based. The Company's regional office facilities are located in rented office space in Indianapolis (5,000 square feet) and Dallas (5,000 square feet). The Company believes that its office space is adequate for its present needs and that it will be able to secure additional office space in the future if necessary.
The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this Annual Report. The consolidated financial statements for 1999 include the accounts and operations of The MIIX Group, Incorporated ("The MIIX Group") and its wholly-owned subsidiaries, including, since August 4, 1999, New Jersey State Medical Underwriters, Inc. and its wholly-owned subsidiaries ("the Underwriter"). The consolidated financial statements for 1999 prior to August 4, 1999, and for 1998 and 1997, include the accounts and operations of the former parent company Medical Inter-Insurance Exchange (the "Exchange") and its wholly-owned subsidiaries.
On August 4, 1999, the reorganization of the Exchange was consummated. The reorganization was conducted according to a Plan of Reorganization adopted by the Board of Governors of the Exchange on October 15, 1997 and approved by members of the Exchange at a special meeting held on March 17, 1999 and by the Commissioner of the New Jersey Department of Banking and Insurance ("the Commissioner"). The Plan of Reorganization included several key components, including: formation of The MIIX Group to be the ultimate parent company for the Company; the transfer of assets and liabilities held by the Exchange to an affiliated stock insurance company, MIIX Insurance Company, formed for that purpose; acquisition of the Underwriter; distribution of shares of The MIIX Group common stock and/or cash to current and former members of the Exchange ("distributees") as defined in the Plan
The MIIX Group sold three million shares of its common stock in an underwritten public offering ("the Offering") that closed on August 4, 1999. On August 11, 1999 an additional 450,000 shares were sold to underwriters of the Offering pursuant to an over-allotment option in the Offering underwriting agreement. The net proceeds of the Offering of approximately $37.3 million consisted of gross proceeds of $46.5 million less reorganization and offering costs of $9.2 million and have been used for general corporate purposes, including payment of dividends and the repurchase of shares under a stock buyback program. During August 1999, the Company approved a stock repurchase program authorizing the purchase of up to one million shares of common stock in the open market. During November 1999, the program was amended, authorizing the purchase of up to an additional two million shares. Through December 31, 1999, 1,236,809 shares had been repurchased at a total cost of $19.2 million.
The medical malpractice industry is cyclical in nature. Many factors influence the financial results of the medical malpractice 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.
Management periodically reviews the Company's guidelines for premiums, surcharges, discounts, cancellations and non-renewals and other related matters. As part of this review, rates and rating classifications for its physicians, medical groups and other insureds are evaluated based on current and historical losses, LAE and other actuarially significant data. The process may result in changes in rates for certain exposure classes.
The determination of loss and loss adjustment expense ("LAE") reserves involves the projection of ultimate losses through an actuarial analysis of the claims history of the Company and other professional liability insurers, subject to adjustments deemed appropriate by the Company due to changing circumstances. Management relies primarily on such historical experience in determining reserve levels on the assumption that historical loss experience provides a good indication of future loss experience despite the uncertainties in loss trends and the delays in reporting and settling claims. As additional information becomes available, the estimates reflected in earlier loss reserves have been and may continue to be revised. The Company increased prior year gross reserves by $16.5 million and $3.8 million in 1999 and 1998 respectively. No adjustments to prior year gross reserves were made during 1997.
The Company's aggregate reinsurance contracts are maintained on a funds withheld basis whereby the Company holds the ceded premiums in a funds withheld account for the purpose of paying losses and related loss adjustment expenses. Interest charges are credited on funds withheld at predetermined contractual rates.
The Company's expansion into new states has increased certain 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 these relationships will reduce the need to make other significant distribution and administrative expenditures. Commissions for policies sold through brokers and agents typically range from 2.0% 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 may increase.
working capital; (ii) the Company's ability to achieve consistent profitable growth; (iii) the Company's ability to diversify its product lines; (iv) the continued adequacy of the Company's loss and loss adjustment expense reserves; and (v) the Company's avoidance of any material loss on collection of reinsurance recoverables. The words "believe," "expect," "anticipate," "project," and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates.
NET PREMIUMS EARNED Net premiums earned increased $25.3 million, or 15.6%, to $187.8 million in 1999 from $162.5 million in 1998, composed of increased direct and assumed premiums earned, offset somewhat by an increase in ceded earned premiums. Direct and assumed premiums earned increased $37.2 million, or 18.7%, to $235.8 million in 1999 from $198.6 million in 1998. This increase was composed of an increase in direct premiums earned of $27.3 million resulting from an increase in direct premiums written during the second half of 1998 and during 1999 and an increase in assumed premiums earned of $9.9 million, principally due to a large assumed excess of loss reinsurance contract written on an institutional account. Ceded earned premiums increased $11.9 million, or 32.8%, to $48.0 million in 1999 from $36.1 million in 1998, primarily resulting from additional ceded losses under aggregate reinsurance contracts during 1999.
NET INVESTMENT INCOME Net investment income increased $10.6 million, or 16.2%, to $75.7 million in 1999 from $65.1 million in 1998. Average invested assets during 1999 increased to approximately $1.2 billion in 1999 from $1.1 billion in 1998. The average pre-tax yield on the investment portfolio increased to 6.22% in 1999 from 5.88% in 1998 primarily as the result of changes in asset allocation with an increased concentration in higher pre-tax yielding securities, including disposition of the Company's equity portfolio with reinvestment of the proceeds in fixed maturity securities, in an increasing market yield environment.
OTHER REVENUE Other revenue increased $7.4 million to $8.3 million in 1999 from $.9 million in 1998. The increase in 1999 consists primarily of $3.4 million of revenues associated with the leasing, brokerage and other businesses acquired by the Company in the acquisition of the Underwriter on August 4, 1999, a gain of $3.5 million resulting from common stock received during 1999 in the demutualization of Manulife Financial Corp., and a $1.0 million death benefit received during 1999 from a corporate owned life insurance policy.
LOSS AND LOSS ADJUSTMENT EXPENSES (LAE) Losses and LAE increased $19.1 million, or 12.3%, to $175.0 million in 1999 from $155.9 million in 1998. Losses and LAE were net of ceded losses and LAE of $96.1 million in 1999 and $62.4 million in 1998. The ratio of net losses and LAE to net premiums earned improved to 93.1% in 1999 from 95.9% in 1998. This improvement is principally attributable to a reduction in the gross loss and LAE ratio on the Company's physician occurrence business written in 1999, combined with an increasing portion of the Company's business being written on a claims made basis which is expected to result in a lower ultimate loss and LAE ratio. Changes in loss and LAE reserves held on prior accident years also impacted the ratio of net losses and LAE to net premiums earned in 1999 and 1998. During 1999, gross loss and LAE reserves were increased by $16.5 million, ceded loss and LAE reserves were increased by $30.5 million, and ceded earned premiums associated with the adjustments to ceded loss and LAE reserves were increased by $10.6 million. During 1998, gross loss and LAE reserves were increased by $3.8 million, ceded loss and LAE reserves were increased by $5.9 million, and ceded earned premiums associated with the adjustments to ceded loss and LAE reserves were increased by $3.3 million.
UNDERWRITING EXPENSES Underwriting expenses increased $.5 million, or 1.3%, to $42.6 million in 1999 from $42.1 million in 1998. The increase in expenses was attributable to the costs of acquiring new business, primarily through a broker distribution network, and to the increased infrastructure costs necessary to service the increased volume of business activity in 1999. The ratio of underwriting expenses to net premiums earned, however, declined to 22.7% in 1999 from 25.9% in 1998. This improvement was primarily the result of greater economies of scale present with the larger premium in 1999 combined with the impact of the Company's cost reduction efforts, including the restructuring undertaken in June 1999.
FUNDS HELD CHARGES Funds held charges increased $.9 million, or 6.8%, to $14.3 million in 1999 from $13.4 million in 1998. Funds held charges relate to the Company's ceded aggregate reinsurance contracts, for which balances due to reinsurers are withheld as collateral for losses and loss adjustment expenses ceded under the contracts. The increase in funds held charges in 1999 was primarily due to the increase in reinsurance recoverable on unpaid losses ceded under the contracts during 1999.
IMPAIRMENT OF CAPITALIZED SYSTEM DEVELOPMENT COSTS During 1998, management replaced its policy administration system and accordingly recognized a $12.7 million pre-tax charge representing the net book value of capitalized costs associated with the old computer system which is no longer being used for the Company's operations.
INCOME TAXES Income taxes decreased $4.5 million, or 40.7%, to $6.6 million in 1999 from $11.1 million in 1998. The effective tax rate decreased to 24.2% in 1999 from 27.3% in 1998, due primarily to the significant realized investment gains in 1998.
NET PREMIUMS EARNED Net premiums earned increased $39.2 million, or 31.8%, to $162.5 million in 1998 from $123.3 million in 1997, composed of increased direct and assumed premiums earned and a decrease in ceded earned premiums. Direct and assumed premiums earned increased $33.0 million, or 19.9%, to $198.6 million in 1998 from $165.6 million in 1997. This increase consisted of additional direct premiums earned of $45.5 million in 1998, primarily representing additional business written during the latter half of 1997 and during 1998 in expansion states for the Company, offset by a decrease in assumed premiums earned of $12.5 million in 1998, primarily due to a large assumed reinsurance contract written on an institutional group in 1997 and not repeated in 1998. Ceded earned premiums decreased $6.2 million in 1998 compared to 1997 largely due to ceded reinsurance premiums associated with this large assumed reinsurance contract in 1997 and not repeated in 1998.
realized gains in 1998 of $12.0 million resulted from sale of fixed-maturity investments in a generally falling market yield environment. In 1997 the net gains consisted of net trading gains of $8.7 million from the equity portfolio and $1.6 million from sale of fixed-maturity investments.
INCOME TAXES Income taxes increased $9.2 million to $11.2 million in 1998 from $2.0 million in 1997. The effective tax rate increased to 27.3% in 1998 from 6.4% in 1997, due primarily to the significant realized gains in 1998 and release of a $4.2 million provision for tax contingencies in 1997.
payment of dividends only out of statutory earned (unassigned) surplus unless the payment out of other funds is approved by the Commissioner. The other insurance subsidiaries are subject to similar provisions and restrictions. No significant amounts are currently available for payment of dividends by insurance subsidiaries other than MIIX Insurance Company without prior approval of the applicable state insurance department or Bermuda Registrar of Companies.
The Company held collateral of $271.6 million and $228.1 million at December 31, 1999 and 1998 respectively, in the form of funds held, for recoverable amounts on ceded unpaid losses and LAE under certain reinsurance contracts. 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 $60 million. Otherwise no restrictions are placed on investments held in support of the funds held. In accordance with the provisions of the reinsurance contracts, the funds held are credited with interest at contractual rates ranging from 7.5% to 8.6%, which is recorded as an expense in the year incurred.
During August 1999, the Company approved a stock repurchase program authorizing the purchase of up to 1,000,000 shares of its common stock in the open market. During November 1999, the program was amended, authorizing the purchase of up to an additional 2,000,000 shares. Through December 31, 1999, 1,236,809 shares had been repurchased at a total cost of $19.2 million.
Because certain computer software programs have historically been designed to use a two-digit code to identify the year for date-sensitive material, such programs may not properly recognize post twentieth century dates. This could result in system failures and improper information processing that could disrupt the Company's business operations.
systems were reviewed and those requiring upgrading or replacement to improve computing capabilities and to ensure Year 2000 compliance were identified. In this process the Company determined that its claims administration systems was not Year 2000 compliant and a replacement system that the vendor represented to be Year 2000 compliant was purchased and is now in operation. The Company also upgraded its telephone system to make it Year 2000 compliant.
The Company completed its Year 2000 review, identification and remediation process during 1999, at a total cost of less than $500,000. No Year 2000 difficulties related to internal systems or the systems of service providers and other external business partners were encountered in January 2000. The Company, however, may still be adversely impacted to the extent Year 2000 difficulties result in claims being made against the Company's insureds. The Company's liability for such claims, if any, is not clearly established. To date, the Company is unaware of any such claims.
At December 31, 1999, the Company had net after-tax unrealized losses on its fixed maturity investment portfolio of $38.8 million, which included a deferred tax valuation allowance of $3.6 million. The net after-tax unrealized losses of $38.8 million on the fixed maturity portfolio represented 10.8% of total stockholders' equity gross of net after-tax unrealized losses on investments. The net unrealized losses were the result of the rise in market interest rates during 1999. The unrealized losses at December 31, 1999 do not significantly impact the Company's ability to meet all regulatory capital requirements.
The Company also holds a portfolio of equity investments. At December 31, 1999, the cost and fair value of equity investments was $12.4 million and $13.2 million respectively. At December 31, 1998, the cost and fair value of equity investments was $3.2 million. A 10% decline in value of the equity investments at December 31, 1999 would result in after-tax accumulated unrealized losses on equity investments of $1.3 million, or .6% of total stockholders' equity gross of net after-tax unrealized losses on investments.
believes that the Company's pricing and loss and LAE reserving processes adequately incorporate the effects of inflation.