Midwest Holding and its subsidiaries own no real estate. Midwest Holding leases office space in Edina, Minnesota with total square feet of 26,069 and a lease term of six years and two months that expires on November 30, 2005. Midwest Holding also leases 5,018 square feet of office space in West Des Moines, Iowa under a three-year lease that expires on August 31, 2003. Midwest Holding leases an additional 4,610 square feet of office space in Omaha, Nebraska under a five-year lease that expires January 31, 2007. Solutions entered a new five-year lease commencing December 2001 for 8,031 square feet of office space in Plymouth, Minnesota. This lease expires December 31, 2006. Services leases a separate 5,437 square foot facility located in Shoreview, Minnesota. This lease expires March 31, 2006. Annual rent expense was approximately $1,020,000 in 2001 and $895,000 in 2000.
(2) Amounts derived from audited consolidated financial statements of Midwest Holding.
The financial statements of Midwest Holding and its subsidiaries are presented on a consolidated basis. In future references in this analysis, which should be read together with the 2001 audited consolidated financial statements and notes thereto appearing under Item 8 of this Form 10-K, Midwest Holding and its subsidiaries are referred to collectively as the Company unless the reference pertains to a specific entity.
In January 2001, the Company purchased an additional $10,000,000 of the real estate investment trusts (REIT) bringing its ownership interest to approximately 7% of the total REIT shares outstanding. The purchase used proceeds from sales of equity securities and was made to capture the current attractive yield on the REIT, approximately 8.5%, and to reduce the Company's portfolio allocation to equities to a level more consistent with the rest of the medical malpractice insurance industry. The Company believes that this will also help to reduce the volatility in the market value of the total investment portfolio.
The Company's cash flow from operations was $(8,829,000) in 2001 versus $1,544,000 in 2000 and $2,187,000 in 1999. The 2001 cash flow from operations was unfavorably impacted by an increase in claim payments, policyholder dividend payments and premium adjustments paid to reinsurers on reinsurance contracts for prior years. These negative cash flows were partially offset by an increase in premium volume. The 2000 cash flow from operations was favorably impacted by premium adjustments received from reinsurers on reinsurance contracts for prior years and federal tax refunds received from the Internal Revenue Service for the 1992 to 1996 tax years. These positive cash flows were partially offset by the payment of policyholder dividends. The 1999 cash flow from operations was favorably impacted by premium adjustments received from reinsurers on reinsurance contracts for prior years and greater premium received at the end of 1999 due to earlier billing of policies with January 2000 effective dates.
As discussed under the reinsurance section of Item 1 of this Form 10-K, the renewal of Midwest Medical's reinsurance agreement resulted in a rate change effective January 1, 2002. The flat, ceded premium rate increased to 9.75% from 8.75%. Although the terrorist attacks of September 11 did not impact the Company directly, the losses suffered by Midwest Medical's reinsurance partners were a factor in the reinsurance rate increase. The rate change coupled with anticipated new business will result in greater reinsurance costs for Midwest Medical in 2002.
The Company believes that its cash and investments combined with internally generated funds will be sufficient to meet its present and reasonably foreseeable operating and capital requirements. Consequently, borrowing funds from external sources is not anticipated. The Company does, however, maintain a $5,000,000 secured line of credit with its bank in the event of an urgent cash need. The Company had no material capital expenditure commitments as of December 31, 2001.
The increases and decreases in shareholders' equity are described in the consolidated statements of changes in shareholders' equity found in the accompanying audited consolidated financial statements.
2. Rate increases and granting fewer premium discounts increased earned premium by approximately $3,400,000 in 2001.
3. Premiums from reporting endorsements that provide policyholder tail coverage increased earned premium by approximately $1,686,000 in 2001.
4. The estimated reinsurance premium applicable to the treaty years 1992-1994 and 1995-1997, which is based in part on reinsured claims experience, increased $3,125,000 in 2001. This compares to an increase for those treaty years of $634,000 in 2000 resulting in a net decrease in premium between years of $2,491,000.
Net premiums earned decreased $5,239,000 in 2000 from 1999. The decrease was the result of the following significant factors:
Net investment income increased $101,000 in 2001 from 2000 and increased $1,290,000 in 2000 from 1999. The pick-up in yield from the additional purchase of the REIT and lower investment expenses due to the drop in market values of equity securities caused the increase in net investment income in 2001. This was partially offset by lower yields on bonds and short-term investments due to the drop in interest rates during 2001. Increasing yields on bonds and short-term investments from the upward movement in interest rates during 1999 and 2000 primarily caused the increase in net investment income in 2000. Also contributing to the increase were proceeds from the sales of equity securities used to pay Class A shareholders for stock restructure redemptions. The proceeds earned interest while held in short-term investments until stock restructure payments were made.
Realized capital gains decreased $3,931,000 to $6,571,000 in 2001 and increased $3,282,000 to $10,502,000 in 2000. During 2001, sales of equity securities realized $6,752,000 of net capital gains while sales of bonds realized $(181,000) of net capital losses. Approximately $3,000,000 of the net realized capital gains on equity securities resulted from the sale of common stocks in the first quarter to fund the additional REIT purchase of $10,000,000. All other 2001 realized capital gains and losses resulted from the management of the portfolio on a pre-tax total return basis. During 2000, sales of equity securities realized $12,245,000 of net capital gains while sales of bonds realized $(1,743,000) of net capital losses. Approximately $7,000,000 of the net realized capital gains on equity securities resulted from the sale of appreciated technology common stocks in the first quarter as holdings in the technology sector were trimmed in order to maintain appropriate portfolio diversification. Another $3,000,000 of net realized capital gains resulted from sales of equity securities in the latter part of 2000 to fund stock restructure redemption payments to Class A shareholders. All other 2000 realized capital gains and losses resulted from the management of the portfolio on a pre-tax total return basis.
Losses and loss adjustment expenses are the costs associated with the settlement of insurance claims and are the Company's principal expense. Incurred loss and loss adjustment expenses were $58,299,000 in 2001 compared to $39,587,000 in 2000 and $41,468,000 in 1999. This resulted in an increase of 47.3% in 2001 versus a decrease of 4.5% in 2000. As shown in Note 6 to the audited consolidated financial statements, the current year's provision for loss and loss adjustment expense, which is based upon policyholder exposure, expected frequency of losses, and severity of losses, increased by $10,664,000 in 2001 compared to $1,521,000 in 2000. The significant increase in 2001 was primarily driven by additional policyholder exposure from the increase in premium volume and the increase in Midwest Medical's retention from $750,000 to $1,000,000 per insured for the primary layer of coverage. Also, a conservative loss position was taken since a significant portion of the increase in premium volume came from newer business lines, such as large, healthcare systems and hospitals. Losses and loss adjustment expenses also include adjustments of prior years' estimates. These adjustments to the liability for loss and loss adjustment expense are evaluated by management and supported by an outside actuarial review performed at the conclusion of the year. As shown in Note 6 of the audited consolidated financial statements, these evaluations resulted in a small increase of $172,000 in 2001 in the estimated liabilities applicable to prior years versus a reduction of $7,876,000 in 2000. The less favorable development on prior years resulted primarily from an increase in claims severity.
Policyholder dividends of $4,050,000 were declared by the Board of Directors of Midwest Medical in 2001 and will be paid to physician and clinic policyholders in 2002. Policyholder dividends of $8,108,000 and $10,175,000 were declared in 2000 and 1999, respectively, and were paid to physician, clinic and hospital policyholders the following year. The $4,050,000 policyholder dividend declared in 2001 will be awarded proportionately based on annual premiums for physician and clinic policyholders that were insured by Midwest Medical in 1997 and remain insured throughout 2002. The dividend will be paid in four equal installments in February, May, August and November of 2002. The decrease in policyholder dividends is primarily due to less favorable loss experience on the 1997 coverage year on which the 2001 policyholder dividend was based. Policyholder dividends represent a return of prior years' profits that were greater than anticipated due to favorable claims and investment experience.
Other operating expenses increased $2,415,000 from $4,407,000 in 1999 to $6,822,000 in 2000. The stock restructure of Midwest Holding caused an additional $1,057,000 of compensation expense to be recognized in 2000 for the vesting of all previously unvested Class A shares. Legal and accounting fees related to the restructure contributed another $201,000. The remaining increase was largely from greater salary and benefit expenses incurred by Midwest Holding, Services and Solutions primarily to service additional business volume.
Income from continuing operations before income taxes increased to $6,022,000 in 2000 compared to $3,919,000 in 1999. Greater realized capital gains from sales of domestic equity securities to maintain appropriate portfolio diversification and to fund the stock restructure primarily drove the increase. Interest on federal tax refunds, favorable development on prior years' loss liabilities and lower policyholder dividends also contributed to the increase. This was partially offset by lower net premiums earned and an increase in other operating expenses.
Income taxes decreased $2,659,000 resulting in an income tax benefit of $(2,222,000) for 2001 compared to an income tax expense of $437,000 for 2000. The effective tax rates for 2001 and 2000 were 34.5% and 7.3%, respectively. The principal factor in the increase in the effective tax rate was a recovery of prior year taxes recorded in 2000. The tax recovery in 2000 was primarily due to federal tax refunds received by Midwest Medical from the Internal Revenue Service for the 1992 to 1996 tax years.
Income taxes decreased $844,000 to $437,000 for 2000 compared to $1,281,000 for 1999. The effective tax rates for 2000 and 1999 were 7.3% and 32.7%, respectively. The principal factor in the decrease in the effective tax rate was a greater recovery of prior year taxes recorded in 2000 compared to 1999.
Net (loss) income recorded by the Company decreased $(9,887,000) to a net loss of $(4,601,000) in 2001 and increased $3,550,000 to net income of $5,286,000 in 2000 due to the factors discussed above.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, in addition to the factors discussed in this Form 10-K, there are or will be other significant factors that could cause actual results to differ materially from those indicated in such statements. These factors include but are not limited to:
1. the impact of changing market conditions on the Company's business strategy;
The above factors should be considered in connection with any forward-looking statement contained in this Form 10-K. The significant factors that could affect such forward-looking statements are subject to change, and the Company does not intend to update any forward-looking statement or the above list of significant factors. By this cautionary note, the Company intends to avail itself of the safe harbor from liability with respect to forward-looking statements provided by Section 27A and Section 21E referred to previously.
We have audited the accompanying consolidated balance sheets of Midwest Medical Insurance Holding Company and Subsidiaries (the Company) as of December 31, 2001 and 2000 and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statements and schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Midwest Medical Insurance Holding Company and Subsidiaries at December 31, 2001 and 2000 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The Company, through its subsidiary Midwest Medical and its predecessors, has been providing professional liability insurance to physicians in the Midwest since October 1980. The current structure of the Company is the result of a reorganization in 1988 followed by two business combinations with other insurers. In 1993, the Company merged with Iowa Physicians Mutual Insurance Trust. In 1996, the Company merged with Medical Liability Mutual Insurance Company of Nebraska. Each combination was accounted for as a pooling-of-interests.
During 1997, the Company formed Solutions as a business development company to strengthen and promote the independence and interdependencies of physicians, clinics and hospitals that the Company serves. Business development opportunities being pursued include practice enhancement, strategic consulting and technology services and support.
In January 1998, Solutions purchased the assets of MedPower Information Services, Inc. Solutions then contributed those assets to its newly formed, wholly-owned subsidiary, Medpower Information Resources, Inc. MedPower was subsequently sold effective July 31, 2001. MedPower processed and electronically submitted medical claims for a network of over 100 provider entities (See Note 2).
Midwest Holding provides management and administrative services to Midwest Medical and Solutions for a fee generally equal to the cost of services provided. Services operates independently with its own management and administrative staff and therefore does not have a management agreement with Midwest Holding.
Midwest Medical provides professional liability insurance to physicians, clinics, hospitals and healthcare systems in Minnesota, Iowa, Nebraska, North Dakota, South Dakota, Wisconsin and Illinois. Insurance policies issued by Midwest Medical are on a "claims made" basis and provide coverage for the policyholder for claims first made against the policyholder and reported to Midwest Medical during the policy period for claims which occurred on or after the retroactive date stated in the policy.
The Company manages its investment portfolio to achieve its long-term investment objective of providing for the financial stability of the Company through preservation of assets and maximization of total portfolio return. Although management believes the Company has the ability to hold its fixed maturity investment portfolio to maturity, these investments are classified as "available for sale," as management may take advantage of opportunities to increase total return through sales of selected securities in response to changing market conditions.
Short-term investments are principally money market funds and commercial paper with maturities of less than one year. Short-term investments are recorded at cost, which approximates fair value.
When evidence indicates a decline, which is other than temporary, in the underlying value or earning power of individual investments, such investments are written down to fair value by a charge to income.
As mentioned in Note 1, the Company sold all of the capital stock of MedPower to ClaimLynx, Inc. effective July 31, 2001. Proceeds from the sale were $150,000. The Company recorded a $240,000 loss on the sale, net of an income tax benefit of $124,000. No significant assets or liabilities of MedPower remain as of December 31, 2001. The Company's consolidated statements of income separately disclose, as discontinued operations, the operating results and sale of MedPower, net of tax. Prior periods have been restated accordingly.
In accordance with the Articles of Incorporation and By-laws of Midwest Holding, only active policyholders of Midwest Medical owned shares of Class A Common Stock of Midwest Holding. At each meeting of the shareholders, every Class A shareholder having the right to vote was entitled to one vote, either in person or by proxy, regardless of the number of Class A shares held by the individual.
Like the Class A shares, Class C shares are not publicly or privately traded. The Class C shares provide all shareholders with the same voting rights as the Class A shares. Class C shareholders, however, do not accrue additional shares and the Class C shares have no redemption value. Issuance of Class C shares are not subject to any vesting requirements. In the event of a liquidation, sale, or similar transaction, Class C shareholders would participate in the proceeds according to a distribution formula developed by the Board of Directors. This formula takes into account the underwriting risk classification and years of coverage of each shareholder. As this is the same distribution formula that was previously applicable to Class A shares, Class C shareholders retained the same percentage ownership after the exchange as they had before the exchange. Class C shares are returned to Midwest Holding upon termination of the shareholder's insurance coverage with Midwest Medical.
The cost (amortized cost for fixed maturities) and fair value of available for sale investments are as follows:
In 1999, Midwest Medical instituted a policyholder dividend program that replaced the previous retrospective premium credit program for physicians. To implement the program, Midwest Medical issued participating policy endorsements to all active physician, clinic and hospital accounts during 1999 and 2000. Participating policies represented approximately 96% of total premiums in force and premium income at December 31, 2001 and December 31, 2000. Dividends declared for the years ended December 31 are as follows:
The reconciliation of the liability for unpaid losses and loss adjustment expenses is as follows:
The deferred income tax provision includes the following differences between financial and income tax reporting:
The Company made income tax payments of $655,000, $2,298,000 and $1,751,000 in 2001, 2000 and 1999, respectively.
To reduce overall risk, including exposure to large losses, Midwest Medical participates in various reinsurance programs. Midwest Medical would only become liable for losses in excess of its retention limits in the event that any reinsuring company were unable to meet its obligations under the existing agreement. Management is not aware of any such default at December 31, 2001. Midwest Medical evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Reinsurance recoverables on paid and unpaid losses of $8,167,000 and $15,117,000 are associated with a single reinsurer, General Reinsurance Corporation, at December 31, 2001 and 2000, respectively. Midwest Medical also holds collateral under related reinsurance agreements in the form of letters of credit totaling $4,399,000 that can be drawn upon in the event the applicable reinsuring company is unable to pay its obligation to Midwest Medical.
The effect of reinsurance on premiums written and earned for 2001, 2000 and 1999 is as follows:
Accounting principles generally accepted in the United States differ in certain respects from the accounting practices prescribed or permitted by insurance regulatory authorities (statutory basis).