We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be five to ten years in length. We currently lease and occupy a total of approximately 45,000 square feet of space in Louisville, Kentucky; Boca Raton, Florida; and Albuquerque, New Mexico. We also own various real estate investment properties as part of our investment portfolio.
As a property and casualty insurer, our results of operations are primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting
incurred but not reported, commonly referred to as IBNR, to provide for future reporting of already incurred claims and developments on reported claims. The reserve for IBNR claims is determined based on historical loss trends.
The assumptions and methodologies used in estimating and establishing the reserve for unpaid losses and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded 8% of our recorded net reserves as of the beginning of the period, but they can materially and adversely affect our results of operations when an adjustment is made. Due to the current volatility of losses in the medical professional liability industry, adjustments have occurred in each of the last several years.
On a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. In 2005, the Company concluded that it had both the intent and ability to hold a significant portion of the Company’s fixed-income securities to maturity. Accordingly, the Company transferred fixed-income securities, with an estimated fair value of approximately $398.3 million at the date of transfer, from the available-for-sale category to the held-to-maturity category. The remainder of the Company’s fixed-income security portfolio, as well as its equity securities held for investment, remains in the available-for sale category.
Insurance premium income is generally recognized on a daily pro rata basis over the respective terms of the policies in-force which is generally one year. Certain extended reporting endorsements, often referred to as tail coverage, allow extended reporting of insured events after the termination of the original claims-made policy by modifying the exposure period of the underlying contract. Tail coverage can modify the exposure period for a definite or indefinite period. Premiums associated with tail policies that provide coverage for a definite period are earned over the period additional coverage is provided using the daily pro rata method. Premiums for tail policies that provide additional coverage for an indefinite period are fully earned at the date of issuance. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.
We annually review the financial stability of all of our reinsurers. This review includes a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2005, there are no known issues with the financial solvency of our reinsurers or their ultimate ability to pay amounts due to us. Our reinsurance arrangements are discussed in more detail in “Item 1. Business - Medical Professional Liability Operations” and in Note 9 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Changes in the valuation allowance during 2005 and 2004 were allocated in the accompanying Consolidated Financial Statements to federal income taxes (a component of net income), other comprehensive income, or other components of shareholders’ equity, depending on the nature of the deferred item that gave rise to the change. The establishment of the valuation allowance in 2003 was all recorded as federal income tax expense in the accompanying Consolidated Statements of Income, included elsewhere in this report. See Notes 1 and 10 of the Notes to Consolidated Financial Statements for further discussion of the deferred tax valuation allowance and its impact on our financial condition and results of operations. Such information is incorporated herein by reference.
As a result of the changes in the mix of our investment portfolio, the decrease in call premiums in 2005 compared to 2004 and the losses on derivative securities discussed above, the overall annual yield on our investment portfolio decreased to 5.43% for the year ended December 31, 2005 compared to 5.93% for the year ended December 31, 2004. We believe that the yield earned in 2005 is more representative of what we anticipate earning in future periods as a result of the realignment of the portfolio.
The decrease in investment expenses was primarily the result of a decrease in depreciation expense in 2005 as a result of the sale of our Grand Rapids real estate properties, which began in the third quarter of 2004. We anticipate investment expense will remain at or slightly below that reported in 2005.
Other expenses relate to employee separation costs and contract termination costs incurred in connection with our exit from the workers’ compensation line of business as well as the sub-lease of office space in Chicago, Illinois. We anticipate that these costs should be minimal in future periods as all available office space has been subleased and there remain only a handful of workers’ compensation employees. For further information relating to the costs associated with the exit of our workers’ compensation line of business, see Note 13 of the Notes to Consolidated Financial Statements included elsewhere in this report.
2004 Compared to 2003. The net income reported for 2004 was primarily attributable to the continued improvements in the underwriting performance (i.e. underwriting gain) of our medical professional liability segment combined with increased investment income over the prior year. Partially offsetting these positive factors were increases in the underwriting losses of the other insurance lines segment, which were primarily attributable to the run-off of the workers’ compensation and health lines of insurance, and increases in general and administrative expenses. The net loss reported in 2003 was the result of the unfavorable development on prior year loss reserves, primarily related to our medical professional liability segment, and an increase in paid loss severity noted during the third quarter, particularly in our Florida, Ohio and Kentucky markets. In connection with the loss reported in the third quarter of 2003 as a result of the unfavorable development on prior year’s medical professional liability loss reserves, we also established a deferred tax valuation allowance of $49.9 million.
The increase in investment income was the result of strong returns on our high-yield bond portfolio during the first part of the year, one-time call premiums of $1.5 million and a decrease in the percentage of our investment portfolio allocated to short-term investments. Although we began to liquidate our high-yield bond portfolio at the end of the first quarter of 2004, the overall yield on our investment portfolio was 5.93% for 2004 compared to 5.55% for 2003, primarily as the result of strong returns on our collateralized mortgage obligations in 2004.
General and administrative expenses increased during 2004 compared to 2003, primarily due to increased legal, audit and other professional fees incurred as a result of actions taken to comply with the Sarbanes-Oxley Act and related SEC requirements and the exploration of strategic alternatives by the Board of Directors.
pricing pressure in the medical professional liability market, we remain committed to our strategy of adequate pricing and strict underwriting. This strategy may result in the loss of additional policyholders. However, we are not willing to compromise our standards, or profitability, for the sake of market share.
Premium rate increases have ranged from 2.5% to 9.0% by state in 2005, except in Kentucky where we increased rates 23.6%. The average premium per policy in-force has increased from approximately $16,400 at December 31, 2004 to approximately $16,900 at December 31, 2005, an increase of 3.0%. Although we began our exit from the Florida market in December 2002 and our premiums written in that state have declined significantly, we continue to have direct premiums written in that state as a result of installment premiums on extended reporting coverage, which we were required by Florida State law to offer insureds as we non-renewed their policies. The premiums for these policies may be paid in annual installments, not to exceed three years. Accordingly, with the exception of premiums related to PIC-FL, we should not have any premium writings in Florida after 2005. Direct premiums written by PIC-FL in the state of Florida increased $600,000 during 2005, to $8.4 million compared to $7.8 million during 2004. Our investment in and consolidation of PIC-FL is more fully described in Note 1 of the Notes to Consolidated Financial Statements. Such information is incorporated herein by reference.
The decrease in net premiums written is consistent with the decrease in direct premiums written. Net premiums earned, however, did not decrease as much as direct and net premiums written as we continue to earn in 2005 the higher premium volume written in 2004.
During 2004 we retained a 30% participation in our primary excess of loss reinsurance layer, which covered the first $500,000 of risk exposure in excess of $500,000. We retained no loss exposure for losses in excess of $1 million related to policies written during 2004. Effective January 1, 2005 we combined the two treaties so that loss exposures greater than $500,000, in all markets except Michigan, were ceded under one treaty. We retained a 20% participation in this treaty. For business written in Michigan, we retained 100% of the first $1 million of loss exposure, and 20% of losses in excess of $1 million. These changes in our reinsurance program did not have a significant impact on the amount of premium ceded under the contracts, as the net written premium to direct written premium ratio was 86.0% in 2005 compared to 86.2% in 2004. While these changes are not anticipated to have a material effect on our net loss and loss adjustment expenses, the ultimate impact on our loss experience will not be known for several years.
Under our 2006 reinsurance treaties we will continue to retain 100% of the first $500,000 of loss exposure and will retain a 50% participation in the exposure layer of $1.5 million in excess of $500,000 in all states except New Mexico and Indiana where state patients’ compensation funds limit our loss exposure to $200,000 and $250,000, respectively. As a result of these terms, we anticipate that the percentage of our direct premiums written ceded to reinsurers to decrease from approximately 14% in 2005 to 10% in 2006. We believe that this layer of business is profitable. However, the ultimate impact of these changes in our reinsurance treaty on net income will depend upon future underwriting results.
The loss ratio has steadily declined over the last several years. However, we believe that this trend will level off as a result of smaller rate increases in the future and a more stable book of business.
2004 Compared to 2003. Direct premiums written for the medical professional liability segment increased in 2004 as we continued to implement rate increases in all markets and increased our market share in New Mexico. This was partially offset by our reduced exposure in the Florida market, as well as Ohio and Kentucky where we reduced exposures in higher risk geographic markets and specialties and discontinued offering occurrence-based policies. Our insured physician count at December 31, 2004 decreased approximately 7.1% from December 31, 2003. This decline was the result of the reasons indicated above, as well as a decrease in the number of insured physicians in Illinois where we took a significant rate increase effective April 1, 2004. The average premium per policy in-force increased to approximately $16,400 at December 31, 2004 from approximately $14,700 at December 31, 2003, an increase of 11.6%. Approximately $4.0 million of the total $7.3 million increase in direct premiums written was attributable to PIC-FL, which completed its first full year of operations in 2004. PIC-FL is more fully described in Note 1 of the Notes to Consolidated Financial Statements.
Our net premiums written and earned during 2004 increased a greater percentage than direct premiums written as effective January 1, 2004 we began retaining a 30% participation in our primary excess of loss reinsurance layer. This increase in net written premiums also resulted in the larger percentage increase in net earned premiums.
The decrease in incurred loss and loss adjustment expenses was primarily the result of $44.3 million of adverse development on prior year loss and loss adjustment expense reserves recorded in 2003 compared with $2.7 million of favorable development, net of $4.1 million of unfavorable development related to the reinsurance commutation with Gerling Global. On an accident year basis, the 2004 loss ratio was 85.3% compared to 96.5% for the 2003 accident year. The decrease in the accident year loss ratio was primarily the result of rate increases in all markets, the exit from the Florida market and certain occurrence-based markets and stricter underwriting standards.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our other insurance lines operations for the years ended December 31, 2005, 2004 and 2003.
The decrease in underwriting expenses is primarily the result of a decrease in corporate and shared services salary, employee benefit and other costs allocated to the other insurance lines segment as a result of the decreased premium volume.
Incurred loss and loss adjustment expenses decreased primarily as a result of the decrease in exposure associated with the reduced number of covered lives in our health line, and the number of policies in-force for workers’ compensation.
APCapital’s only material assets are the capital stock of American Physicians and its other subsidiaries, cash obtained from the proceeds from its junior subordinated deferrable interest debentures, or debentures, issued in 2003, and dividends from its subsidiaries. APCapital’s ongoing cash flow will consist primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. In 2005, American Physicians paid cash dividends of $17.3 million to APCapital. The amount of dividends that APCapital’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding net realized gains (losses) on the sale of investments, or 10% of statutory surplus as of the preceding year end. Accordingly, as of January 1, 2006, approximately $26.1 million could be paid by the APCapital’s insurance subsidiaries without prior regulatory approval.
APCapital’s primary uses of cash, on both a short and long-term bases include periodic interest payments, operating expenses, the repurchase of its outstanding common shares and the repayment of the debentures. APCapital’s cash and cash equivalent resources totaled approximately $5.3 million at December 31, 2005.
However, following the termination of the stock purchase agreement, American Physicians purchased from some of the same shareholders a total of 1,942 shares of PICW common stock, representing 9.9% of PICW’s outstanding shares of common stock. The purchase price was $3,800 per share, or approximately $7.4 million. In addition, approximately $200,000 of costs incurred in connection with the acquisition were capitalized, bringing the total cost of the investment to $7.6 million. The purchase of the 1,942 shares was disputed by the OCI and PICW.
On December 21, 2005, ProAssurance Corporation filed a plan to acquire all the outstanding shares of the common stock of PICW. The OCI thereafter entered a stay of proceeding relating to American Physicians’
acquisition of 1,942 shares until the ProAssurance Corporation transaction is either approved or disapproved, and until the conclusion of a reasonable time period for closing that transaction.
From time to time, the Board of Directors authorizes the Company to purchase shares of its outstanding common stock. On November 2, 2005, the Board of Directors authorized the purchase of an additional five percent of the Company’s outstanding common shares. This resulted in an authorization to repurchase an additional 425,000 shares, bringing the total number of shares authorized to be repurchased under publicly announced plans to 4,040,439.
Additional cash was provided in 2005 and 2004 by investment returns and reduced expenses.
At December 31, 2005, the Company had $273.0 million of cash and cash equivalents, and approximately $224.1 million of available-for-sale fixed-income securities to meet short-term cash flow needs. On a long-term basis, fixed-income securities are purchased on a basis intended to provide adequate cash flows from future maturities to meet future policyholder obligations and ongoing operational expenses. As of December 31, 2005, we had approximately $25.5 million, $94.3 million and $35.4 million of held-to-maturity fixed-income securities that mature in the next one to five years, five to ten years and more than ten years, respectively. We also have approximately $190.5 million of mortgage-backed securities that provide periodic principal repayments. Subsequent to December 31, 2005, we have purchased approximately $89.3 million of tax-exempt municipal bonds and $16.0 million of government agency fixed-income securities. We anticipate that over the next three to six months, we will deploy more of our cash resources to various other securities, including tax-exempt municipals, investment-grade corporate bonds and mortgage-backed securities. See Note 4 of the Notes to Consolidated Financial Statements for further information regarding the anticipated maturities of our fixed-income securities.
Activity in the liability for unpaid loss and loss adjustment expenses by insurance segment for the year ended December 31, 2005 was as follows:
The unfavorable development associated with prior accident years in the other insurance lines is primarily related to the workers’ compensation line of business. Prior year development, both favorable and unfavorable, is relatively common for lines that are in run-off, as the actual loss patterns that emerge as claims are run off often differ from what the historical data would predict. This occurs because claims that are settled as the line runs off are often less severe in nature than those that remain open. In addition, as the number of open claims diminishes, the predictive nature of actuarial models becomes less precise because of their reliance, in part, on historical averages of claims and payment statistics. While the run off of our workers’ compensation claims continues to add an element of variability to the already inherently variable process of reserve estimation, we believe that in the second half of 2005, our workers’ compensation reserves began to stabilize. Accordingly, while prior year development will continue to occur as we run this line off, we do not anticipate that such development will be as significant as that noted during 2005 and 2004.
The volatility of professional liability claim frequency and severity makes the prediction of the ultimate loss very difficult. Likewise, the long time frame for professional liability claims to develop and be paid further complicates the reserving process.
During 2005, the company realized $4.4 million of favorable development on reserves established as of December 31, 2004. The favorable development was the result of $6.4 million favorable development in
Professional Liability offset with $2.0 million adverse development in Other Lines. The favorable development in Professional Liability was the result of fewer than expected reported claims and lower indemnity claim costs on the 2003 and 2004 accident years, particularly in the Ohio and Michigan markets. The adverse development in Other lines arose primarily from workers compensation in the first half of 2005, partially offset by favorable development in the company’s accident and health business.
Due to the long-tailed nature of the medical professional liability and workers’ compensation lines of insurance, changes in the actuarially projected ultimate loss severity can have an even greater impact on the balance of recorded reserves than with most other property and casualty insurance lines. While we believe that our estimate for ultimate projected losses related to our medical professional liability and workers’ compensa-
tion lines of business are adequate based on our open and reported claim counts, there can be no assurance that additional significant reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
Accrued expenses and other liabilities at December 31, 2005 were $41.8 million, a decrease of $9.1 million compared to December 31, 2004. This decrease was primarily attributable to a decrease in the amount payable related to pending security transactions, which was $9.5 million at December 31, 2004 compared to $17,000 at December 31, 2005.
Shareholders’ equity at December 31, 2005 was $261.2 million, an increase of $59.1 million, from $202.1 million at December 31, 2004. Retained earnings increased $72.4 million as a result of the net income recorded for the year ended December 31, 2005, which included the reversal of the deferred tax valuation allowance. This increase was offset by a decrease of $12.5 million in additional paid-in-capital related primarily to the purchase and retirement of the Company’s common stock. The Company’s book value per common share outstanding at December 31, 2005 was $31.35 per share, based on 8,333,417 shares outstanding, compared to $23.31 per common share outstanding at December 31, 2004. Total shares outstanding at December 31, 2004 were 8,671,984.
In May 2003, we formed two subsidiary statutory trusts for the purpose of issuing mandatorily redeemable trust preferred securities, referred to as “trust preferred securities”. The proceeds from the trust preferred securities that were issued were used by the trusts to purchase debentures issued by APCapital, which are shown as long-term debt in the Consolidated Balance Sheets included elsewhere in this report. APCapital used the amounts borrowed pursuant to these debentures to increase its available capital and has subsequently contributed substantially all of the proceeds to American Physicians to increase its statutory surplus. The debentures and the trust preferred securities have terms and maturities that mirror each other. In accordance with the guidance given in Financial Accounting Standards Board Interpretation No. 46, “Variable Interest Entities,” we have not consolidated these subsidiary trusts. APCapital has guaranteed that amounts paid to the trusts related to the debentures, will subsequently be remitted to the holders of the trust preferred securities. In accordance with the nature of the transactions, the amounts guaranteed by APCapital, are also recorded as liabilities in the Consolidated Financial Statements, as they represent obligations to the trusts, which are in turn obligated to the holders of the trust preferred securities. The obligations are more fully described in Note 8 of the Notes to Consolidated Financial Statements included elsewhere in this report, which description is incorportated herein by reference.
The Company’s reserves for unpaid loss and loss adjustment expenses are an estimate of future cash flows necessary to fulfill insurance obligations based on insured events that have already occurred, but the amount and timing of the cash outflow is uncertain.
We have audited the accompanying consolidated balance sheet of American Physicians Capital, Inc. and Subsidiaries (the “Company”) as of December 31, 2005 and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and Subsidiaries at December 31, 2005, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of American Physicians Capital, Inc. (“APCapital”) and its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation (“APSpecialty”), Alpha Advisors, Inc., APIndemnity (Bermuda) Ltd., APManagement Ltd. and American Physicians Assurance Corporation (“American Physicians”). Effective January 24, 2005, APCapital’s wholly owned subsidiaries, APConsulting LLC and APDirect Sales, LLC, were dissolved. In addition, the accounts of Physicians Insurance Company, a Florida domiciled insurance company (“PIC-FL”), have been consolidated in the accompanying Consolidated Financial Statements. See “Minority Interests” near the end of Note 1 for further information regarding PIC-FL and its related accounting treatment in the accompanying Consolidated Financial Statements. APCapital and its consolidated subsidiaries are referred to collectively herein as the Company. All significant intercompany accounts and transactions are eliminated in consolidation.
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers. In addition, the Company has historically provided workers’ compensation and health insurance; however, in 2003 the Company initiated plans to exit these lines. These lines are now included in the other insurance lines segment. Medical professional liability and other insurance direct premiums written accounted for approximately 98.9% and 1.1%, respectively, of the Company’s total direct premiums written in 2005.
Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method for investments acquired at other than par value. Amortization for loan-backed, or mortgage-backed, securities is adjusted prospectively for changes in pre-payment speed assumptions. Pre-payment speed assumptions are updated at least annually and are based on the average of assumptions obtained from ten leading brokerage firms. Interest income is recognized when earned. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
The Company’s investments are evaluated for other than temporary impairment (“OTTI”) using both quantitative and qualitative methods that include, but are not limited to (a) an evaluation of the Company’s ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, (b) the recoverability of principal and interest related to the security, (c) the duration and extent to which the fair value has been less than cost for equity securities, or amortized cost for fixed-income securities, (d) the financial condition, near-term and long-term earnings and cash flow prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions, and (e) the specific reasons that a security is in a significant unrealized loss position, including market conditions that could affect access to liquidity. A decline in the market value of an available-for-sale or held-to-maturity security below its cost or amortized cost that is deemed to be other than temporary results in a reduction in the carrying amount of that security to fair value.
Write-downs for OTTI are recorded as realized losses in the period the security is considered impaired. The Company does not record realized gains for subsequent recoveries in the market value of an impaired security until the security is sold or otherwise disposed of. However, in periods subsequent to the recognition of
an OTTI on a fixed income security, the security is accounted for as if the security had been purchased on the measurement date of the OTTI. That is, the security, based on the new cost basis, will be amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows.
During part of 2005, 2004 and 2003, the Company held interest-only certificates that the Company has determined contain an embedded derivative instrument as defined by Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” These certificates paid a variable rate of interest that was inversely related to the London Interbank Offered Rate (“LIBOR”).
Deferred policy acquisition costs (“DAC”) (carried on the accompanying Consolidated Balance Sheets in other assets) include commissions, premium taxes and other costs incurred in and that vary with premium
generation. These costs are deferred and amortized over the period in which the related premiums are earned, typically one year. Future investment income has been considered in determining the recoverability of deferred costs.
Claims-made policies provided by the Company include coverage for extended period reporting claims in the event of the death, disability or retirement (“DD&R”) of the insured. The reserve associated with this DD&R benefit is recognized during the term of the original claims-made policy and is based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of future premiums associated with this coverage. The amount of this reserve is $15.0 million and $14.0 million at December 31, 2005 and 2004, which includes a discount of approximately $5.7 million and $5.9 million at December 31, 2005 and 2004, respectively, related to the present value calculation. The reserve for DD&R benefits is included in unpaid loss and loss adjustment expenses in the accompanying Consolidated Balance Sheets. Changes in this reserve are charged or credited to income in the period in which the changes first become known.
Reinsurance premiums and losses related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Reinsurance recoverables and prepaid reinsurance premiums are accounted for in accordance with SFAS No. 113, “Accounting and Reporting for Reinsurance.” Premiums ceded to other companies have been reported as a reduction of premium income. Reinsured losses are reported as a reduction of gross losses incurred. The reserve for unpaid losses and loss adjustment expenses is presented gross of recoverables from reinsurers, which are included in the amounts recoverable from reinsurers.
The Company’s reinsurers are reviewed for financial solvency, at least quarterly. This review includes, among other quantitative and qualitative factors, a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2005 and 2004, the Company has established an allowance of $200,000 and $112,000, respectively, for amounts in dispute. See Note 9 for recoverable amounts from individually significant reinsurers.
In 2003, the Company decided that the negative evidence presented by the Company’s recent loss history outweighed the positive evidence regarding the availability of future taxable income. Accordingly, the Company established a full valuation allowance in 2003, which was recorded as federal income tax expense. In 2004, changes in the valuation allowance were allocated to federal income tax expense (which is included as a component of net income), components of comprehensive income, or other components of shareholders’ equity, depending on the nature of the temporary differences that created the change in the valuation allowance. In 2005, after several consecutive quarters of reporting a pre-tax profit, the Company determined that a valuation allowance was no longer necessary and accordingly, reversed the entire deferred tax asset
Concurrent with the initial reversal of the valuation allowance, which resulted in a credit to federal income tax benefit, the Company decreased the federal income tax benefit for the effect of changes in the valuation allowance related to unrealized depreciation on the Company’s available-for-sale investment securities that were lodged in accumulated other comprehensive income. See Note 10 for additional information regarding income taxes, the deferred tax valuation allowance, and the related accounting treatment.
The Company records any “windfall” tax benefits related to employee share-based awards as a credit to additional paid in capital in the year that they are currently deductible in the Company’s consolidated tax return.
Until the Company adopts SFAS No. 123R: “Share-Based Payment,” effective January 1, 2006, it will continue to use the intrinsic value-based method to account for all stock-based employee compensation plans and has adopted the disclosure alternative of SFAS No. 123: “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148: “Accounting for Stock-Based Compensation - Transition and Disclosure.” In accordance with SFAS No. 123, as amended by SFAS No. 148, the Company is required to disclose the pro forma effects on operating results as if the Company had elected the fair value approach to account for its stock-based employee compensation plans. The anticipated effect of the adoption of SFAS No. 123R is more fully described in Note 2. The Company’s policy regarding stock options is to issue options with an exercise price equal to the quoted market price on the date of grant. Accordingly, no compensation expense has been recognized for options granted in 2005, 2004, and 2003. The Company, however, does recognize compensation expense related to restricted stock grants, equal to the quoted market price as of the date of grant, as there is no consideration due from employees for these awards at the date they vest. This expense is recognized on a straight-line basis over the period of vesting, with future compensation expense, net of deferred taxes, reflected as a reduction of shareholders’ equity in the accompanying Consolidated Balance Sheets.
Had compensation expense been determined based on the fair value at the grant date, consistent with the provisions of SFAS No. 123, our net income (loss) and net income (loss) per share would have been impacted as follows for the years ended December 31, 2005, 2004 and 2003:
In management’s opinion, existing stock option valuation models do not provide an entirely reliable measure of the fair value of non-transferable employee stock options with vesting restrictions. In addition, such pro forma disclosures may not be representative of future compensation costs as options may vest over several years and additional grants may be made.
The Company’s investment in PIC-FL was made in conjunction with its decision to exit the Florida medical professional liability market. The intent was for PIC-FL to write as much medical professional liability insurance business as its capital and surplus levels would reasonably support, thereby limiting the Company’s exposure from its obligation under Florida State law to offer tail coverage to policyholders as we non-renewed their policies.
At December 31, 2005 and 2004, PIC-FL’s total assets were approximately $16.1 million and $12.9 million, respectively, and its net premiums earned were $3.3 million and $2.3 million, respectively, for the years then ended. The Company has no future obligations with respect to its investment in PIC-FL, nor do creditors of PIC-FL have any recourse to the general credit of the Company.
On December 31, 2004, the Company consummated a transaction in which PIC-FL’s other investor assumed ownership of 100% of PIC-FL’s outstanding common stock. In exchange for its 49% ownership interest, American Physicians received a $3 million interest-bearing note receivable. During 2005, monthly interest-only payments were made on the note. Principal payments on the note begin in January 2006 and continue every month for seven years thereafter. The note is collateralized by 100% of the outstanding common stock of PIC-FL. Because the note received in exchange for American Physicians ownership interest is secured by the common stock of PIC-FL, the exchange was deemed not to be a sale in accordance with GAAP, but was rather accounted for as a secured borrowing with pledge of collateral. Accordingly, the Company continues to consolidate PIC-FL in accordance with the original assessment made under FIN No. 46R.
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R eliminates the option of accounting for share-based payments using the intrinsic value method and making only pro forma disclosures of the impact on earnings of the cost of stock options and other share-based awards measured using a fair value approach. SFAS No. 123R will require that companies measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (i.e., the requisite service period) which is usually equal to the vesting period. In accordance with the transitional guidance given in SFAS No. 123R, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service period has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123 for either recognition or pro forma disclosure requirements. SFAS No. 123R is effective starting January 1, 2006 for calendar-year public companies.
Under the transitional guidance given in SFAS No. 123R, the Company may choose one of three transition methods. The Company intends to use the modified prospective transitional method upon adoption. Under the modified prospective method, there would be no compensation charge for vested awards that are outstanding on the effective date of SFAS No. 123R. Unvested awards that are outstanding on the effective date would be charged to expense over the remaining vesting period. In addition, SFAS No. 123R requires the Company to make an assumption regarding forfeitures. Historically, the Company has recorded forfeitures as they occur.
SFAS No. 123R requires that a company make a policy decision about whether to recognize compensation cost for an award with only service conditions that has a graded vesting schedule (a) on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards or (b) on a straight-line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). The Company has historically treated its option grants as multiple awards with separate vesting periods, while non-vested stock awards have been amortized on a straight-line basis over the requisite service period for the entire award. However, going forward the Company intends to recognize compensation expense for all stock-based awards as if they were multiple awards with separate vesting periods.
the securities are sold, as are other than temporary impairments for both available-for-sale and held-to-maturity securities in the period the impairment is recorded. These realized gains and losses, however, have also been included in other comprehensive income as unrealized appreciation or depreciation or amortization in either the current period or previous periods, and therefore must be deducted from other comprehensive income in the current period to avoid including them in comprehensive income twice. The amount of net realized gains related to the investment securities that must be deducted from other comprehensive income as a reclassification adjustment was $1.8 million, $4.6 million, and $1.6 million for the years ended December 31, 2005, 2004 and 2003, respectively. The reclassification adjustments for 2005, 2004 and 2003 are net of taxes of $976,000, $2.5 million and $854,000, respectively.
The following table shows the components of net unrealized appreciation on investments, net of deferred federal income taxes included in accumulated other comprehensive income in the shareholders’ equity section of the accompanying Consolidated Balance Sheets at December 31, 2005 and 2004:
The following tables show the Company’s gross, unrealized in the case of available-for-sale securities, or unrecognized for held-to-maturity securities, investment losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 and 2004, respectively.
The estimated fair value of fixed-income securities classified as available-for-sale and the carrying value and estimated fair value of fixed-income securities classified as held-to-maturity at December 31, 2005, by contractual maturity, were:
Proceeds on the sales of investments in bonds totaled $33.0 million in 2005, $154.9 million in 2004, and $43.8 million in 2003. Gross gains of $358,000, $7.5 million and $3.2 million were realized on the sales of investments in bonds for the years ended 2005, 2004 and 2003, respectively. Gross losses of $329,000, $1.3 million and $206,000 were realized on the sales of investments in bonds for the years ended 2005, 2004 and 2003, respectively.
Changes in deferred policy acquisition costs for the years ended December 31, 2005, 2004, and 2003 are summarized as follows:
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2005, 2004, and 2003 was as follows:
The Company has worked over the last few years to reunderwrite risks in virtually all markets. These efforts have resulted in a decrease in the frequency and severity of reported and paid losses that are now beginning to emerge in the loss data used to make actuarial projections of ultimate losses. Accordingly, the favorable development in 2005 was the result of fewer than anticipated reported claims and lower than expected claims settlement costs, especially in the Company’s Ohio and Michigan markets.
The unfavorable development in 2004 includes approximately $4.4 million incurred in connection with the commutation of reinsurance treaties with Gerling Global Reinsurance Corporation. The remaining $1.8 million of unfavorable development relates primarily to the run-off of the Company’s workers’ compensation line of business, partially offset by favorable development from the medical professional liability segment. The unfavorable development on the workers’ compensation line of business is the result of pattern of increasing paid loss severity that emerged in 2004. The increase in paid severity caused management to revise upwards its estimate of ultimate losses on claims reported and incurred but not reported claims. The favorable development on medical professional liability reserves was primarily due to lower than projected paid claim severity, most notably in the Company’s Ohio and Michigan markets.
The gross proceeds from the trust issuances, and the cash from the equity contribution, were used by the trusts to purchase Debentures issued by APCapital. The TPS issued by the trusts have financial terms similar to the floating rate junior subordinated deferrable interest debentures (the “Debentures”) issued by APCapital.
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and three-month LIBOR plus 4.20% for the second trust issuance, payable quarterly. The interest rate is adjusted on a quarterly basis provided that prior to
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation. A reconciliation of direct premiums to pnet premiums, on both a written and earned basis, for the years ended December 31, 2005, 2004, and 2003 is as follows:
The Company’s policy is to enter into reinsurance contracts only with highly rated reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. If the reinsurance company is unable to meet its obligations under existing reinsurance agreements, the Company remains liable for ceded reserves for unpaid losses, loss adjustment expenses and unearned premiums.
The Company had reinsurance recoverables from the following reinsurers at December 31, 2005 and 2004:
The Company commuted its ceded reinsurance treaties with Gerling Global Reinsurance Corporation (“Gerling”) during 2004. The Company recognized the $13.5 million cash settlement received from Gerling as reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) in 2004. In connection with the commutation, the Company released Gerling from its obligations under the treaties, which resulted in a reduction of the Company’s reinsurance recoverables of approximately $17.9 million (thereby increasing losses and loss adjustment expenses incurred). The net effect of the commutation was an increase in losses and loss adjustment expenses of $4.4 million, partially offset by an $837,000 increase in net premiums earned.
Income taxes incurred do not bear the usual relationship to income (loss) before income taxes for the years ended December 31, 2005, 2004, and 2003 due to the following:
The following table reflects the number of shares repurchased during the years ended December 31, 2005, 2004 and 2003, the cost of shares repurchased, the average price per share repurchased during those periods, as well as the cumulative inception to date totals.
The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of December 31, 2005, the Company has 409,869 shares remaining to be purchased under current authorizations.
In addition to the shares above, which were repurchased in connection with publicly announced plans, the Company repurchased 166,017 shares that were tendered in lieu of cash in connection with the exercise of stock options awards in 2004.
In 2003, the Company began to exit its workers’ compensation line of business. A total of twelve employees were terminated and others given incentives to remain to manage the run-off of this line through June 2007. Employee separation costs related to these remaining individuals will be recognized prospectively over the future service period. At December 31, 2005, total future employee separation costs are estimated to be approximately $43,000.
The activity in the liability for termination benefits for the years ended December 31, 2005, 2004 and 2003 was as follows:
In 2004, the Company subleased approximately 10,000 square feet of office space in Chicago, Illinois to an unrelated third party. In 2005, the Company subleased the remaining available 3,000 additional square feet. The difference in the cash flows between the Company’s obligations for the subleased space, in accordance with the original lease terms, and the rent the Company will receive from the sublessor over the next nine years, has been discounted using an interest rate of approximately six-percent, to approximate the fair value of the liability incurred in connection with the contract termination. Other costs incurred in connection with the subleased space, such as broker commissions, were also included in the calculation of the original liability.
In 2004, the $6.0 million obligation to the Company’s former President and CEO was repaid in its entirety in connection with his retirement.
The former President and CEO of the Company is a majority owner of SCW Agency Group, Inc., an agency that sells the Company’s medical professional liability insurance in Michigan, Illinois, Kentucky, Florida and Nevada and workers’ compensation insurance in Michigan, Kentucky and other states. Direct premiums written by the agency during 2005, 2004, and 2003 totaled $63.9 million, $74.4 million, and $75.3 million, respectively, representing, 34.5%, 34.8% and 29.4% of total direct premiums written during such
SCW leased approximately 10,000 square feet of office space from the Company for a portion of 2004 and all of 2003. The Company received $80,000 and $214,000 in rental income in 2004 and 2003, respectively, from the agency related to this leased office space.
The Board of Directors has authorized the American Physicians Capital, Inc. Stock Compensation Plan (the “Plan”). The Plan provides for the award of stock options and stock awards for officers, directors and employees of the Company. These awards must be approved by the compensation committee of the board of directors. The total number of shares of the Company’s common stock which shall be available for options and stock awards is 1,200,000 shares.
Certain executive officers, board members and employees have been granted options to purchase shares of APCapital common stock. Options granted during 2005, 2004 and 2003 vest in annual installments of 33%, 33%, and 34% on the first through the third anniversaries, respectively, of the date of grant. All options expire on the tenth anniversary of the grant date.
In January 2004, the Company issued 30,000 shares of restricted stock to certain employees with a market price at the date of grant of $17.20 per share. The shares granted in 2004 vest annually at a rate of 33%, 33% and 34% in January 2005, 2006 and 2007, respectively, as long as the grantees remain employed by the Company. The Company recognizes compensation cost for the stock awards on a straight-line basis over the period of vesting based on the awards’ intrinsic value.
The following table shows the number of unvested shares outstanding, the number of shares granted, vested and forfeited, as well as the compensation cost recognized in the Consolidated Income Statements related to these awards for each of the three years ended December 31, 2005, 2004 and 2003.
Expected volatilities are based on historical volatility for the Black-Scholes valuation model. Under the binomial lattice model, expected volatility is based on a number of factors, including historical volatility, return on equity, price to book value ratios and trends impacting the medical professional liability insurance industry. We use historical data to estimate option exercise and employee termination behavior within the valuation model. Separate employee groups and option characteristics are considered separately for valuation purposes. The expected term represents an estimate of the period of time options are expected to remain outstanding. The risk-free interest rate is based on the yield of a zero coupon U.S. Treasury security with a remaining term to maturity equal to the contractual term of the option, in the case of the binomial lattice model, and over the expected term for the Black Scholes model.
The Company is obligated under operating leases, which have various expiration dates through October 2013. Minimum future lease payments are as follows: 2006 - $1,092,000; 2007 - $824,000; 2008 - $712,000; 2009 - $702,000 and 2010 and thereafter - $2,607,000. Rental expense was $710,000 in 2005, $1,321,000 in 2004, and $1,615,000 in 2003.
As of September 17, 2004, American Physicians entered into a stock purchase agreement with various shareholders of PICW to acquire a substantial minority interest in PICW. The stock purchase agreement, as amended in November 2004, stated that American Physicians will purchase 4,782 shares of PICW common stock at a purchase price of $3,800 per share in cash, or approximately $18.1 million. On August 31, 2005, American Physicians terminated the stock purchase agreement. Concurrently with the termination, American Physicians withdrew its Form A application pending before the Office of the Commissioner of Insurance of Wisconsin (“OCI”) to acquire the interest in PICW.
Following the termination of the stock purchase agreement, American Physicians purchased from some of the same shareholders a total of 1,942 shares of PICW common stock, representing 9.9% of PICW’s outstanding shares of common stock. The purchase price was $3,800 per share, or approximately $7.4 million. In addition, approximately $200,000 of costs incurred in connection with the acquisition were capitalized, bringing the total cost of the investment to $7.6 million. The purchase of the 1,942 shares was disputed by the OCI.
On December 21, 2005, ProAssurance Corporation filed a plan to acquire all the outstanding shares of the common stock of PICW. The OCI thereafter entered a stay of proceeding relating to the American Physicians’ acquisition of 1,942 shares until the ProAssurance Corporation transaction is either approved or disapproved, and until the conclusion of a reasonable time period for closing that transaction.
American Physicians, APSpecialty and ICA, domiciled in the State of Michigan, are included in the accompanying Consolidated Financial Statements in accordance with GAAP. These organizations are subject to regulation by the State of Michigan Office of Financial and Insurance Services and file financial statements using statutory accounting practices prescribed or permitted by the state insurance regulators. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Such practices vary in certain respects from GAAP. The principal variances are as follows:
Deferred federal income taxes applicable to operations are recorded in income for GAAP, whereas changes in deferred federal income taxes are recorded in surplus for statutory accounting purposes.
A valuation allowance is required under GAAP when it is determined that gross deferred tax assets cannot be realized, in whole or in part. For statutory accounting purposes, the valuation allowance is replaced with a more objective admitted asset test, which is intended to serve the same purpose as the GAAP valuation allowance. This more quantitative approach under statutory accounting can sometimes result in differing amounts of deferred tax assets being carried for GAAP and statutory accounting purposes.
American Physicians’ investment in PIC-FL is not consolidated, but rather, accounted for based on the equity method of accounting.
The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding net realized gains (losses) on the sale of investments, or 10% of statutory surplus as of the preceding year end. Accordingly, as of January 1, 2006, approximately $26.1 million could be paid by the Company’s insurance subsidiaries without prior regulatory approval as dividends totaling $17.3 million have already been paid.
The unaudited operating results by quarter for 2005 and 2004 are summarized below:
The audit referred to in our report dated March 3, 2006 relating to the consolidated financial statements of American Physicians Capital, Inc. and Subsidiaries, which is contained in Item 8 of this Form 10-K included in the audit of financial statement schedules listed in the accompanying index for the year ended December 31, 2005 only. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audit.
In our opinion such financial statement schedules for the year ended December 31, 2005 only, present fairly, in all material respects, the information set forth therein.
In 2003, APCapital issued $30.9 million of floating rate junior subordinated deferrable interest debentures (“Debentures”) to subsidiary trusts. The trusts have issued mandatorily redeemable trust preferred securities that have terms that are essentially the same as the Debentures issued by APCapital, which are the only assets of the trusts. See Note 8 of the Notes to Consolidated Financial Statements for a description of the Debentures and the transactions in which they were issued.
In January of 2004, APCapital made a $25 million cash surplus contribution to American Physicians. Effective March 31, 2004, APCapital contributed the stock of APSpecialty to American Physicians. The statutory surplus of APSpecialty at the date of transfer was $20.5 million. In December 2004, American Physicians paid an $8.0 million dividend to APCapital, which enabled APCapital to make a surplus contribution of $4.0 million to ICA in December 2004. In addition, APIndemnity paid an $800,000 dividend to APCapital in December 2004.