The following table sets forth selected consolidated financial and operating data for the Company. The income statement data set forth below for each of the four years in the period ended December 31, 1998 and the balance sheet data as of December 31, 1998, 1997, and 1996 are derived from the consolidated financial statements of the Company audited by Ernst & Young LLP, independent auditors, and should be read in conjunction with, and are qualified by reference to, the consolidated financial statements and the related notes thereto contained herein. The income statement data for the year ended 1994 and the balance sheet data as of December 31, 1994 and 1995 are derived from unaudited consolidated financial statements of the Company which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All selected financial data are presented in accordance with GAAP, except for the item entitled "statutory surplus," which is presented in accordance with Statutory Accounting Principles ("SAP"). The statutory surplus amounts are derived from the audited statutory financial statements of the Company and, in the opinion of management, fairly reflect the specified data for the periods presented.
The Exchange was organized as a New Jersey reciprocal insurance exchange in 1977. A New Jersey reciprocal insurance exchange is an entity that may be formed by persons seeking a particular type of insurance coverage. In the case of the Exchange, medical and osteopathic physicians formed the Exchange to provide medical malpractice insurance.
The medical malpractice insurance industry is cyclical in nature. Many factors influence the financial results of the medical malpractice insurance industry, several of which are beyond the control of the Company. These factors include, among other things, changes in severity and frequency of claims; changes in applicable law; regulatory reform; and changes in inflation, interest rates and general economic conditions.
The availability of medical malpractice insurance, or the industry's underwriting capacity, is determined principally by the industry's level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy.
The Aggregate Contract provides several coverages on an aggregate excess of loss, specific excess of loss, and quota share basis. The primary coverage afforded under the Aggregate Contract attaches above a Company retention measured as a 75% loss and allocated loss adjustment expense ratio ("loss and ALAE ratio"). Reinsurers provide coverage for an additional 75% loss and ALAE ratio, with an aggregate annual limit of $200 million. The Company has maintained aggregate excess of loss coverage substantially similar to that just described since 1993.
There are significant inherent uncertainties in estimating ultimate losses in the casualty insurance business and these uncertainties are increased in periods when a company is expanding into new markets with new distribution channels. The uncertainties are even greater for companies writing long-tail casualty insurance, such as medical malpractice insurance, and in particular the occurrence or occurrence-like coverages that substantially make up the Company's current reserves. These additional uncertainties are due primarily to the longer period of time during which an insured may seek coverage for a claim in respect of an occurrence or occurrence-like policy as opposed to a claims made policy. With the longer claim reporting and development period, reserves are more likely to be impacted by, among other factors, changes in judicial liability standards and interpretation of insurance contracts, changes in the rate of inflation and changes in the propensities of individuals to file claims.
Initially, the Company establishes its best estimate of loss and LAE reserves using pricing assumptions. The reserves are evaluated every quarter and annually and are adjusted thereafter as circumstances warrant. These periodic evaluations include a variety of loss development techniques that incorporate various data accumulated in the claims settlement process including paid and incurred loss data, accident year development statistics, and loss ratio analyses. Important in these analyses are considerations of the amounts for which claims have settled in comparison to the case reserves held at settlement. Case reserves are eliminated upon settlement of related claims. Actual settlement amounts above or below case reserves are then regularly evaluated to determine whether estimated ultimate losses by accident year, including IBNR reserves, should be adjusted. Changes to aggregate reserves reported in the financial statements are made based upon the extent and nature of these variances over the long claim development period together with changes in estimates of the total number of claims to be settled. As a final test of management's determination as to whether it believes that aggregate reserves reported in the financial statements are adequate and appropriate, management considers the detailed analysis performed by the actuarial staff of its independent auditors in connection with the audit of the Company's financial statements.
The Company is currently expanding its operations into a number of states, and the Company expects that the majority of the policies issued in such states will be on a claims made basis. See "Business -- Product Offerings." As a result, the Company believes that as claims made reserves begin to comprise a greater percentage of aggregate reserves it is likely that more frequent adjustments to aggregate reserves recorded in the financial statements will become necessary because the reporting period for claims made policies is shorter, which facilitates the ability of the Company to more quickly determine ultimate losses.
Underwriting Expenses. The Company's continued expansion into other states and markets will most likely increase underwriting expenses. The Company believes that its plan of expansion through broker and agent distribution channels will increase its marketing expenses, but it also believes that this relationship will reduce the need to make other significant expenditures in order to expand into other states. Commissions for policies sold on a brokerage basis typically range up to 12.5% of premiums, whereas the Company does not incur commissions on products it sells directly. To the extent that brokered business represents an increased percentage of the Company's business in the future, expense ratios will continue to increase.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
Direct premiums written. Direct premiums written were $230.3 million for the year ended December 31, 1998, a $67.9 million or 41.8% increase over the $162.4 million written during 1997. An increase of $29.9 million was a result of successful marketing efforts directed at large medical institutions in Pennsylvania and Connecticut during the third quarter of 1998. Individual physician and surgeon premiums written in Ohio and Kentucky increased by $19.4 million primarily due to successful marketing efforts directed at former policyholders of PIE Mutual Insurance Company ("PIE Mutual"), an insurer which ceased writing business in these states during 1997. Additional premium written increases of $21.5 million primarily occurred in Maryland, Texas, Massachusetts, Michigan and Illinois as a result of successful marketing efforts to physicians, surgeons and institutions in these targeted expansion states. This increase in business written outside of New Jersey more than offset a net $2.9 million decrease in New Jersey direct premiums written for the year ended December 31, 1998, as compared to the year ended December 31, 1997. The net decrease in New Jersey business during 1998 was composed of an increase of $1.6 million in 1998 policy year premiums and a decrease of $4.5 million relating to policies that normally would have renewed January 1, 1998, but which were accelerated to November, 1997 as part of the Company's competitive strategy. The Company's decision to accelerate the renewal of such policies reduced the concentration of premium renewals, which substantially exposed the Company's book of business to market competition in one time period. Additional direct premiums written were therefore recognized in 1997 which would have otherwise been recognized in 1998 but for this change. The acceleration of premiums written had no impact on net premiums earned in 1997 or 1998. The Company's geographic expansion is continuing to reduce the concentration of business in New Jersey which comprised 50% of direct premiums written for the year ended December 31, 1998, as compared to approximately 73% in 1997 and 89% in 1996.
Net investment income. Net investment income increased approximately $11.2 million or 20.8% to $65.1 million for the year ended December 31, 1998 from $53.9 million for the same period in 1997. Average invested assets increased to approximately $1.1 billion during the year ended December 31, 1998 compared to approximately $1.0 billion for the same period last year. The average annualized pre-tax yield on the investment portfolio increased to 5.77% for the year ended December 31, 1998 from 5.61% for the same period in 1997, primarily as a result of changes in asset allocation with an increased concentration in higher pre-tax yielding securities and a corresponding decrease in government and tax exempt security holdings.
Realized investment gains. Net realized investment gains increased approximately $26.1 million to $36.4 million for the year ended December 31, 1998 compared to $10.3 million for the same period in 1997. In 1998, the Company implemented an "equity collar" around its equity securities of $85 million. An "equity collar" is an option position created with the simultaneous purchase and sale of an equal number of put and call options. This resulting option position establishes, for a specified time period, both a ceiling and a floor with respect to the financial performance of the underlying asset upon which the equity collar is established. The purpose of the collar was to reduce equity market volatility and to stabilize unassigned surplus. The collar was constructed using European-style S&P 500 options. A "European-style" option is an option contract that may be exercised only upon expiration of the contract whereas an "American-style" option may be exercised at any time prior to the expiration of the contract. The reference to "S&P 500" refers to the underlying asset upon which the option contract's value will be based. To minimize loss exposure due to credit risk, the Company utilized intermediaries with a Standard and Poor's rating of "AA" or better. Approximately $24.4 million of the net gains realized during 1998 resulted from the liquidation of the Company's equity portfolio during the third quarter of 1998. This net gain was comprised of a gain of approximately $38.4 million on the disposition of the equities, which was partially offset by a $14.0 million loss realized (since gains were capped at 5% by the equity collar and any gains above the equity collar are treated as a realized loss to be offset against the gross realized gains) on the expiration of the Company's equity collar position on July 13, 1998.
Losses and loss adjustment expenses (LAE). The provision for losses and LAE increased $35.4 million or 29.4% to $155.9 million for the year ended December 31, 1998 from $120.5 million for the same period in 1997. As a percentage of earned premiums, however, incurred losses and LAE decreased to 95.9% for the year ended December 31, 1998 from 97.7% for the same period in 1997. The decrease in the loss ratio is principally attributable to an increasing portion of the Company's business being written on a claims made basis which resulted from the Company's geographic expansion. The provision for losses and LAE for the year ended December 31, 1998 included favorable reserve development of $2.1 million relating to prior years, the net result of adverse gross reserve development of $3.8 million offset by favorable development of ceded reserves of $5.9 million. The provision for losses and LAE for the year ended December 31, 1997 included no development relating to prior years. At December 31, 1998 and 1997, reserves for gross losses and allocated loss adjustment expenses on incurred but not reported claims amounted to $623.8 million and $593.2 million respectively, of which $436.3 million and $430.3 million related to prior years. While certain individual cases were settled during the years ended 1998 and 1997 at values more or less than specific case reserve amounts established in prior years, there were no overall indications that prior established aggregate reserves, including the significant portion of reserves for incurred but not reported claims, should be adjusted beyond the amounts recorded. Medical malpractice business, particularly occurrence or occurrence-like coverage, has a very long development period. Cases may take years to be reported, and as a rule, take several years to adjust, settle or litigate. The provision for losses and LAE is net of $62.4 million and $68.9 million for the years ended December 31, 1998 and 1997, respectively, of incurred losses and LAE ceded to reinsurers, primarily on a funds withheld basis.
Income taxes. Income taxes increased approximately $9.2 million to $11.2 million for the year ended December 31, 1998, resulting in an effective tax rate of 27.3%, compared to $2.0 million and an effective tax rate of 6.4% for the year ended December 31, 1997. This increase was primarily attributable to three factors: an increase in pre-tax income in 1998 of $9.8 million resulting in additional tax of $3.4 million at a 35% rate; an increase in taxes of $0.8 million associated with a reduction in tax exempt interest in 1998; and release of a provision of $4.2 million for tax contingencies in 1997.
Net premiums earned. Net premiums earned were $123.3 million for the year ended December 31, 1997, an increase of 14.3% over the $107.9 million for the year ended December 31, 1996. This increase is generally consistent with the increase in direct premiums written.
Losses and loss adjustment expenses (LAE). The provision for losses and LAE was $120.5 million for the year ended December 31, 1997, an increase of 9.0% over the $110.6 million for the year ended December 31, 1996. The loss and LAE ratio was 97.7% for the year ended December 31, 1997 compared to 102.5% for 1996. The decrease in the loss and LAE ratio is primarily attributed to changes in the Company's business mix with an increasing amount of policies being issued on a claims made basis. The provision for net losses and LAE for the years ended December 31, 1997 and 1996 included no development relating to prior years. Gross loss and loss adjustment expenses incurred related to prior years increased by $0.2 million for the year ended December 31, 1997 and did not change for the year ended December 31, 1996. Reviews of gross losses and loss adjustment expenses conducted as of December 31, 1996 and 1997 did not indicate a basis to further revise prior estimates at December 31, 1997 or December 31, 1996. At December 31, 1996 and 1997, reserves for gross losses and allocated loss adjustment expenses on incurred but not reported claims amounted to $500.0 million and $593.2 million, respectively, of which $350.9 million and $430.3 million related to prior years. While certain individual cases were settled during 1996 and 1997 at values more or less than specific case reserve amounts established in prior years, there were no overall indications that prior established financial reserves, including the significant portion of reserves for incurred but not reported claims, should be adjusted. Medical malpractice business, particularly occurrence or occurrence-like coverage, has a very long development period. Cases may take years to be reported, and as a rule, take several years to adjust, settle or litigate. The provision for losses and LAE is net of $68.9 million for the year ended December 31, 1997 and $56.8 million for the year ended December 31, 1996 of incurred losses and LAE ceded to reinsurers.
Underwriting expenses. Underwriting expenses were $25.4 million for the year ended December 31, 1997, an increase of 44.8% over the $17.6 million for the year ended December 31, 1996. The expense ratio was 20.6% for the year ended December 31, 1997 compared to 16.3% for the year ended December 31, 1996. Approximately $5.0 million of the increase is attributable to staffing, commissions, premium taxes and facilities costs related to the Company's geographic expansion and increases in direct premiums earned. Additional increases of approximately $1.6 million are related to various consulting projects geared towards business process enhancements and approximately $0.6 million relates to an increase in the reserve for uncollectible accounts receivable with the remaining increases attributable to the Company's geographic expansion.
Funds held charges. Funds held charges of $13.4 million for the year ended December 31, 1997 increased by $3.1 million or 30.1% over the $10.3 million for the year ended December 31, 1996 and relate to the interest credited on amounts held under certain ceded aggregate excess reinsurance contracts. This increase is the result of the net effect of the increase in interest expense accrued on funds held under these contracts, consistent with the increase in the related funds held balances.
Net income. Net income was $29.1 million for the year ended December 31, 1997, a 65.5% increase from the $17.6 million for the year ended December 31, 1996, principally as a result of higher investment income and realized investment gains and lower income taxes.
Fixed maturities available for sale, including short-term investments, aggregated approximately $1.2 billion, or 99.7% of the investment portfolio of the Company as of December 31, 1998. At that date, the average credit quality of the fixed income portfolio was "AA-," as defined by Standard & Poor's, while the total portfolio effective duration (including short-term investments) was 4.45 years.
In 1997, the Company implemented an "equity collar" around its equity securities of $81.6 million. An "equity collar" is an option position created with the simultaneous purchase and sale of an equal number of put and call options. This resulting option position establishes, for a specified time period, both a ceiling and a floor with respect to the financial performance of the underlying asset upon which the equity collar is established. The collar transaction was executed on July 8, 1997 and expired on January 2, 1998. The purpose of the collar was to reduce equity market volatility and to stabilize unassigned surplus. The collar was constructed using European-style S&P 500 options, and as of December 31, 1997, the collar had no unrealized gain or loss. A "European-style" option is an option contract that may be exercised only upon expiration of the contract whereas an "American-style" option may be exercised at any time prior to the expiration of the contract. The reference to "S&P 500" refers to the underlying asset upon which the option contract's value will be based. To minimize loss exposure due to credit risk, the Company utilized intermediaries with a Standard and Poor's rating of "AA" or better.
Equity. Total equity was $322.8 million at December 31, 1998 and $310.0 million and $262.3 million at December 31, 1997 and 1996, respectively. The increases were attributable to net income and changes in unrealized net appreciation of investments.
The payment of dividends to The MIIX Group by MIIX Insurance will be subject to limitations imposed by the New Jersey Holding Company Act. Based upon these limitations, the maximum amount that will be available for payment of dividends to The MIIX Group by MIIX Insurance in any year without the prior approval of regulatory authorities is subject to restrictions related to surplus and net income. MIIX Insurance's future cash flow available to The MIIX Group may be influenced by a variety of factors, including cyclical changes in the medical malpractice insurance market, MIIX Insurance's financial results, insurance regulatory changes, including changes in the limitations imposed by the New Jersey Holding Company Act on the payment of dividends by MIIX Insurance, and changes in general economic conditions. The MIIX Group expects that the current limitations that will be imposed on MIIX Insurance should not affect its ability to declare and pay dividends sufficient to support The MIIX Group's initial dividend policy. See "Business -- Regulation -- Regulation of Dividends from Insurance Subsidiaries."
The Company held collateral of $228.1 million and $182.6 million at December 31, 1998 and 1997 respectively, in the form of funds withheld, for recoverable amounts on ceded unpaid losses and loss adjustment expenses under certain reinsurance agreements. Under the contracts, reinsurers may require that a trust fund be established to hold the collateral should one or more triggering events occur, such as a downgrade in the Company's A.M. Best rating to B+ or lower, or a reduction in statutory capital and surplus to less than $20 million. Otherwise, no restrictions are placed on investments held in support of the funds withheld. In accordance with the provisions of the reinsurance contracts, the funds withheld are credited with interest at contractual rates ranging from 7.5% to 8.6%, which is recorded as an expense in the year incurred.
The Company primarily invests its positive cash flow from operations in fixed maturity securities. The current investment strategy, which will be continued by MIIX Insurance immediately after the Reorganization, seeks to maximize after-tax income through a high quality, diversified, duration sensitive, taxable bond and tax-preferenced municipal bond portfolio, while maintaining an adequate level of liquidity.
Based on historical trends, market conditions and its business plans, the Company believes that its sources of funds will be sufficient to meet its liquidity needs over the next 18 months and beyond. However, because economic, market, and regulatory conditions may change, there can be no assurance that the Company's funds will be sufficient to meet these liquidity needs.
Remediation costs to date (including expenditures associated with replacement systems) have been approximately $390,000 and are estimated to be less than $1 million through the completion of remediation, which is expected in 1999. These costs have been considered in preparing the Company's capital and operating budgets. There can be no assurance, however, that remediation efforts will be completed within these estimated costs and time periods.