SELECTED FINANCIAL AND OPERATING DATA (in thousands, except per share data)
(2) In the second quarter of 1996, the Company estimated an additional $9.0 million of policyholders dividends would be paid due to favorable loss experience related to policy years 1987 through 1992. This policyholder dividend will be paid to members of the Exchange in the form of premium credits in 1997. Except for this final dividend the Company will cease paying such dividends to its policyholders.
The following discussion should be read in conjunction with the financial statements and the related notes thereto appearing elsewhere in this Form 10-K report. The financial statements for 1996 and prior years include the accounts of the Exchange and its wholly-owned subsidiaries and certain affiliates.
The following discussion contains forward-looking statements regarding the Company, its business, prospects and results of operations that are subject to certain risks and uncertainties posed by many factors and events that could cause the Company's actual business, prospects and results of operations to differ materially from those that may be expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors are discussed below and under "Business -- Risk Factors" and in periodic filings with the Securities and Exchange Commission.
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. Historically, the financial performance of the medical malpractice industry has tended to fluctuate between a soft insurance market and a hard insurance market. In a soft insurance market, competitive conditions could result in premium rates and underwriting terms and conditions which may be below profitable levels. For a number of years, the medical malpractice insurance industry in California has faced a soft insurance market. There can be no assurance as to whether or when industry conditions will improve or the extent to which any improvement in industry conditions may improve the Company's financial condition and results of operations.
mutual protection trust. In addition, commercial insurance companies have recently returned to the California market to insure medical groups and physicians.
POLICYHOLDER DIVIDENDS Since 1981, SCPIE has followed a practice of paying discretionary dividends to its physician and other healthcare provider members in the form of premium credits on the basis of the results of prior policy years, as the actual experience for such years becomes known. The Company paid dividends to its members of $9.9 million, $9.5 million and $11.2 million in 1996, 1995 and 1994, respectively, in the form of premium credits. Such dividends were paid primarily to insureds who were members of the Exchange in 1990 and prior policy years and were based primarily on underwriting results in such years. These dividends have been accrued as an expense for the year in which the related premiums were earned and not the year paid or declared. In 1996, the Board of Governors declared a final dividend to members of the Exchange of record on November 5, 1996, which is being paid in the form of premium credits in 1997. This dividend of approximately $9.0 million (offset by a $0.6 million credit for forfeited dividends declared in 1995) was reflected as an expense in the year ended December 31, 1996. Except for this final dividend, after the Reorganization, the Company will cease paying such premium credit dividends to its policyholders. Therefore, the Company may find it more difficult to compete with other insurance companies offering such dividends.
LOSS AND LAE RESERVES Medical malpractice and other property and casualty loss and loss adjustment expense ("LAE") reserves are established based on known facts and interpretation of circumstances, including the Company's experience with similar cases and historical trends involving claim payment patterns, loss payments and pending levels of unpaid claims, as well as court decisions and economic conditions. The effects of inflation are considered in the reserving process. Establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that currently established reserves will prove adequate in light of subsequent actual experience. The Company follows a practice of conservatively estimating its future liabilities relating to losses already incurred and has attempted to establish its loss and LAE reserves at the upper end of a reasonable range of reserve estimates. The Company believes that it has been particularly difficult to make such estimates for medical malpractice claims in California because of the uncertain benefits of tort reform measures and more recently a change in the judicial process. The tort reform measures, known as the Medical Injury Compensation Reform Act of 1975 ("MICRA"), were not declared constitutional by the California Supreme Court until the mid-1980s and their impact on settlements was difficult to evaluate until some years later. The change in judicial process, known as "fast track," became fully effective for most California counties in 1992 and requires, among other things, that all non-complex civil actions, including most medical malpractice actions, proceed to trial within approximately one year after filing. Prior to this rule, in some of California's larger counties, a trial typically did not occur until more than four years after the related complaint had been filed. "Fast track" has accelerated costs and expenses of investigation and defense, but has also led to more rapid settlements, judicial resolutions and, the Company believes, overall cost reductions. The Company believes that it has now realized virtually all of the benefits from the past tort reform legislation and from the institution of "fast track."
recognition of liability, and therefore higher case reserves, and (ii) faster settlement of claims, ultimately resulting in lower indemnity payments and reduced legal expenses.
The Company believes that a combination of the factors discussed above and other factors have contributed to the recent redundancies in reserves established by SCPIE for prior years. The original reserves were established without full knowledge of the effect of these factors. Redundant reserves, which have been released in every year since 1985, have contributed significantly to reported earnings in recent years. The Company reduced reserves for prior years by $59.7 million, $57.8 million and $60.4 million in the years ended December 31, 1996, 1995 and 1994, respectively. The Company cannot predict whether similar redundancies will be experienced in future years. The Company continues to establish its loss and LAE reserves at what it believes is the upper end of a reasonable range of reserve estimates, but there is no assurance that such reserves will ultimately prove to be redundant. The Company believes that some reduction in the amount of the redundancies recently experienced is reasonably likely. If such redundancies do not occur or loss and LAE experience does not improve, the Company's net income could be significantly reduced or a net loss could occur.
OPERATING EXPENSES The Company's planned expansion into other states and markets may increase operating expense levels to achieve and service this expansion. The Company believes that its relationship with SKA will increase its marketing expenses, but it also believes that this relationship, if successful, will reduce the need to make other significant expenditures in order to expand into other states. Commissions for hospital and other healthcare provider liability policies, which are sold on a brokerage basis through SKA and other brokers, typically range from 7.5% to 15.0% of premiums, whereas the Company does not incur commissions on products sold directly. To the extent that hospital and other healthcare provider policies represent an increased percentage of the Company's business in the future, expense ratios will increase.
PREMIUMS EARNED Premiums earned increased approximately $4.1 million, or 3.5%, to $120.5 million in 1996 from $116.4 million in 1995. The increase was principally due to a $3.7 million increase in assumed reinsurance premiums. Medical malpractice premiums from physicians and medical groups were approximately $112.7 million in 1996 compared to $113.3 million in 1995. An average 4.4% increase in premium rates in effect during 1996 was offset by a 4.2% decrease in the average number of policies in force during 1996 as compared to 1995. Hospital medical malpractice premiums were approximately $2.3 million in 1996 compared to $1.3 million in 1995. Assumed reinsurance premiums were approximately $4.5 million in 1996 compared to less than $1.0 million in 1995.
POLICYHOLDER DIVIDENDS The governing board of the Exchange declared a final dividend to members of the Exchange of record on November 5, 1996 who were also members of the Exchange during policy years 1987 through 1992. Such dividend is being paid in the form of premium credits during 1997. This dividend of $9.0 million (offset by a $0.6 million credit for forfeited dividends declared in 1995) was reflected as an expense for the year ended December 31, 1996. Dividends declared in prior years have been accrued as an expense for the period in which the related premiums were earned and not the year paid or declared. Accordingly, there is no expense reflected for the comparable period in 1995.
NET INVESTMENT INCOME Net investment income increased approximately $0.7 million, or 1.9%, to $40.4 million in 1995 from $39.7 million in 1994. Invested assets increased by $58.1 million to $695.0 million for the year ended December 31, 1995 as compared to a $42.3 million decrease to $636.9 million for the year ended December 31, 1994. The average pre-tax yield on the investment portfolio was virtually unchanged at 5.9% in both 1995 and 1994. The increase in investment income resulted from additional interest of approximately $1.9 million on a Federal income tax refund due the Company and was partially offset by lower rates available on fixed-maturity investments purchased since 1994.
LOSSES AND LAE Losses and LAE increased $9.3 million, or 8.6%, to $118.0 million in 1995 from $108.7 million in 1994. As a percentage of premiums earned, losses and LAE increased to 101.4% in 1995 from 97.4% in 1994. In 1995, SCPIE increased its prior accident years' reserves by $23.9 million for free tail coverage to be provided by the Company to currently insured physicians at the time of their death, disability or retirement. The increase was the result of a refinement in the actuarial methodology used to calculate this reserve. This additional expense was more than offset by a decrease of approximately $81.7 million in loss and LAE reserves in 1995 for claims incurred in prior accident years, compared to a reserve decrease of $60.4 million in 1994 for claims incurred in prior accident years.
OTHER OPERATING EXPENSES Other operating expenses increased $0.8 million, or 6.1%, to $12.6 million in 1995 from $11.8 million in 1994. This increase was principally attributable to legal and consulting fees incurred in 1995 relating to an employment law matter in litigation, which the Company successfully defended, and a small increase in personnel and compensation levels. The expense ratio was 10.8% in 1995 and 10.6% in 1994.
PREMIUMS EARNED Premiums earned decreased by $1.5 million, or 1.4%, to $111.7 million in 1994 from $113.2 million in 1993. The decrease in premiums earned is due to the fact that reinsurance premiums ceded in 1994 were approximately $7.5 million, while they were negligible in 1993. Reinsurance premiums in 1993 included an offset of $7.2 million in profits realized on the 1993 commutation of certain reinsurance by SCPIE attributable to prior years. There was no comparable offset in 1994. Direct premiums written in 1994 increased by approximately $7.5 million, or 6.7%, to $120.0 million in 1994 from $112.5 million in 1993, due primarily to an average 9.0% increase in premium rates in effect during 1994, which was partially offset by a 3.3% decrease in the average number of policies in force during 1994.
LOSSES AND LAE Losses and LAE decreased $16.7 million, or 13.3%, to $108.7 million in 1994 from $125.4 million in 1993. As a percentage of premiums earned, losses and LAE also decreased to 97.4% in 1994 from 110.7% in 1993. In 1994, there was a decrease of approximately $60.4 million in estimated losses and LAE incurred in prior years compared to a decrease of $43.4 million in 1993. Both years reflect favorable changes in reserve estimates made in prior years, as more experience became available for analysis by management.
FEDERAL INCOME TAXES Federal income taxes increased $0.6 million, or 6.9%, to $9.2 million in 1994 from $8.6 million in 1993. The effective tax rate increased to 29.2% in 1994 from 25.3% in 1993, principally due to an increase in the Federal income tax marginal rate to 35.0% in 1994 from 34.0% in 1993.
SCPIE has consistently experienced positive cash flow from operations. 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 year to year. Cash provided by operating activities for SCPIE, before the payment of dividends to policyholders, was $39.8 million in 1996, an increase of $18.8 million compared to 1995. The higher amount of cash flow from operations in 1996 was due to a refund of federal income tax and interest of $25.9 million in settlement of a tax dispute for the 1985 through 1988 tax years.
The Company invests its positive cash flow from operations in both fixed-maturity securities and equity securities. The Company's current policy is to limit its investment in equity securities and real estate to no more than 8.0% of the total market value of its investments. Accordingly, the Company's portfolio of unaffiliated equity securities was reduced from $61.1 million at December 31, 1995 to $20.0 million at December 31, 1996. The Company plans to continue this focus on fixed-maturity securities for the indefinite future. The Company has made limited investments in real estate, which is used almost entirely in the Company's operating activities, with the remainder leased to third parties.
The Company maintains a portion of its investment portfolio in high-quality, short-term securities to meet short-term operating liquidity requirements, including the payment of losses and LAE. Short-term investments totaled $29.6 million, or 4.1% of invested assets, at December 31, 1996. The Company believes that all of its short-term and fixed-maturity securities are readily marketable.
The Company is seeking to obtain a new bank credit facility in the principal amount of approximately $30.0 million from a large lender. The Company expects that this facility will be an unsecured revolving line of credit to be used by the Company for general corporate purposes. There can be no assurance that the Company will be able to obtain this new bank facility, or any bank facility, on terms that are satisfactory to the Company.
The Company has no planned material expenditures for property or equipment.
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.