MDS currently owns the executive offices used by the Company, MDA, MDS and MDIC. The executive offices are in Springfield, Missouri, and consist of approximately 16,000 square feet. Management believes such facility is adequate to support its business plans, both now and in the foreseeable future.
Management's discussion and analysis of financial condition and results of operations is intended to provide a review of significant factors affecting the financial condition and results of operations of Medical Defense Holding Co. (the "Company") and its subsidiaries as of December 31, 1996 and 1995 and for each of the three years presented elsewhere herein. These financial statements give retroactive effect to the acquisition of MDA and its subsidiaries by the Company on June 26, 1995. The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto of the Company which appear elsewhere herein.
See "Business of Medical Defense Associates - Reserves for Unpaid Losses and Loss Adjustment Expenses."
During 1995, total expenses for the Company increased $1,292,514 or 7.2% compared to 1994. This increase was primarily the net result of an approximate $1.4 million increase in loss and loss adjustment expenses and a decrease in other expenses of about $140,000. The reserves for loss and loss adjustment expenses are based on actuarially determined estimates and any change to the estimated total reserve is reflected in current earnings. For 1995 total incurred direct loss and loss adjustment expenses are estimated at $18,115,000. This is an increase of $1,487,000 from the initial estimated incurred direct loss and loss adjustment expenses of $16,628,000 for 1994. The decrease in other expenses was the net result of small increases in deferred acquisition costs and miscellaneous holding company expenses which totaled approximately $110,000 and a decrease in other expenses of approximately $250,000 which was the result of various MDA demutualization and conversion expenses incurred in 1994 in excess of related amounts incurred in 1995.
For the year ended December 31, 1995, the Company's income before provision for income taxes increased $582,336 compared to the year ended December 31, 1994. The Company's total tax provision for 1995 was $248,263 which was a decrease of $337,651 compared to 1994. The decrease in the Company's tax provision for 1995, when compared to 1994, was primarily the result of differences in loss and loss adjustment expense reserve discounting for tax purposes. As a result, the Company's net income for 1995 was $1,816,378 compared to $896,391 for 1994.
Total consolidated liabilities of the Company at December 31, 1996 were $74,943,004 decreased $3,699,108 from the previous year end. This decrease was the result of the increase in claim payments resulting in an approximate $2.5 million decline in unpaid losses and loss adjustment expenses, the decrease in income taxes payable of approximately $0.6 million, and a decline of approximately $0.5 million in the unearned premium reserve which was primarily due to the decrease in policyholders. Over 84% of the Company's total liabilities at December 31, 1996 relate to reserves for unpaid losses and loss adjustment expenses, which declined approximately $2.5 million from the prior year end. These unpaid loss and loss adjustment expense reserves are established based on actuarially determined estimates and are reviewed regularly by management and the Company's independent actuary.
The Company's consolidated net cash flow provided by operating activities decreased by $12,750,632 for the year ended December 31, 1996 compared to the previous year. This decrease was primarily the result of several factors including a decrease in net income for 1996 compared to 1995 of approximately $7.3 million, a decrease in unpaid loss and loss adjustment expenses during 1996 compared to 1995 of approximately $2.5 million, and the collection in 1995 of amounts recorded as receivable from reinsurers which accounted for approximately $2.2 million of the variation from 1995. For the year ended December 31, 1995 net cash flow provided by operating activities increased by $8,623,699 compared to the change in the previous year. This increase was due to the increase in net income for 1995 compared to 1994 of approximately $920,000, the collection in 1995 of amounts recorded as receivable from reinsurers during 1994 accounting for approximately $4.6 million of the variation, a decline in premiums receivable from insureds of about $1.9 million which was primarily the result of changes in payment options available to policyholders and other routine changes in MDA's book of business, and a decrease in paid loss and loss adjustment expenses during 1995 compared to 1994 of approximately $1.4 million.
On November 15, 1996 the Company completed the acquisition of 2,781,338 shares of its preferred stock at $0.40 per share in a tender offer dated September 12, 1996. On June 26, 1995 the Company received $499,996 in cash for the sale of shares of Class A Common Stock to Company principals in conjunction with the consummation of the conversion of MDA to a wholly-owned stock subsidiary of the Company.
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1996, 1995 and 1994
MDA was organized in 1976 as a mutual assessment insurance organization for the purpose of providing protection against loss from medical professional liability claims for Missouri health care professionals. MDA's wholly-owned subsidiary, Medical Defense Services Corp.("MDS") provides management services primarily to MDA. MDS's wholly-owned subsidiary, Medical Defense Insurance Company ("MDIC"), is a stock insurance company organized under Chapter 379 RSMo for the purpose of providing protection against loss from medical professional liability claims. MDIC is licensed to operate in Missouri and Kansas but only wrote business in Kansas from its inception in 1982 until September 1, 1988 when it ceased writing business. In 1994, MDIC again began writing policies in Kansas.
The maximum amount of dividends which can be paid by Missouri insurance companies without prior approval of the Insurance Commissioner is subject to statutory provisions. Dividends paid by MDA to the Company during 1996 and 1995 were $0 and $2,600,000, respectively. The maximum dividend payout which may be made in 1997 is $2,106,000.
F. Investments, continued: The Company has classified all investments in fixed maturities as available for sale and carries such investments at market value as a result of the Company's willingness to sell investments based on market conditions and interest rate changes. The adoption of SFAS 115 in 1994 had no financial statement impact as the Company previously carried such investments at market under SFAS 60. Should the Company experience declines in market value that are other than temporary, the difference between amortized cost and market would be recognized through current earnings.
Fair value is defined as market value based on third-party quoted market prices or when unavailable, on similar investments.
Investment income includes amortization of premium and accretion of discount relating to fixed maturities acquired at other than par value.
At December 31, 1996 and 1995, short-term investments consist of certificates of deposit which mature between three months and one year, a repurchase agreement investing exclusively in securities issued and guaranteed by the U.S. Treasury, and U.S. Treasury Bills with original maturities between three months and one year. The carrying amounts reported in the balance sheet for these instruments approximate their fair values.
Gains or losses on sales of investments are determined on a specific cost identification basis.
G. Property and Equipment: Property and equipment are carried at cost less accumulated depreciation. Depreciation is computed over the estimated useful lives of the assets using the straight-line method. Maintenance, repairs and minor renewals are charged to expense as incurred while renewals and betterments are capitalized.
I. Cash Equivalents: Cash equivalents represent certificates of deposit with original maturity dates within 90 days.
On September 12, 1996, MDHC initiated a tender offer for up to 5,000,000 shares of the Company's $1.00 par value redeemable preferred stock at a price ranging from $0.30 to $0.40 per share, utilizing a method commonly referred to as a Dutch auction. This offer closed on November 1, 1996, with the Company accepting 2,781,338 tendered shares at a price of $0.40 per share. The tender offer was completed on November 15, 1996, with the Company's payment of $1,112,535 for all preferred shares accepted for purchase. The difference between the payment and the par value of the stock has been credited to additional paid-in capital.
The Company has issued shares of $0.50 par value Class A common stock, in accordance with an agreement and plan of conversion dated November 29, 1994, in exchange for cash.
To comply with the Missouri Department of Insurance, MDIC had a U.S. Treasury Note with a par value of $850,000 as of December 31, 1996 and 1995, on deposit with the state of Missouri.
Escrow Funds: Pursuant to the settlement agreement for a specific claim, MDA has deposited $400,000 in escrow to guarantee future annuity payments. MDA receives all earnings on the escrowed funds. At December 31, 1996 and 1995, the escrowed funds were invested in a $400,000 par value U.S. Treasury Note with a fair value of $400,876 and $408,248, respectively, which is included with investments on the balance sheet. This U.S. Treasury note matures April 30, 2001.
A reserve for estimated retrospective premium due reinsurers has been established for the excess of the anticipated reinsurance premium payable over the amount paid to date for reinsurance treaty years 1980 through 1987. The ultimate reinsurance premium to be paid is based on an actuarial evaluation of the ultimate loss developments for claims arising during those treaty years. Changes in the estimated amount due reinsurers is reflected in current operations.
The Company files a consolidated federal income tax return. Pursuant to a tax allocation agreement, the Company has followed a policy of allocating a portion of its consolidated income tax provision to all consolidated entities in amounts generally equivalent to the provision (benefit) which would result if each entity filed a separate return.
The following table accounts for the differences between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate to income before income taxes:
Projection of future income is inherently uncertain and the achievability of any projection is made more difficult by the length of the discount period. Historical losses cannot be adjusted precisely to future cost levels and the impacts of future emergence of new classes of losses or types of losses which may not be represented sufficiently in the Company's data base or which are not yet quantifiable, cannot be precisely anticipated. Utilizing an outside actuary, management believes that it can reasonably estimate the amount of the loss reserves which will likely settle in the next three years. Based on this estimate, management can determine how much of the discount will likely reverse and could be recovered, if necessary, from taxes paid in the three-year carryback period.
The reserves include estimates of future trends in claim frequency, severity and cash flow, which could vary as the losses are ultimately settled; thus, the ultimate liability may be in excess of, or less than, the amounts provided in the accompanying financial statement.
Company management and their independent actuary believe the reserves are reasonably stated to cover the ultimate net cost of losses and related loss adjustment expenses which are unpaid at December 31, 1996 and 1995, respectively; however, as the reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. Developments on 1995 and prior years are due primarily to increases in claim severity that have been considered in ultimate loss projections at December 31, 1996.
The Company is party to a number of insurance claims arising in the normal course of business. While the results of litigation cannot be predicted with certainty, management, based upon the advice of Company's counsel, believes that the final outcome of such litigation will not have a material adverse effect on the consolidated financial position or results of operations of the Company.