(2) Basic and diluted loss per share of common stock for the year ended December 31, 2003 is computed using the weighted average number of common shares outstanding during the year of 13,436,586.
exploring all of its alternatives. In connection with that exploration, the financial advisors have contacted more than 50 prospective purchasers of assets of the Company or investors in the Company. As a consequence of that effort, the Company has received one indication of interest from MDAdvantage to acquire certain assets of the Underwriter and one additional possible offer. The Company is proceeding to negotiate with MDAdvantage the documentation relating to a possible sale of the Underwriter's assets, subject to the receipt of all necessary approvals and "higher or better offers" prior to closing. The Company is also continuing to seek other buyers for its assets.
The Company offered traditional occurrence coverage from 1977 through 1986 and offered a form of occurrence-like coverage, "modified claims-made," from 1987 to August 31, 2002. Occurrence and modified claims-made coverages constituted the majority of the Company's business throughout its history. In recent years, however, the Company increased its claims-made business. Development of losses and LAE is longer and slower for occurrence business than claims-made business.
The Company currently reinsures its risks under various Specific Excess and Aggregate Excess of Loss Reinsurance Contracts, along with five Facultative Contracts. During January 2002, the Company renewed five institutional policies with Facultative Reinsurance Contracts, which reduced the amount of risk that MIIX retained on each policy. The contracts are on a quota share basis; therefore MIIX shares a portion of the premium and loss on each Facultative Reinsurance Contract. The quota share amount that MIIX retains ranges between 25% and 50%.
The Aggregate Contract in 2002 provided coverages on an aggregate excess of loss and quota share basis. The primary coverage afforded under the Aggregate Contract attaches above a Company retention measured as a 65% loss and ALAE ratio. Reinsurers provide coverage for an additional 75% loss and ALAE ratio, with an aggregate annual limit of $100 million. The Company has maintained aggregate excess of loss coverage generally similar to that described above since 1993.
MIIX's aggregate reinsurance contracts are maintained on a funds withheld basis, whereby MIIX holds the ceded premiums in a funds withheld account for the purpose of paying losses and related LAE. Interest charges are credited on funds withheld at predetermined contractual rates. Each of the aggregate excess reinsurance contracts also contains a provision requiring that the funds withheld be placed in trust should the A.M. Best rating assigned to MIIX fall below B+. On March 22, 2002, A.M. Best lowered the rating of MIIX to C+, and MIIX withdrew from the interactive rating process with A.M. Best. As a result of the downgrade, reinsurers
LOSS AND LOSS ADJUSTMENT EXPENSES. The Company estimates its liability for losses and LAE using actuarial projections of ultimate losses and LAE and other quantitative and qualitative analyses of conditions expected to affect the future development of claims and related expenses. The estimated liability for losses is based upon paid and case reserve estimates for losses reported, adjusted through judgmental formulaic calculations to develop ultimate loss expectations; related estimates of IBNR losses and expected cash reserve developments based on past experience and projected future trends; deduction of amounts for reinsurance placed with reinsurers; and estimates received related to assumed reinsurance. Amounts attributable to ceded reinsurance derived in estimating the liability for loss and LAE are reclassified as assets in the consolidated balance sheets as required by FAS No. 113. The liability for LAE is provided by estimating future expenses to be incurred in settlement of claims provided for in the liability for losses and is estimated using similar techniques.
The Company also has direct and assumed liabilities under covered extended reporting endorsements associated with claims-made policy forms, which generally provide at no additional charge, continuing coverage for claims-made insureds in the event of death, disability or retirement. These liabilities are carried within unearned premium reserves and are estimated through formula calculations that have been verified by the Company's independent actuarial firm using techniques, which possess elements of both loss reserves and pension liabilities, and thus include additional assumptions for mortality, morbidity, retirement, interest and inflation. Since the Company had no policies in force as of December 31, 2003, the Company had no liability with respect to extended reporting endorsements at that date.
the Company in determining whether declines in the fair value of fixed maturity securities are other than temporary include: (1) the significance of the decline, (2) the Company's ability and intent to retain the investment for a sufficient period of time for it to recover, (3) the time period during which there has been a significant decline in value, and (4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to review. Where such analysis results in a conclusion that declines in fair values are other than temporary, the security is written down to fair value. See Note 5 (Investments), to the consolidated financial statements for a general discussion of the methodologies and assumptions used to determine estimated fair values.
As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general overall economic conditions as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future ratings agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions required by the Company to estimate the fair values of securities, including projections of expected future cash flows and pricing of private securities. The Company is routinely monitoring developments and updating underlying assumptions and financial models based upon new information.
Short-term investments include investments maturing within one-year and other cash and cash equivalent balances earning interest.
The Company's scope of operations has been significantly diminished. As a result of the entry of the Order or Rehabilitation, the Company no longer controls the operations of MIIX, the process of resolving claims, or the management of MIIX's investment portfolio. As a result, the Company's cash flow has decreased significantly. The Company does not believe that it has adequate cash to continue to operate.
The Company is subject to litigation that could have a material adverse effect on its financial condition.
Because of the foregoing risks and uncertainties, the Company's financial statements and the discussion that follows in Management's Discussion and Analysis of Financial Condition and Results of Operation should not be relied upon by investors as indicating the Company's ability to operate.
The Company ceased its insurance underwriting operations in 2002 and entered solvent runoff. The financial results of the Company reflect the cessation of insurance underwriting operations. During this same period the Company was impacted by the historic decline in interest rates and the continuing decline in the size of the investment portfolio as a result of claims settlements.
The Company recorded a $237.4 million net adjustment to loss and LAE reserves in 2003 to maintain the loss and LAE reserve at management's best estimate levels. Loss and LAE reserve for 2003 included an increase to direct and assumed prior year loss and ALAE reserves of $353.0 million reduced by ceded loss and LAE reserves of $119.9 million. Adjustments to direct and assumed loss and ALAE reserves included a net increase in Pennsylvania hospitals of $67.6 million, a net increase to New Jersey physicians business of $190.4 million, an increase to Pennsylvania physicians of $20.9 million and a net increase to all other states hospitals and physicians business of $60.3 million and $30.5 million, respectively. The net adjustment primarily reflects adverse development and increased severity trends, and to a certain extent acceleration of claims, particularly with respect to Pennsylvania hospital claims and to New Jersey physicians for coverage years prior to 1999.
FUNDS HELD CHARGES. Funds held charges decreased $11.2 million, or 20.7%, to $43.0 million in 2003 from $54.2 million in 2002. Funds held charges relate to the Company's ceded aggregate reinsurance contracts, and represent balances due to reinsurers, which are withheld as collateral for losses and LAE ceded under the contracts.
INCOME TAXES. An income tax benefit of $6.8 million was recorded in 2003, compared to an income tax benefit of $11.2 million in 2002. The tax benefit in 2003 primarily reflects the reduction in the deferred tax valuation allowance specifically resulting from changes in deferred taxes on unrealized portfolio gains. The deferred tax benefit recorded in operations is offset by a charge in other comprehensive income.
NET INVESTMENT INCOME. Net investment income decreased $19.4 million, or 24.2%, to $60.8 million in 2002 from $80.2 million in 2001. The decrease was primarily attributable to the combined effects of lower market yields and a decrease in average invested assets resulting mainly from claims payments and a corresponding increase in average short-term investments held during 2002. Because two of the Company's insurance subsidiaries, MIIX and LP&C, were in solvent runoff, the Company has modified its investment portfolio to (1) manage an expected increase in accelerated claims and a lower invested asset base and (2) improve the overall average credit quality of the portfolio.
LOSS AND LOSS ADJUSTMENT EXPENSES. Losses and LAE decreased $54.3 million, or 21.6%, to $196.5 million in 2002 from $250.8 million in 2001. Losses and LAE were net of ceded losses and LAE of $115.3 million in 2002 and $97.5 million in 2001. The ratio of net losses and LAE to net premiums earned increased to 196.1% in 2002 from 170.8% in 2001.
UNDERWRITING EXPENSES. Underwriting expenses decreased $14.0 million, or 29.7%, to $33.1 million in 2002 from $47.1 million in 2001. This decrease is primarily due to the effects of discontinued insurance operations, with reduced commissions, premium
taxes and a reduction in compensation and benefits resulting from downsizing actions taken during 2002. The ratio of underwriting expenses to net premiums earned increased to 33.1% in 2002 from 32.1% in 2001. The increase resulted primarily from lower net earned premiums which was impacted by additional ceded premiums associated with additional losses ceded under the Company's aggregate reinsurance contracts.
FUNDS HELD CHARGES. Funds held charges increased $11.7 million, or 27.6%, to $54.2 million in 2002 from $42.5 million in 2001. Funds held charges relate to the Company's ceded aggregate reinsurance contracts, and represent balances due to reinsurers which are withheld as collateral for losses and LAE ceded under the contracts. Funds held charges increased $30.0 million resulting from adjustments made to ceded loss and LAE reserves and ceded premiums recorded during the first, third and fourth quarters of 2002. In 2001, funds held charges increased $19.8 million resulting from changes to less reserves, ceded losses and ceded premiums during 2001.
RESTRUCTURING CHARGE. The Company announced in March, 2002, that LP&C's operations would be placed into runoff and recorded a restructuring charge of $2.6 million during the first quarter of 2002 relating to the reduction of regional and home office staff and the closing of regional offices in Dallas and Indianapolis. No such event occurred during 2001.
INCOME TAXES. An income tax benefit of $11.2 million was recorded in 2002, as compared to an income tax expense of $41.9 million in 2001. The tax benefit resulted from the recognition of a net operating loss carryback due to a tax law change enacted during 2002. This benefit was net of an increase in the valuation allowance of $29.7 million during 2002. At December 31, 2001, the Company recorded a $95.1 million valuation allowance against the net deferred tax asset in accordance with Statement of Financial Accounting Standards 109, "Accounting for Income Taxes," offset by an increase in pre-tax loss of $52.0 million resulting in an increased tax benefit of $18.2 million at a 35% tax rate, a tax contingency reserve release of $10.2 million, and a net increase in taxes of $2.9 million in other items including $1.0 million due to lower tax exempt interest. The release of the tax contingency reserve resulted from the establishment of the valuation allowance, at full value.
The MIIX Group is a holding company whose assets primarily consist of all of the capital stock of its subsidiaries. Cash flow needs at the holding company level include corporate operating expenses. Prior to the Order of Rehabilitation, the Company's principal sources of funds were dividends and other permissible payments from its subsidiaries and revenues from its non-insurance operations. Subsequent to the Order of Rehabilitation, the Company's principal source of funds is derived from the management contract with MDAdvantage. The Company does not believe that its cash flow will be sufficient to allow it to continue to operate. Accordingly, the Company continues the wind-down of its business activities. See "Recent Developments," "Management's Discussion and Analysis of Financial Condition and
Results of Operation - Risks and Uncertainties," "Business - Business Strategy" and "Business - Regulation - Risk-Based Capital."
MIIX, while in runoff through September 28, 2004, needed to have cash and liquid assets available to meet its obligations to policyholders in accordance with contractual obligations, in addition to having funds available to meet ordinary operating costs. The primary sources of the Company's liquidity are net investment income, proceeds from the maturity or sale of invested assets, recoveries from reinsurance, revenues from non-insurance operations and unearned premium. Funds are used to pay losses and LAE, operating expenses, reinsurance premiums and taxes. The Company's net cash flow used in operating activities were approximately $(280.4) million, $(181.7) million and $(24.3) million for the years ended December 31, 2003, 2002 and 2001, respectively. The decrease in cash flow during 2003 was primarily the result of increased loss payments reflecting the maturation of the Company's expansion book of business and the settlement of several higher severity cases, lower investment income and a decrease in premium collection reflecting the decrease in written premium offset. Because of the inherent unpredictability related to the timing of the payment of claims, it is not unusual for cash flow from operations for a medical malpractice insurance company to vary, perhaps substantially, from year to year. However, as a result of the Order of Rehabilitation on September 28, 2004, the Company no longer has control over the operations of MIIX and, accordingly, the financial position and results of operations of MIIX will no longer be reflected in the Company's financial statements after September 28, 2004. See "Business - Recent Developments" and "Management's Discussion and Analysis of Financial Condition and Results of Operation - Risks and Uncertainties."
The Company, through the normal course of operations, entered into contractual obligations relating to leases for premises and equipment. The following table details the Company obligations for the years presented (In thousands).
At December 31, 2003, and 2002, the Company held collateral of $292.1 million and $332.7 million, respectively, in the form of funds held, and $161.2 million in the form of letters of credit, 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 below B+, a reduction in statutory capital and surplus to less than $60 million, or a change in control. Under the contracts, and as a result of the downgrade of the Company's A.M. Best rating to below B+ during the first quarter of 2002, reinsurers requested that assets supporting the funds withheld account be placed in trust. The Company established the required trust accounts in accordance with contract provisions. The Company does not anticipate a material impact on the Company's financial condition or results of operations from placing the funds withheld in trust. In accordance with the provisions of the reinsurance contracts, the funds held are credited with interest at contractual rates ranging from 6.0% to 8.6%, which is recorded as an expense in the year incurred.
The information on the tables below and the paragraphs that follow represent historical information and do not discuss the change resulting from the Order of Rehabilitation on September 28, 2004.
In addition to interest rate risk, fixed maturity securities like those comprising the Company's investment portfolio involve other risks such as default (or credit deteriorating quality). The Company manages these issues by limiting the amount of higher risk corporate obligations (determined, among other variables, by credit rating assigned by private rating agencies) in which it invests.
The Company also held a number of equity investments. At December 31, 2003, the cost and fair value of equity investments was $2.8 million and $3.2 million, respectively. At December 31, 2002, the cost and fair value of equity investments was $4.8 million and $5.2 million, respectively. The value of the common stock investments is dependent upon general conditions in the securities markets and the business and financial performance of the individual companies in the equity portfolio.