare liability insureds expired by December 31, 2004. The Company remains exposed under extended reporting policies required to be issued upon cancellation or non-renewal of the non-core insureds. This exposure is currently reserved and declines over time.
During 2006, 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.
The Company underwrites professional and related liability policy coverages for physicians (including oral and maxillofacial surgeons), physician medical groups and clinics, hospitals, dentists, managed care organizations and other providers in the healthcare industry. As a result of the Company’s withdrawal from certain segments of the healthcare industry, the premiums earned are allocated between core and non-core premium. Core premium represents California and Delaware business excluding the Brown & Brown dental program and hospital business. Non-core business represents business related to physician and dental programs formerly conducted for the Company primarily in states outside California and Delaware by Brown & Brown, other state non-standard physician programs and hospital programs including those in California. The following tables summarize by core and non-core businesses the underwriting results of the direct healthcare liability insurance segment for the periods indicated:
Premiums written for the core direct healthcare liability insurance business decreased 1.4% in 2005 due to a decrease in the number of insureds that was not offset by the rate increase of 6.5% in 2005. Premiums written increased 4.4% and 5.4% in 2004 and 2003, respectively, due to a rate increase of 9.9% in October 2003 that more than offset a decrease in the number of insureds in both these years. Premiums earned in the core business increased 3.5%, 3.4% and 2.6% in 2005, 2004 and 2003, respectively, primarily due to the rate increases. The Company has historically had a high renewal rate in its core business. The renewal rates of insureds who were offered renewal was 95% for 2005 and 92% for 2004 and 2003. The Company primarily loses insureds due to underwriting actions taken by the Company, 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 2005, 2004, and 2003 were 1,077, 1,124, and 1,225, respectively. The core business policies inforce at year end 2005, 2004, and 2003 were 10,397, 10,684, and 11,137 policies, respectively.
The premiums written and earned in 2005 are generated by policyholders exercising their right to purchase tail coverage. The negative premiums written and earned in 2004 represent reinsurance premiums paid by the Company in connection with the reinstatement of excess of loss layers for older years. Premiums written decreased in 2003 to $5.3 million from $21.9 million in 2002. This resulted from the significant decline in the number of insureds from 2,997 at December 31, 2001, to 813 and 379 insureds at December 31, 2002 and 2003, respectively. The decline in insureds resulted from the Company’s actions taken to withdraw from this business. After March 6, 2003, no new or renewal business was written in the non-core programs.
The underwriting gain in 2005 is primarily the result of reserve reductions for prior losses. The underwriting loss incurred in 2004 is primarily due to two adverse litigation decisions, reserve increases attributable to older years on dentists coverage and a general reserve increase of $3.0 million in the fourth quarter 2004. The underwriting loss in 2003 arose primarily due to reserve increases for prior losses.
As the reserves and cases of non-core healthcare claims continue to decline, it becomes more difficult to establish reserve estimates for the remaining claims based on actuarial techniques. The ultimate losses become more related to specific case results, (including litigation) rather than estimates based on actuarial techniques. Unexpected legal verdicts or settlements reached at trial can produce unexpected reserve development.
During 2002, the Company pursued various financial alternatives to improve its capital position, including a complete or partial divestiture of its assumed reinsurance operations. In December 2002, the Company entered into a quota share reinsurance transaction with Rosemont Reinsurance Ltd. (Rosemont Re) (formerly known as GoshawK Reinsurance Limited), a Bermuda reinsurance subsidiary of GoshawK Insurance Holdings plc, a publicly held London-based Lloyd’s underwriter (GoshawK), under which the Company ceded to Rosemont Re
almost all of its unearned assumed reinsurance premiums as of June 30, 2002, together with written reinsurance premiums after that date, in each case related to the assumed reinsurance business for the 2001 and 2002 underwriting years. The Company retained certain losses related to the assumed reinsurance business, including those related to the World Trade Center, and the Company continued to participate in one Lloyd’s syndicate for the 2003 underwriting year. The Rosemont Re treaty relieved the Company of underwriting leverage and improved the Company’s risk-based capital adequacy ratios under both the A.M. Best and NAIC models. Other than net premiums written of $18.3 million and $1.2 million from one Lloyd’s syndicate in 2003 and 2004, respectively, the Company had no significant premiums written from prior year contracts.
The Company ceased writing assumed reinsurance business at the end of the 2003 underwriting year. The premiums written in 2003 and 2004 are almost entirely attributable to the one Lloyd’s syndicate that the Company supported in 2003. The premiums earned in 2005 are also attributable to this syndicate. Premiums earned in 2004 and 2003 also include some premiums written in earlier periods that were not ceded to Rosemont Re.
The treaty has no limitations on loss recoveries and includes a profit-sharing provision should the combined ratios calculated on the base premium ceded be below 100%. The treaty requires Rosemont Re to reimburse the Company for its acquisition and administrative expenses. In addition, the Company is required to pay Rosemont Re additional premium in excess of the base premium ceded of 14.3% or an estimated $24.0 million. The additional premium reduced 2003, 2004 and 2005 earned premium by $5.5, $(0.4), and $(0.01) million, respectively.
The Rosemont Re reinsurance treaty has both prospective and retroactive elements as defined in Financial Accounting Standards Board Statement (FASB) No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. As such, any gains under the contract will be deferred and amortized to income based upon the expected recovery. No gains are anticipated currently. Losses related to future earned premium ceded, as well as development on losses related to existing earned premium ceded after June 30, 2002, will ultimately determine whether a gain will be recorded under the contract.
Net investment income decreased to $17.8 million for 2005 from $19.2 million in 2004 and $22.0 million in 2003. The decrease in net investment income is primarily related to the reduction in invested assets as losses are settled and paid in the non-core areas.
The Company currently has a net deferred tax asset of $51.2 million as of December 31, 2005, of which $24.9 million relates to a net operating loss carryforward which expires in 2021. The Company will be able to utilize this carryforward to reduce taxes in future periods. The losses in recent years 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 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. During 2005, 2004 and 2003, the Company had negative cash flow from operations of $20.2 million, $63.3 million and $46.8 million, respectively. The negative cash flow during this period is primarily related to the declining premium receipts and the increasing claims payments associated with the non-core physician 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 continue to have negative cash flow from operations.
Common stock dividends paid to stockholders were $0.40 per share in 2003. These dividends were funded through dividends received from the Insurance Subsidiaries in prior years. In March 2004, the Board of Directors suspended the Company’s quarterly dividends. The payment and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions. As of December 31, 2005, SCPIE Holdings held cash and short-terms securities of $3.4 million. Based on historical trends, market conditions and its business plans, the Company believes that its sources of funds (including dividends from the Insurance Subsidiaries) will be sufficient to meet the liquidity needs of SCPIE Holdings over the next 18 months.
The Company’s capital adequacy position has been weakened by the losses in the non-core business. The Company’s current rating from A.M. Best is B (Fair), with a negative outlook. A.M. Best assigns this rating to companies that have, in its opinion, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. The Company believes that it has strengthened its capital adequacy position at December 31, 2005, under the methodology followed by A.M. Best, but does not know whether this will result in a 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, 2005, the RBC level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2005, SCPIE Indemnity exceeded this threshold by $85.9 million.
The Company may determine that it is in its best interests to raise additional capital through financings to improve its financial position and grow its business. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company.
The primary effect of inflation on the Company is considered in pricing and estimating reserves for unpaid losses and LAE for claims in which there is a long period between reporting and settlement, such as medical malpractice claims. The actual effect of inflation on the Company’s results cannot be accurately known until claims are ultimately settled. Based on actual results to date, the Company believes that loss and LAE reserve levels and the Company’s rate making process adequately incorporate the effects of inflation.
In connection with the preparation of this Annual Report on Form 10-K and the audit of the Company’s consolidated financial statements, Ernst & Young LLP (“E&Y”) identified a matter that might reasonably be thought to bear on its independence. Seven years before joining the Company in May 2002, Robert Tschudy, Chief Financial Officer, was a partner with E&Y. After leaving E&Y in 1995, Mr. Tschudy was the chief financial officer of another public company until 2001. Based on his prior service with E&Y, Mr. Tschudy was entitled to standard E&Y retirement benefits consisting of fixed annual payments payable at a future date. To date, Mr. Tschudy has not received any E&Y retirement benefit payments as he has not met the requisite age. A portion of the fixed future payments, actuarially estimated to be those expected to be paid in 2016 and thereafter, was not fully funded and therefore could have been viewed as “dependent on the revenues, profits or earnings” of E&Y, which is inconsistent with the auditor independence rules of the Securities and Exchange Commission. On March 9, 2006, Mr. Tschudy and E&Y addressed this matter by transferring the previously unfunded portion of Mr. Tschudy’s retirement benefits into a rabbi trust. The fixed annual amount to be paid to Mr. Tschudy in respect of his E&Y retirement benefits remains unchanged. As a result of the transfer of funds to the rabbi trust, Mr. Tschudy’s E&Y retirement benefit is now fully funded.