The selected financial data presented below for the fiscal years ended December 31 should be read in conjunction with FPIC’s consolidated financial statements and the notes thereto, which are included in Item 8, herein. For additional information with respect to FPIC’s business see Item 7, Management’s Discussion and Analysis of Financial Condition and Result of Operations.
The competitive environment in which FPIC operates, including reliance on agents to place insurance, physicians electing to practice without insurance coverage, related trends and associated pricing pressures and developments;
The dependence of the reciprocal management segment upon a single major customer, Physicians Reciprocal Insurers (“PRI”), for the preponderance of its revenue and consequently, the effect of rates and claims experience on PRI’s ability to maintain or grow its premium base;
Risk factors associated with the impact of rising interest rates on the market value of FPIC’s investments;
Rates, including rates on excess policies, being subject to or mandated by legal requirements and regulatory approval, which could affect our business or reinsurance arrangements;
Uncertainties relating to government and regulatory policies (such as subjecting FPIC to insurance regulation or taxation in additional jurisdictions or amending, revoking or enacting any laws, regulations or treaties affecting our current operations);
Changes in our financial ratings resulting from one or more of these uncertainties or other factors and the potential impact on our agents’ ability to place insurance business on behalf of FPIC; and
The words “believe,” “anticipate,” “foresee,” “estimate,” “project,” “plan,” “expect,” “intend,” “hope,” “should,” “will,” “will likely result” or “will continue” and variations thereof or similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. FPIC undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
Frequency and severity trends (numbers of claims and how much we will pay for each claim on average for one or more periods);
Frequency of claims closed with indemnity payments (the percentage of claims received that ultimately result in a loss payment versus those that are settled and closed without a loss payment);
In addition, due to the relatively small number of claims and the average cost per claim, any change in the trends assumed in the ultimate values for these factors may be expected to result in a significant change in the reserve estimates. Because our aggregate loss and LAE reserves are so large, this also means that virtually any change in the level of our carried reserves will be material to results of operations and may be material to our financial position. As an example, a 1% increase or decrease in carried reserves, net of reinsurance, as of December 31, 2003, would result in an after-tax addition or reduction in reported net income of nearly $2 million, or 12% of our consolidated net income for the year ended December 31, 2003. A typical range of reasonable values for MPL reserve estimates is considered to be as wide as 15%; thus, our results of operations and financial position are very sensitive to our reserve estimates and judgments, in addition to the performance of the business itself.
Reinsurance does not relieve us from our primary obligations to policyholders. Therefore, the failure of reinsurers to honor their obligations could result in losses to us. The amounts recoverable from reinsurers on our unpaid losses and LAE are calculated by applying the terms of the respective ceded reinsurance contracts to our estimates of the underlying loss and LAE reserves that are subject to reinsurance. Thus, to the extent our reinsured reserves change or are adjusted, so will the related reinsurance recoverable amounts and our exposure.
A valuation allowance against deferred tax assets is estimated and recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. Valuation allowances are based on estimates of taxable income and the period over which deferred tax assets will be recoverable. We estimate and believe it is more likely than not that our deferred tax assets will be fully realized. In the event that actual results differ from our estimates or those estimates are adjusted in future periods, we may need to establish a valuation allowance, which would impact our financial position and results of operations.
We have obtained independent appraisals annually since the adoption of FAS 142, the most recent of which was performed as of December 31, 2003, which indicate that our goodwill and other intangible assets are fully recoverable. Our remaining goodwill and intangible assets of $19.7 million will continue to be subject to impairment testing through independent appraisal or otherwise at least annually, and potentially more often should a triggering event occur. A triggering event under FAS 142 might include such things as a significant adverse change in legal factors or business climate, an adverse action or assessment by a regulator, unanticipated competition, or a loss of key personnel.
There is an exception to the treatment noted above if and when an investment security considered to be available for sale is deemed to be other-than-temporarily impaired. An other than temporary impairment may occur when the market value of a security falls below its cost by a material amount for an extended period of time (generally one year but can be less under certain circumstances) or when other creditworthiness issues arise with regard to an issuer. If and when a security is deemed to be other than temporarily impaired it is written down to its estimated market value with a corresponding realized investment loss recognized in net income.
Some of our assumed reinsurance agreements with Physicians’ Reciprocal Insurers (“PRI”) for the year ended December 31, 2001 and prior, contained adjustable premiums based upon loss experience. Our financial statements for the year ended December 31, 2001, included estimated adjustments accrued based on our loss experience under these agreements. These agreements have since been non-renewed, amended or commuted. The assumed reinsurance agreements with PRI for periods since then are fixed premium contracts with no such adjustable features. See the following MD&A section.
Administrators for the Professions, Inc. (“AFP”) has a 10-year management agreement with PRI, under which it receives a management fee annually equal to 13% of PRI’s direct premiums written. The current term of the management agreement runs through December 31, 2008. Under the terms of the management agreement, AFP receives this fee in exchange for performing services necessary to conduct and manage the entire operation of PRI. Such services include all or substantially all marketing, underwriting, policy issuance, policy administration, investment management, claims handling, and general and administrative functions, including human resources, accounting, financial reporting, and others, on an on-going basis over the life of the agreement. AFP is also reimbursed by PRI for certain expenses paid on PRI’s behalf. The expenses reimbursed by PRI are principally salaries and related payroll expenses, and overhead costs associated with claims, legal and risk management course personnel employed by AFP who work on PRI business.
The assumed reinsurance and fronting fees on PRI business of First Professionals are included in the Insurance Segment and are also discussed further in the following applicable sections of this MD&A. Additional financial information and disclosures about our assumed reinsurance and fronting fees from PRI can be found in Note 22, Related Party Transactions to our consolidated financial statements.
In addition to their contributions to our results of operations, our agreements and business arrangements with PRI as a major client of ours also means that our revenues and results of operations are financially sensitive to its revenues and financial condition. We do not own PRI, or have a controlling financial interest in PRI, nor is PRI considered a variable interest entity under FIN 46R, Consolidation of Variable Interest Entities (as Revised), and so PRI’s financial statements are not consolidated or included in ours. Instead, PRI is similar to a mutual insurer and the risks and rewards of ownership vest with the policyholders of PRI.
Despite the unique aspects of the business and regulatory environments PRI operates in, as an MPL insurer, it is still subject to many of the same types of risks as those of other MPL and property-casualty insurers, including similar risks to many of those described under “Safe Harbor Disclosure.”
Net income in 2003 increased to $16.6 million, or $1.71 per diluted share, up 11% and 8%, respectively over income before accounting change of $14.9 million and $1.58 per diluted share for 2002. Income before accounting change for 2002 was up over 400% compared with 2001 net income of $2.9 million, or $0.31 per diluted share. All three of our business segments were profitable in 2003. The year 2003 was the third year in a row of significant improvements in insurance pricing. In addition, our reciprocal management and third party administration (“TPA”) segments have reported improved profits.
For the year ended December 31, 2002, we reported a net loss of ($14.7) million, or ($1.56) per diluted share, compared to net income of $2.9 million, or $0.31 per diluted share, for the year ended December 31, 2001. Our net loss for 2002 includes a $29.6 million after-tax ($48.4 million pre-tax) charge for the cumulative effect of accounting change related to the adoption of FAS 142 on goodwill and other intangible assets. The transitional impairment charges, resulting from the adoption of FAS 142, were associated entirely with our non-insurance segments. Our income before the cumulative effect of accounting change was $14.9 million, or $1.58 per diluted share, for the year ended December 31, 2002.
During 2003, we completed the placement of $10.0 million in senior notes and created three trusts that issued 30-year trust preferred securities for which the proceeds from such issuances together with cash previously contributed to the trusts were used to purchase junior subordinated debentures from FPIC totaling $36.1 million. We used the proceeds along with other internally generated funds to retire our bank term loan and revolving credit facility. We also completed the integration of APAC operations and transitioned the management of APAC and Intermed Insurance Company (“Intermed”) into First Professionals. During the fourth quarter 2003, we negotiated and completed the commutation of our reinsurance with Gerling Global Reinsurance Corporation of America (“Gerling”). We also negotiated our primary excess of loss reinsurance program renewal for 2004 at a reduced cost for the first time in several years. Finally, we played an active part in tort reform on behalf of our policyholders, as well as the healthcare economy and the citizens of the State of Florida.
Our total revenues for the year ended December 31, 2002 increased 12% to $221.9 million from $197.6 million for the year ended December 31, 2001. The increase in revenues was primarily the result of price improvements on our core MPL business and growth in the number of policyholders. Net premiums earned on our MPL business increased 23% to $148.6 million for the year ended December 31, 2002 from $120.5 million for the year ended December 31, 2001. Revenues earned by our reciprocal management segment increased $2.4 million primarily as the result of an increase in claims administration and management fees earned. In addition, brokerage commissions earned by FPIC Intermediaries increased when compared with the prior year.
Our total expenses for the year ended December 31, 2002 increased less than 1% to $198.2 million from $196.5 million for the year ended December 31, 2001. Net losses and LAE incurred for the year ended December 31, 2002 increased $11.2 million or 9% when compared with the year ended December 31, 2001. Net losses and LAE incurred on our MPL business increased 17% to $137.7 million for the year ended December 31, 2002 from $117.4 million for the year ended December 31, 2001. Net losses and LAE incurred in 2002 were also reduced by losses and LAE incurred of $39.0 million that were ceded under the net account quota share reinsurance agreement with Hannover Re (“Hannover Re agreement”). The increase in net losses and LAE incurred for the year ended December 31, 2002, reflects the growth in our business, taking into consideration expected loss trends. The increases in total expenses were offset primarily by ceding commissions related to the Hannover Re net account quota share reinsurance agreement and our adoption of FAS 142. The adoption of FAS 142 eliminated amortization expense of approximately $3.5 million for the year ended December 31, 2002.
We plan to continue to focus on growing our insurance capital base and to work to reduce the additional reinsurance we are now carrying so that we can retain and grow this business for our own account.
A great deal of the progress we made has been possible in large part because of favorable market conditions we experienced since the end of 2000. Therefore, one of the most obvious risks to our ability to continue this level of performance would be an unexpected increase in competition resulting in a softening of the market and leading to downward pressure on our insurance rates and profits. There can be no assurance as to how long the current stable market conditions will continue.
Average net paid loss per professional liability claim closed with indemnity payment
Insurance segment net income decreased 19% for the year ended December 31, 2003. The decrease for the year was the result of lower net realized investment gains, lower net investment income, higher debt-related costs, and higher net intersegment expenses, comprised mainly of commissions payable to the reciprocal management segment. The holding company, which is grouped with the insurance segment for reporting purposes, incurred debt-related costs of $1.5 million after income taxes ($2.5 million before income taxes) during 2003 as a result of unwinding interest rate swap agreements in the second and fourth quarters in connection with the repayment and retirement of our term loan and revolving credit facility. Our improved underwriting margin (defined as net premiums earned less net losses and LAE and other underwriting expenses) of $5.2 million after tax ($8.5 million before income taxes) is mostly attributable to pricing improvements. Approximately $1.3 million of the after-tax improvement ($2.2 million, pre-tax) in 2003 is attributable to the Hannover Re agreement.
Net premiums earned, net losses and LAE incurred and other underwriting expenses, all declined (-13%, -15% and -41%, respectively) for the year 2003, primarily as a result of the reinsurance ceded under the Hannover Re agreement, which became effective July 1, 2002, and other growth management initiatives put into place in 2002.
Net premiums written decreased 5% to $140.2 million for the year ended December 31, 2002 from $147.1 million for the year ended December 31, 2001. The decline in net premiums written is related to the Hannover Re agreement effective July 1, 2002 between our largest subsidiary, First Professionals, and two companies of the Hannover Re group.
Net premiums earned, net losses and LAE incurred, and other underwriting expenses incurred were reduced by amounts ceded under the Hannover Re agreement of $87.3 million, $71.0 million and $22.1 million, respectively, for the year ended December 31, 2003, and by $48.2 million, $39.0 million and $12.8 million, respectively, for the year ended December 31, 2002. Before the amounts ceded under the Hannover Re agreement, net premiums earned, net losses and LAE and other underwriting expenses increased in 2003 by $19.1 million (10%), $11.3 million (6%), and $1.4 million (4%), respectively.
The growth in net premiums earned and related increases in loss costs and other underwriting expenses in 2003 before the Hannover Re agreement were primarily the result of pricing improvements. The year 2003 marks the third consecutive year that First Professionals, APAC and Intermed have implemented significant rate increases. These price improvements also contributed to the increase in net premiums earned, excluding the Hannover Re agreement, in contrast to the significant decline in the number of professional liability policyholders for all companies combined by nearly 3,000, or 18%, to 13,919 as of December 31, 2003 from 16,915 as of December 31, 2002. Of this decline, the sale of the renewal rights to the Interlex legal professional liability book of business in 2002 accounted for approximately 1,800 fewer policies. The remaining declines occurred in non-core states and in Missouri as we freed up capacity, with a view towards using it for First Professionals’ core MPL business in Florida. The declines in Missouri were expected as we implemented a very large rate increase in 2003.
The number of claims with an indemnity payment (“CWIP”) during 2003 also decreased 3% from 2002’s CWIP claims. The percentage of CWIP to all closed claims for 2003 was 13%, or 1 percentage point higher than the 2002 CWIP percentage of 12%. Our 2003 and 2002 CWIP percentages are significantly lower than 2001’s CWIP percentage of 18%. This significant improvement is largely the result of claims management initiatives implemented beginning in 2001, and the implementation of more restrictive underwriting and risk selection criteria. The average net paid loss per indemnity claim closed with payment increased 16% in 2003, which although higher than our assumed loss trend, can be attributed to the effects of the annual aggregate deductibles under our 2000 and 2001 excess of loss reinsurance treaties and the impact of now retaining a portion of our excess of loss reinsurance as a result of the Gerling commutation. It should also be noted that all of our loss and LAE data presented above is calendar year information and, thus can fluctuate above and below the long-term coverage year assumptions used in estimating our loss and LAE reserves from period to period.
Our other underwriting expenses were $11.2 million, or 41% lower in 2003 than 2002. The ceding commission under the Hannover Re agreement, which is a credit to other underwriting expenses, increased $9.8 million from $13.2 million in 2002 to $23.1 million in 2003. Other underwriting expenses, excluding the effects of the Hannover Re agreement, increased $1.4 million, or 4%. This increase compares favorably with the corresponding increase in net premiums earned and is indicative of an overall gain in productivity. The ratio of other underwriting expenses to net premiums earned before the effects of the Hannover Re agreement decreased from 16% to 15%.
Other underwriting expenses decreased 26% to $19.2 million for the year ended December 31, 2002 from $25.9 million for the year ended December 31, 2001. The decline in other underwriting expenses is attributable to ceding commissions recognized under the terms of the Hannover Re agreement in the amount of $13.2 million. In addition, First Professionals, our largest insurance subsidiary, performed a study of its 2001 expenses incurred in the administration of claims and based on the results of this study, decreased the amount of expenses allocated to LAE in 2002.
Net investment income declined 9% to $20.8 million for the year ended December 31, 2002 from $22.9 million for the year ended December 31, 2001. The decline in net investment income was primarily due to lower prevailing interest rates and reduced yields on fixed income investments, beginning in the second half of 2001. We also continued to hold significant funds in short-term invested cash in anticipation of possible improvements in fixed income rates rather than committing those funds to longer-term investments at historically low yields. The effects of historically low yields have been offset at least to some extent by growth in cash and invested assets.
Also included in 2003 net realized gains and losses were charges of $5.3 million for other-than-temporary impairments (“OTTI”) of two private equity holdings. Included in the OTTI charge was $4.5 million related to our investment in American Professional Assurance, Ltd. (“APAL”). Plans were put into place during the second quarter of 2003 to transition management of our APAC insurance subsidiary to First Professionals and to non-renew our existing management agreement with APA Management, Inc. (“APAM”) and our 25% quota share reinsurance agreements with APAL effective December 31, 2003. The 25% quota share reinsurance agreements with APAL comprise a significant component of its revenues. In addition to this anticipated decline in future revenues, APAL reported net losses and declines in shareholder’s equity in its most recent financial statements provided to FPIC during the second quarter of 2003.
As of December 31, 2003, our consolidated investment portfolios of bonds and U.S. Government securities and equity securities had net unrealized gains of $6.5 million (comprised of gross unrealized gains of $9.5 million and gross unrealized losses of $3.0 million.) As of December 31, 2002, our consolidated investment portfolios of bonds and U.S. Government securities and equity securities had net unrealized gains of $11.8 million (comprised of gross unrealized gains of $13.3 million and gross unrealized losses of $1.5 million.)
The increase in interest expense on debt for the year 2003 as compared with 2002 is primarily due to charges of $2.5 million included in 2003 expense to unwind swap agreements associated with the pay down and retirement of our former bank credit facility. This was offset by the lower total borrowing costs, as compared with the former bank credit facility, of FPIC’s newly issued junior subordinated debentures and unsecured senior notes and the recapture of the amortization of unrealized losses of previous interest rate swap agreements.
The increase in other expenses in 2003 is due to growth of the funds withheld by us under the Hannover Re agreement and the corresponding finance cost in the form of interest credited to Hannover Re on those funds of $4.5 million and $1.1 million for the year ended December 31, 2003 and 2002, respectively. Other expenses increased 49% to $1.6 million for the year ended December 31, 2002 from $1.1 million for the year ended December 31, 2001. The increase in other expenses is due to the interest related to the Hannover Re agreement, partially offset by a decline in amortization expense due to our adoption of FAS 142. In accordance with FAS 142, we ceased the amortization of goodwill and indefinite lived intangible assets during the first quarter of 2002.
Our reciprocal management segment is made up of AFP, our New York subsidiary, and its two wholly owned subsidiaries, FPIC Intermediaries and Group Data. AFP acts as administrator and attorney-in-fact for PRI, the second largest medical professional liability insurer for physicians in the state of New York. FPIC Intermediaries acts as a reinsurance broker and intermediary in the placement of reinsurance for PRI and FPIC. Group Data acts as a broker in the placement of annuities for structured settlements. The segment also includes the business of PMA, an 80% owned subsidiary (70% owned prior to January 1, 2003.) PMA provides brokerage and administration services to PRI for professional liability insurance programs. PRI owns 10% of PMA. Additional information about our management agreement and other business with PRI appears in the preceding section of this MD&A, Business with PRI. Financial and selected other data for the reciprocal management segment for the years ended December 31, 2003, 2002, and 2001 is summarized in the table below. Dollar amounts are in thousands.
Reciprocal management income before cumulative effect of accounting change increased during the year ended December 31, 2002, primarily due to higher management fees and commission income. The growth in these revenues was the result of growth in 2002 of premiums written at PRI and higher ceded premiums at PRI and our insurance companies, which are co-brokered by FPIC Intermediaries. Also contributing to the higher 2002 income before cumulative effect of accounting change were lower total expenses due to ceasing the amortization of goodwill, previously recognized in other expenses, in accordance with the adoption of FAS 142 during the first quarter of 2002.
The reciprocal management segment recorded a transitional impairment charge of $24.4 million, after income taxes, during the first quarter of 2002, as a result of the adoption of FAS 142. This transitional impairment charge is accounted for as a cumulative effect of accounting change. The non-cash transitional impairment charge primarily reflects certain intangibles and synergies, which, in our opinion, are opportunistic in nature and carry a significant degree of uncertainty; therefore, we treated these intangibles conservatively in the valuation required by FAS 142.
The increase in commission income for the years ended December 31, 2003 and 2002 is primarily due to increases in co-brokerage commissions earned by FPIC Intermediaries from third party reinsurers for the placement of reinsurance and by PMA based on growth in the insurance program it manages for PRI in Pennsylvania. FPIC Intermediaries’ brokerage commissions are determined as a percentage of reinsurance premiums ceded and have increased significantly as the underlying ceded premiums have grown at both our insurance subsidiaries and PRI, for which FPIC Intermediaries participates in the placement of reinsurance. In addition, commission income of approximately $0.5 million was recognized in 2002 as a result of a brokerage fee earned from Hannover Re related to the placement of our net account quota share reinsurance agreement. Additional information about FPIC Intermediaries and its business with PRI appears in the preceding section of this MD&A, Business with PRI.
The increase reported in reciprocal management expenses for the year ended December 31, 2003 is due to the combination of an increase in operating expenses at AFP to manage growth at PRI and an increase in operating and commission expenses at PMA associated with an increase in premiums written and placed on behalf of PRI.
Our TPA segment’s income before cumulative effect of accounting change increased during the year ended December 31, 2003, primarily due to higher claims administration fees and improved operating margins. Growth in the number of covered members serviced by the ambulance service organization to which we provide administrative services along with cost savings and productivity initiatives helped improve our margins in 2003.
TPA income before cumulative effect of accounting change increased during the year ended December 31, 2002, primarily due to improved operating margins and lower total expenses. Operating margins improved through a combination of cost saving and productivity initiatives and pricing improvements. Total expenses for the year ended December 31, 2002 decreased primarily due to ceasing the amortization of goodwill, previously recognized in other expenses, in accordance with the adoption of FAS 142 during the first quarter of 2002. The TPA segment recorded a transitional impairment charge of $5.2 million, after income taxes, during the first quarter of 2002, as a result of the adoption of FAS 142. This transitional impairment charge is accounted for as a cumulative effect of accounting change. The non-cash transitional impairment charge primarily reflects changes in market conditions and an increase in competition in recent years in the markets served by the TPA segment.
Claims administration fees earned by EMI are classified with claims administration and management fees in our consolidated statements of income. The increase in claims administration fees in 2003 is primarily due to an increase in the number of members serviced by the ambulance service organization to which we provide administrative services and to a lesser extent, improvements in pricing.
Cash and investments increased $84.0 million to $622.7 million as of December 31, 2003 from $538.7 million as of December 31, 2002. The increase in cash and investments is primarily due to growth in insurance premiums and the cash received from the commutation of reinsurance formerly placed with Gerling, which helped generate net operating cash flows of $89.9 million for the year ended December 31, 2003.
Insurance Assets (Premium Receivables, Reinsurance Recoverable, Ceded Unearned Premiums, and Deferred Policy Acquisition Costs)
Insurance assets, including premiums receivable, reinsurance recoverable and related assets, increased as a group as of December 31, 2003 when compared with December 31, 2002. The growth in our insurance assets is primarily the result of continued growth in the insurance premiums of our core MPL business during 2003.
In keeping with our growth management strategy, we have exited all but one remaining fronting program as of December 31, 2003 or prior. Therefore, we expect the insurance assets and liabilities associated with former fronting programs to level off and begin to decline in the future.
In the fourth quarter of 2003, we successfully negotiated and completed the commutation of reinsurance formerly placed with Gerling. Gerling ceased writing and renewing business voluntarily in the United States during 2002 and we replaced Gerling’s participation in our reinsurance programs beginning in 2003. A. M. Best downgraded Gerling several times during 2003 and ultimately ceased assigning them a rating.
The increases in our insurance liabilities as of December 31, 2003, including the liability for losses and LAE, unearned premiums and reinsurance payable are attributable to growth in our core MPL insurance business.
During 2003, we completed the placement of $10.0 million in senior notes and created three trusts that issued 30-year trust preferred securities for which the proceeds from such issuances together with cash previously contributed to the trusts were used to purchase junior subordinated debentures from FPIC totaling $36.1 million. We used the proceeds along with other internally generated funds to retire our bank term loan and revolving credit facility, make a capital contribution to our insurance operations and unwind hedge agreements related to the revolving credit facility and term loan. The new securities issued mature in 30 years and are described more fully under the section, Liquidity and Capital Resources, below.
The significant decreases in other assets and accrued expenses and other liabilities of approximately $38.2 million and $37.9 million, respectively, as of December 31, 2003, are primarily attributable to purchase and sale transactions involving investment securities, which were entered into prior to December 31, 2002, but for which settlements occurred in January 2003. We did not have similar investment transactions at the end of 2003.
Refer to the applicable section in Liquity and Capital Resources for information about the restricted net assets of our insurance subsidiaries.
FPIC guarantees the floating rate interest and principal obligations under the trust preferred securities issued by its separately created, unconsolidated trusts, which have been established solely for the purpose of issuing the securities. The total principal balance of these trust preferred securities was $35 million as of December 31, 2003. FPIC also carries corresponding junior subordinated debentures on its balance sheet, which debentures were issued to these trusts in exchange for the proceeds raised by the trusts upon their respective issuances of the trust preferred securities. The junior subordinated debentures of FPIC are comprised of the same maturities, floating interest rates and other applicable terms and are the instruments by which FPIC funds the related interest and principal obligations of the unconsolidated trusts. See Note 13, Long Term Debt, Revolving Credit Facility and Term Loan, to the consolidated financial statements for additional disclosures about FPIC’s trusts and junior subordinated debentures.
FPIC has issued an irrevocable letter of credit in the amount of $500,000 as collateral under the operating lease for the building occupied by AFP and PRI in Manhasset, New York. See Note 16, Commitments and Contingencies, to the consolidated financial statements for additional information about this irrevocable letter of credit.
In addition to the above-mentioned letter of credit, FPIC issues irrevocable letters of credit or places assets in trust under its assumed reinsurance contracts with PRI. These assets in trust or letters of credit serve as collateral to corresponding insurance liabilities recorded on our balance sheet and are not considered to be off-balance sheet obligations.
Under our stock repurchase program, we may repurchase shares at such times, and in such amounts, as management deems appropriate. We did not repurchase any shares during the year 2003 and a total of 365,500 shares remain available to be repurchased under the program. On November 10, 2003, we repaid the remaining outstanding balance of our revolving credit facility and retired the credit facility. We are therefore no longer subject to the credit facility’s covenants and restrictions, including the previous restrictions on stock repurchases. However, under certain circumstances, limitations are placed on FPIC’s ability to purchase its capital stock by the terms of agreements relating to its junior subordinated debentures. For information regarding these limitations, refer to Note 13, Long Term Debt, Revolving Credit Facility and Term Loan to the consolidated financial statements. For additional information, see also the discussion of Liquidity and Capital Resources, below.
Our net cash flows from operating activities during the last three years, and in particular, during 2003 and 2002, grew to high levels relative to our historical operating cash flows mainly as the result of unprecedented growth in our insurance business in terms of both increased numbers of MPL policyholders and pricing improvements. As a result of growth management initiatives we have implemented, we do not expect to sustain net cash flows from operating activities at the levels achieved in 2003 and 2002.
Furthermore, liquidity and capital risks can come about as the result of the broader business and financial risks facing us including the uncertainties and factors disclosed in the Safe Harbor Disclosure. Many, if not most of these types of uncertainties, could have a corresponding and materially negative effect on our liquidity and capital resources, as well as our financial condition and results of operations. In order to compensate for such risk, we:
Monitor our reserves and regularly perform actuarial reviews of loss and LAE reserves; and
We established three wholly owned, but not consolidated, trusts, FPIC Capital Trust I, FPIC Capital Statutory Trust II and FPIC Capital Statutory Trust III for the sole purpose of issuing the trust preferred securities. The proceeds received by the three trusts were used to purchase junior subordinated debentures from FPIC of the same amounts, maturities and other applicable terms and features. The debentures issued by FPIC, which are reported as long term debt in the consolidated statements of financial position, to the three trusts are subordinated to all senior indebtedness, including the senior notes, and are equal in standing to one another.
The securities are uncollateralized and bear a floating interest rate equal to the three-month LIBOR plus a spread ranging from 3.85% to 4.2% (the floating interest rates ranged from 5.01% to 5.37% as of December 31, 2003). The floating interest rate will be adjustable quarterly with changes in the three-month LIBOR, and in the case of the first two offerings, the maximum rate that may be charged under the securities within the first five years is 12.5%. We have also purchased hedging instruments designed to maintain the ultimate floating rate interest cost on all of these securities within a stated range for five years from closing. We have the option to call the trust preferred securities at par or its equivalent beginning five years from closing. The trust preferred securities also contain features that allow us the option, under certain conditions, to defer interest payments for up to 20 quarters and to redeem the securities before the first optional call date in five years. In the case of the potential earlier call date, the redemption or call price payable by us may be different than par. The securities have stated maturities of thirty years and are due in May and October 2033.
The net proceeds from the trust preferred securities and senior notes, the application of liquid collateral previously set aside under the terms of our bank debt, and other internally generated funds were used to fully pay down and ultimately retire our bank credit facility and related interest rate swap agreements in the fourth quarter of 2003.
The National Association of Insurance Commissioners has developed risk-based capital (“RBC”) measurements for insurers, which have been adopted by the Florida and Missouri Departments of Insurance. RBC measurements provide state regulators with varying levels of authority based on the adequacy of an insurer’s adjusted surplus. At December 31, 2003, our insurance subsidiaries maintained adjusted surplus in excess of their required RBC thresholds.
In December 2003, the FASB issued Revised FASB Interpretation No. 46 (FIN 46R or the “Interpretation”), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (“ARB”) No. 51. The primary objective of the Interpretation is to provide guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights; such entities are known as variable-interest entities (VIEs). FIN 46R is the guidance that determines (1) whether consolidation is required under the “controlling financial interest” model of ARB No. 51, Consolidated Financial Statements, or (b) other existing authoritative guidance, or, alternatively, (2) whether the variable-interest model under FIN 46R should be used to account for existing and new entities. We have adopted FIN 46R. The result of adoption was the deconsolidation of the three trusts that we created during 2003 in connection with the issuance of trust preferred securities. This resulted in offsetting increases in other assets and long term debt of approximately $1.1 million each.
As discussed in Notes 2 and 9 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill following adoption of Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets.”
Ceded unearned premiums ((Includes related party amounts of $16,486 and $17,123) Note 22)
Losses and loss adjustment expenses ((Includes related party amounts of $20,555 and $17,314) Note 22)
Reinsurance payable ((Includes related party amounts of $11,761 and $4,508) Note 22)
Common stock, $0.10 par value, 50,000,000 shares authorized; 9,770,843 and 9,390,795 shares issued and outstanding at December 31, 2003 and December 31, 2002, respectively
Basic earnings (loss) per common share before cumulative effect of accounting change
Diluted earnings (loss) per common share before cumulative effect of accounting change
Effective December 1, 2002, Interlex ceased writing LPL Insurance. Interlex sold the renewal rights to its LPL policies to an unrelated insurance organization on October 3, 2002.
Provides management, administrative and brokerage services to Physicians’ Reciprocal Insurers (“PRI”), a professional liability insurance reciprocal that conducts business in the state of New York. (PRI is not a subsidiary of FPIC.) Reciprocal management also provides reinsurance brokerage and administrative services to FPIC.
Professional Medical Administrators, LLC (“PMA”) (70% owned by FPIC as of December 31, 2002; effective January 1, 2003, FPIC has an 80% ownership interest in PMA.)
Risks inherent in FPIC’s operations include legal/regulatory risk, credit risk, underwriting risk and market risk. These risks are discussed below.
Legal/Regulatory Risk is the risk that changes in the legal or regulatory environment in which FPIC operates will change and reduce revenues or create additional costs or expenses not anticipated in pricing our products. That is, regulatory initiatives designed to reduce FPIC’s profits or new legal theories may reduce revenues or create costs for FPIC as compared with those currently reflected in the consolidated financial statements. This risk is concentrated in Florida, Missouri and New York, where FPIC has written or assumed most of the insurance and reinsurance business we have retained for our own account.
Credit Risk is the risk that issuers of securities owned by FPIC will default, or other parties, primarily our insureds and reinsurers that owe FPIC money, will not pay. Financial instruments that potentially expose FPIC to concentrations of credit risk consist of fixed maturity investments, premiums receivable, deposits with reinsurers, and assets carried for reinsurance recoverable related to unpaid losses and LAE and unearned premiums. Reinsurers that are neither authorized nor accredited by applicable state insurance departments (“unauthorized reinsurers”) are required to provide collateral in the form of an irrevocable letter of credit or investment securities held in a trust account to collateralize their respective balances due to FPIC.
Investments. We account for our investments in debt and equity securities under Statement of Financial Accounting Standard No. (“FAS”) 115, “Accounting for Certain Investments in Debt and Equity Securities.” Under the provisions of FAS 115, FPIC is required to classify investments in debt and equity securities into one of three categories: held-to-maturity, available-for-sale or trading. All of our investments in debt and marketable equity securities are classified as available-for-sale and reported at estimated fair values on the consolidated statements of financial position, with the change in fair values during the period excluded from earnings and recorded net of tax as a component of other comprehensive income. Fair values for debt and marketable equity securities are based on quoted market prices.
Real estate investments consist of a building, a condominium unit and developed land. These investments are carried at cost less accumulated depreciation. Depreciation is computed over the estimated useful lives of the property (exclusive of land, which is non-depreciable), using the straight-line method. Estimated useful lives range from twenty-seven to thirty-nine years. Rental income and expenses are included in net investment income.
Reinsurance recoverables include balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve our insurers from their primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to FPIC. We evaluate the financial condition of our reinsurers and monitor concentrations of credit risk with respect to the individual reinsurer that participates in our ceded programs to minimize our exposure to significant losses from reinsurer insolvencies. We hold collateral in the form of letters of credit, funds withheld or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the domiciliary Departments of Insurance.
We periodically review our property and equipment for impairment and assess whether significant events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. An impairment loss is recognized when the carrying amount of an asset exceeds the anticipated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded, if any, is calculated by the excess of the assets carrying value over its fair value.
Goodwill and Intangible Assets. FPIC has made acquisitions in the past that have included goodwill and other intangible assets. Under accounting principles in effect through December 31, 2001, these assets were amortized as expense over their estimated useful lives. They were also tested periodically to determine if they were recoverable from operating earnings on an undiscounted basis.
Claims administration and management fee income is comprised of revenues from the reciprocal management and TPA segments. Management fees of the reciprocal management segment, determined as a percentage of PRI’s premiums, are recognized as billed and earned under the contract, which generally corresponds with the reported premiums written of PRI, net of an estimate for premium refunds, for the calendar year. Such management fees are estimated, billed and earned for quarterly reporting purposes based upon semi-annual estimates of the reported premiums written of PRI rather than actual written premiums for a quarter, which may vary significantly from quarter to quarter. This convention is used so that management fees are recognized ratably over the period in relation to the services provided by the reciprocal management segment to PRI. Claims administration and management fees of the TPA segment are subject to contractual arrangements, some of which exceed one year. These revenues are recognized as earned and billed under the terms of these contracts, which generally correspond with the provision of services to customers.
Because the ultimate settlement of claims (including IBNR reserves) is subject to future events, no single claim or loss and loss adjustment expense reserve can be considered accurate with certainty. Our analysis of the reasonableness of loss and LAE reserve estimates does include consideration of the amount of potential variability in the estimate.
Amounts attributable to ceded reinsurance derived in estimating the liability for loss and LAE are reclassified as assets in the consolidated statements of financial position as required by FAS 113.
Per Share Data. Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per common share are calculated using the combination of dilutive common share equivalents and the weighted average number of common shares outstanding during the period.
Accounting for Stock-based Compensation. In December 2002, the Financial Accounting Standards Board (“FASB”) issued FAS 148, “Accounting for Stock-Based Compensation, Transition and Disclosure” to provide transition guidance for a voluntary change to the fair value based method of accounting for stock-based employee compensation and to amend the disclosure requirements of FAS 123 “Accounting for Stock-Based Compensation” for both annual and interim financial statements. FAS 148 requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. The transition and annual disclosure requirements of FAS 148 were effective for fiscal years ended after December 15, 2002. The interim disclosure requirements of FAS 148 are effective for interim periods beginning after December 15, 2002. The adoption of the provisions of FAS 148 did not have an impact on FPIC’s consolidated financial statements; however, we have modified the disclosures as provided for in the new standard.
See Note 18, Stock Options and Employee Stock Purchase Plans, for discussion about the methods and assumptions used in estimating the fair value of stock options used in preparation of the pro-forma information presented in the above tabular presentation.
Interest Rate Collars and Swaps. We account for our interest rate collars and swaps in accordance with FAS 133, “Accounting for Derivative Instruments and Hedging Activities” as amended by FAS 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” and FAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” FPIC uses derivative financial instruments to manage market risks related to the effects of changes in interest rates on its floating rate long-term debt. The cost of these contracts is being amortized over their respective maturities. In addition, the remaining balances are adjusted and carried at their estimated fair values, with the changes therein reported as unrealized gains or losses in other comprehensive income. The differential, if any, to be paid or received as interest rates change is accrued and recognized as an adjustment to interest expense related to the debt. The related amount payable to or receivable from the counter parties are included as adjustments to accrued interest. See Note 14 for additional information related to the interest rate collars and swaps. FPIC does not currently hold and has not issued any other derivative financial instruments.
Reclassification. Certain amounts for 2002 and 2001 have been reclassified to conform to the 2003 presentation.
In December 2003, the FASB issued Revised FASB Interpretation No. 46 (FIN 46R or the “Interpretation”), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (“ARB”) No. 51. The primary objective of the Interpretation is to provide guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights; such entities are known as variable-interest entities (VIEs). FIN 46R is the guidance that determines (1) whether consolidation is required under the “controlling financial interest” model of ARB No. 51, Consolidated Financial Statements, or (b) other existing authoritative guidance, or, alternatively, (2) whether the variable-interest model under FIN 46R should be used to account for existing and new entities. We have adopted FIN 46R. The result of adoption was the deconsolidation of the three trusts that we created during 2003 in connection with the issuance of trust preferred securities. This resulted in offsetting increases in other assets and long term debt by approximately $1,083.
Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of FPIC.
Interest rate collars - Fair value was estimated using quotes from an institutional broker and represents the cash requirement if the existing agreement had been settled at year-end.
The following table presents the carrying values and estimated fair values of FPIC’s financial instruments as of December 31, 2003 and 2002.
The amortized cost and estimated fair value of investments in debt and equity securities as of December 31, 2003 and 2002 were as follows:
The amortized cost and estimated fair value of debt securities at December 31, 2003 by contractual maturity are shown below. Expected maturities will differ from contractual maturities, because borrowers have the right to call or prepay these obligations with or without call or prepayment penalties.
Net investment income for the years ended December 31, 2003, 2002 and 2001 was as follows:
Proceeds from sales and maturities of bonds were $607,201, $313,313 and $221,596, for the years ended December 31, 2003, 2002 and 2001, respectively. Proceeds from sales of equity securities were $566 for the year ended December 31, 2001. Gross gains of $11,211, $8,769 and $4,530 were realized on sales of debt and equity securities for the years ended December 31, 2003, 2002 and 2001, respectively. Gross losses of $4,059, $4,092 and $3,101 were realized on sales of debt and equity securities for the years ended December 31, 2003, 2002 and 2001, respectively. Included in net realized investment gains for the year ended December 31, 2002 is a gain of $37 recognized on the sale of one of our limited partnerships and a loss of $27 on the sale of another of our invested assets.
At December 31, 2003, FPIC’s other invested assets included investments in three limited partnerships and one private corporation. These assets were recorded at an aggregate value of $3,692 and $8,782 at December 31, 2003 and 2002, respectively. FPIC sold its investment in APS Insurance Services, Inc. (“APS”) for a total consideration of $2,050 during the fourth quarter of 2003. FPIC sold its investment in HCIF Management Company during November 2002 and received payment in the amount $174. In December 2002, FPIC sold its investment in, a private investment, Renaissance LLP, and recorded a note receivable in the amount $2,037, all of which has been collected in 2003.
During 2002, we recorded a charge related to our MPL business at Intermed, as it was estimated that not all of its deferred policy acquisition costs were recoverable. As a result, deferred policy acquisition costs were reduced by $1,304.
The provision for income taxes differs from the statutory corporate tax rate of 35% for 2003, 2002 and 2001 as follows:
At December 31, 2003 and 2002, the significant components of the net deferred tax asset were as follows:
FPIC has remaining net operating loss carry forwards of approximately $6,140 as of December 31, 2003 that may be used to offset taxable income in future years subject to an annual limitation imposed by the Internal Revenue Code. These net operating loss carry forwards expire in the years 2018 and 2019.
Under the market multiple approach, the values of the reporting units were based on the market prices and performance fundamentals of similar public companies.
Under the DCF approach, the values of the reporting units were based on the present value of the projected future cash flows to be generated.
Based on the results of the impairment tests conducted in the first quarter of 2002, goodwill was not deemed to be impaired at the insurance segment, since the fair value of the reporting unit exceeded its carrying value. Therefore, the second step of the goodwill impairment test was not performed. However, the carrying values of the reciprocal management and TPA segments exceeded their respective fair values, indicating an impairment of goodwill. Under step 2 of the test, the implied fair values of the reciprocal management and TPA goodwill were compared to their carrying values to measure the amount of impairment loss. As a result, a non-cash transitional impairment charge of $48,362 ($29,578, after an income tax benefit of $18,784) was recognized and recorded as a cumulative effect of accounting change in the accompanying consolidated statements of income for the year ended December 31, 2002. The results of the transitional impairment tests and charges were as follows:
(Dollars in thousands, except per share amounts and elsewhere as noted)
At December 31, 2003, 2002 and 2001 identifiable intangible assets consisted of the following:
Activity in the liability for losses and LAE for the years ended December 31, 2003, 2002 and 2001 was as follows:
Effective July 1, 2002, our largest insurance subsidiary, First Professionals, entered into a net account quota share reinsurance agreement with two insurance companies of the Hannover Re group (“Hannover Re”). The agreement, which calls for First Professionals to cede quota share portions of its written premiums, contains adjustable features, including sliding scale ceding commissions and a cap on the amount of losses that may be ceded to the reinsurer. The original agreement also contained a loss corridor on business ceded through March 31, 2003, which was removed along with other modifications made in connection with the amendment and extension of the agreement discussed below. The effect of these features is to limit the reinsurers’ aggregate exposure to loss and thereby reduce the ultimate cost to First Professionals as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by First Professionals. While First Professionals does not receive pro-rata protection relative to the amount of premiums ceded, the amount of such protection is significant, as determined in accordance with guidance under both statutory accounting practices and GAAP. In addition to ceding a significant portion of its risks to Hannover Re, the agreement also allows First Professionals to reduce its financial leverage and to realize immediate reimbursement for related up-front acquisition costs, thus adding to its financial capacity.
On May 6, 2003, we entered into an amendment to the Hannover Re agreement that, effective April 1, 2003, extends its expiration date to include policies written and renewed through December 31, 2004. The agreement has also been amended to remove the loss corridor on business written and ceded, beginning April 1, 2003, and to reduce the lower end of the sliding scale ceding commission range from 27.5% to 20%. A provision has also been added that will allow First Professionals to reduce the quota share amount of premiums to be ceded under the agreement in 2004. Cancellation provisions have also been added; one that gives First Professionals the option to cancel the agreement on or after January 1, 2004, with 30 days notice, and one that gives Hannover Re the option to cancel the agreement as of the effective date of any decrease in First Professionals’ base rate for its MPL insurance policies that exceeds 5%.
Reinsurance Recoverable on Paid and Unpaid Losses and LAE and Ceded Unearned Premiums
As of December 31, 2003, we had reinsurance recoverable on paid losses, due from reinsurers on unpaid losses, and ceded unearned premiums in the amounts of $15,950, $275,766 and $71,435, respectively, or $363,151, in aggregate.
As of December 31, 2003, $90,169 of our aggregate reinsurance recoverables are associated with program business under fronting agreements with related parties and others. Of this amount, $40,330 is due from PRI, the New York insurance reciprocal managed by our subsidiary, AFP, and for which we hold collateral of $40,578 in the form of securities held in trust. Reinsurance recoverables of $25,804 are due from segregated portfolios or cells of APAL (SPC) Ltd., a subsidiary of APAL, a Cayman Islands insurer in which we have a 9.8% interest, and are collateralized by securities in trust, an irrevocable letter of credit and other funds held totaling $28,018.
On November 25, 2003, FPIC received $23,500 in exchange for commuting its reinsurance treaties with Gerling Global Reinsurance Corporation of America (“Gerling”), one of its reinsurers. The amount collected includes payments for commutation of Gerling’s quota share treaty for facultative reinsurance coverage on non-standard risks, Gerling’s portion of the excess of loss reinsurance program and payments for estimated future claims under the Gerling treaties. Gerling participated in our excess of loss reinsurance programs in 2000 at 15%, and in 2001 and 2002 at 20%. We replaced Gerling’s participation in our reinsurance programs, effective with our renewal as of January 1, 2003. No gain or loss was recognized on the commutation transaction. As a result of the commutation, we have no reinsurance recoverable from Gerling as of December 31, 2003.
Our outstanding debt, as of December 31, 2003 and 2002, consisted of the following:
Senior notes due May 23, 2033 (callable by FPIC beginning May 23, 2008); uncollateralized and bearing floating rate interest at three-month LIBOR
The securities are uncollateralized and bear a floating interest rate equal to the three-month LIBOR plus a spread ranging from 3.85% to 4.2% (the total interest rates ranged from 5.01% to 5.37% as of December 31, 2003). The floating interest rate will be adjustable quarterly with changes in the three-month LIBOR, and in the case of the first two offerings, the maximum rate that may be charged under the securities within the first five years is 12.5%. We have also purchased hedging instruments designed to maintain the ultimate floating rate interest cost on all of these securities within a stated range for five years from closing. We have the option to call the trust preferred securities at par or its equivalent beginning five years from closing. The trust preferred securities also contain features that allow us the option, under certain conditions, to defer interest payments for up to 20 quarters and to redeem the securities before the first optional call date in five years. In the case of the potential earlier call date, the redemption or call price payable by us may be different than par. The securities have stated maturities of thirty years and are due in May and October 2033.
Issuance costs for all three offerings in the aggregate amount of approximately $1,404 were capitalized and will be amortized over their respective stated maturity periods of thirty years.
Indenture agreements, relating to FPIC’s junior subordinated debentures and trust preferred securities contain limitations, under certain circumstances, as to (i) the declaration or payment of dividends, or distributions thereon, or the redemption, purchase, acquisition or liquidation with respect to any capital stock of FPIC or its affiliates; (ii) the payment, in certain circumstances, of principal of, premium or interest on, or the repayment, repurchase or redemption of, debt securities of FPIC or its affiliates that rank in equal standing with or are junior in interest to the debentures; or (iii) the payment, in certain circumstances, under any guarantees of FPIC or its affiliates that rank equal in standing with or junior in interest to capital securities guarantees relating to the issuance of the debentures. Circumstances that would result in such limitations include a continuing event of default, as defined by the indenture agreements, a default with respect to payment of any obligations under capital securities guarantees, or a continuing interest deferral election by FPIC.
The rate collars and terms as of December 31, 2003 are presented below with their corresponding effects on the floating rate interest costs associated with the trust preferred securities and senior notes.
The interest rate collars were purchased to effectively place floors and caps on the three-month LIBOR floating interest of approximately 1.0% to 1.20% and 4.40% to 4.65%, respectively, on notional principal corresponding with the principal amounts of each offering, for 5 years. These instruments will effectively serve to hedge our total floating interest rate borrowing costs under the securities to within a range of 4.85% to 8.6% for five years and until such time that we have the right to call the securities.
FPIC formally documents the relationships between the hedging instruments and the underlying long-term debt instruments. FPIC also assesses the effectiveness of the hedging instruments on a quarterly basis. If it is determined that the hedging instruments are no longer highly effective, the change in the fair value of the ineffective portion of the swaps would be included in earnings rather than comprehensive income. For the years ended December 31, 2003 and 2002, the net gain or loss on the ineffective portion of the swap agreements was not material.
At December 31, 2003, 2002 and 2001, FPIC’s deferred credit consisted of the following:
Effective January 1, 2000, FPIC’s insurance subsidiaries entered into a 100% quota share reinsurance agreement with PRI to assume the death, disability and retirement (“DD&R”) risks under PRI’s claims-made insurance policies in exchange for cash and investments. FPIC completed a GAAP valuation of the underlying liability during 2000 and a deferred credit in the amount of $13,205 was recognized. The deferred credit, which will be accreted into income over 20 years, represents the difference between the GAAP valuation of the underlying liabilities and the initial premium received. The liability was calculated using benefit assumptions and elements of pension actuarial models (i.e., mortality, morbidity, retirement, interest and inflation rate assumptions). The benefit assumptions equate to coverage for MPL claims and the related losses and LAE that may be brought against an insured in the future based on insured counts that might occur anytime while the insured is a PRI policyholder. It is therefore subject to inherent uncertainties as are our loss and LAE reserves over time. The DD&R reserves and the related estimation methods are continually reviewed and revised, if necessary, to reflect current conditions and trends. The resulting adjustments are reflected in current year net income. While management believes the DD&R reserves are adequate to cover the ultimate liability, the actual ultimate loss costs may vary from the amounts presently estimated and such differences could be material.
In addition to standard assessments, the Florida and Missouri Legislatures may also levy special assessments to settle claims caused by certain catastrophic losses. FPIC would be assessed on the basis of premiums written in the state. During 2001, a special assessment was levied on First Professionals and APAC that totaled $0.9 million. No special assessments were made in 2003 and 2002. In addition, FPIC could be subject to additional assessments in the future as a result of damages caused by catastrophic losses, such as a hurricane.
The management agreement between AFP and PRI was amended to remove the sharing by AFP of 10% of PRI’s statutory net income or loss, effective January 1, 2002. With regard to profit sharing amounts already earned and collected, AFP has agreed to hold the years 1999, 2000 and 2001 open for re-determination and possible adjustment for a period of five years each (expiring 2004, 2005 and 2006, respectively.) Such adjustments would be based primarily on development of and related adjustments, if any, to loss and LAE reserves for those years. AFP has earned and collected profit sharing amounts under the original agreement totaling $3,584 for the three years ended December 31, 2001. As of December 31, 2003, and based on PRI’s operating results, no amounts were payable under this provision of the amended management agreement. See Note 22, Related Party Transactions, to the consolidated financial statements for additional information about the management agreement with PRI. Also, FPIC has issued an irrevocable letter of credit in the amount of $500,000 as collateral under the operating lease for the building occupied by AFP and PRI in Manhasset, New York.
Diluted loss per common share for the three months ended December 31, 2001 is based only on the weighted average number of common shares outstanding during the period, as the inclusion of 115 common stock equivalents would have been anti-dilutive.
FPIC has a stock option plan for officers and key employees (the “employee plan”) and a plan for non-employee directors (the “director plan”). Under the director plan, only non-qualified stock options may be issued. Under the employee plan, both incentive stock options and non-qualified stock options may be granted to the same individual. The option price of an incentive stock option may not be less than 100% of the fair market value of shares on the grant date. The option price of a non-qualified option may not be less than 50% of the fair market value of shares on the grant date. Under the terms of the director plan, 5,000 shares are granted to each director on the date that person becomes a director and on an annual basis as approved by the Board. The plan also provides for discretionary grants at future dates as approved by the Board. Stock grants made under the director plan are at a price not less than 100% of the fair market value of the underlying stock on the grant date.
The following table summarizes information for options outstanding and exercisable at December 31, 2003:
The weighted average fair value of options granted during 2003, 2002 and 2001 are as follows:
In accordance with FAS 123, the weighted average fair value of stock options granted is required to be based on a theoretical statistical model using the preceding Black-Scholes assumptions. In actuality, because FPIC’s incentive stock options are not traded on any exchange, employees and directors can receive no value nor derive any benefit from holding stock options under these plans without an increase in the market price of FPIC’s stock. Such an increase in stock price would also benefit other stockholders.
FPIC also maintains an Employee Stock Purchase Plan that allows employees to purchase FPIC’s common stock at 85% of the market value on the first or last day of the offering period, whichever is lower. At December 31, 2003 and 2002, 26,860 and 11,279, respectively, shares of FPIC’s common Stock were reserved for issuance in connection with this plan.
FPIC also has a SERP that provides certain executives with income at retirement equal to 60% of pre-retirement base compensation, less qualified pension plan benefits paid by FPIC and all predecessor plans and Social Security benefits. The plan has no vesting prior to age 55. The total liability included in the financial statements for this plan amounted to approximately $1,961 and $1,541 as of December 31, 2003 and 2002, respectively. FPIC had a net periodic pension cost of $192, $258 and $386 under this plan in 2003, 2002 and 2001, respectively. Assumptions used in the accounting for the SERP liability are as follows: mortality rates are based on the 1983 group annuity mortality table; withdrawal rates are based on a table showing the probability of terminating service for reasons other than death, disability or retirement within one year after attaining certain ages; disability rates are included in the withdrawal rates; retirement age is 65; marital status assumes 100% of employees are married, with males three years older than females; social security projection assumes wage base of 3% per annum; inflation rates are assumed to be 3% annum, compounded annually.
The AFP defined contribution and profit sharing and defined benefit plans are available to all eligible employees of AFP. The benefits under these plans are based on years of service and employee compensation. AFP’s funding policy is to contribute to the plans an amount sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus any additional amounts determined to be appropriate from time to time. Contributions are intended to be sufficient to cover the costs of benefits earned for service to date and an estimate of those costs for future service. AFP contributed $2,035, $1,221 and $957 to the plans in 2003, 2002 and 2001, respectively. The invested assets of the plans consist of investments in various types and categories of stocks and bonds. At December 31, 2003 and 2002, the fair market value of plan assets was $8,852 and $6,732, respectively. Pension costs for the years 2003, 2002 and 2001 amounted to $1,905, $1,255 and $978, respectively.
The EMI defined contribution profit sharing plan is available for all employees of EMI upon meeting certain eligibility requirements. Under the plan, employees can contribute up to 16% of their annual salary, subject to IRS limits, of which EMI may, at its discretion, contribute a matching amount of up to 100% of the employee contributions. Historically, EMI has contributed a matching amount equal to approximately 30% of the employee contribution. At December 31, 2003 and 2002, the fair market value of plan assets was $2,653 and $2,167. The expense for this plan amounted to $87, $94 and $147, for 2003, 2002 and 2001, respectively.
Assumptions used in the accounting for the net periodic pension cost and plan status for our two defined benefit plans and SERP combined for the years ended December 31, 2003, 2002 and 2001, were as follows:
Assumptions used in the accounting for the benefit obligation for our two defined benefit plans and SERP combined for the years ended December 31, 2003, 2002 and 2001, were as follows:
Following is a summary of the related party transactions of FPIC and its consolidated subsidiaries included in the consolidated financial statements as of December 31, 2003 and 2002, and for the twelve months ended December 31, 2003, 2002 and 2001. Credit balances are presented parenthetically.
Corresponding direct premiums earned under fronting arrangements were ($45,726), ($52,079) and ($35,374) for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
Corresponding direct losses and LAE incurred under fronting arrangements were $44,768, $27,290 and $34,713 for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
Effective June 30, 1998, FPIC entered into a management services agreement with APAM and CGA, to provide FPIC with all necessary insurance management and administrative services for APAC, a wholly owned subsidiary of FPIC. FPIC has an indirect financial interest in APAM through its 9.8% interest in APAL, which owns 100% of APAM. Prior to January 1, 2002, the agreement provided that APAM would receive an annual fee of 14.5% of direct premiums (net of refunds) consisting of an annual 10.5% service fee and 4% claims management fee. Effective January 1, 2002, the agreement was amended to implement a sliding fee scale of 14.5% on the first $8 million of written premiums, 11% on written premiums between $8 million and $10 million, and 10% on all written premiums in excess of $10 million. In addition, the CGA fee is $500 annually. The agreement as it concerns APAM also provides that anesthesiologist business produced by First Professionals or its respective agents will be transferred to APAC upon renewal, assuming the insured agrees, and that APAM will receive an annual 1% service fee on such business.
As of December 31, 2003 the management agreement with APAM and the CGA consulting agreement had expired.
On July 1, 1998, First Professionals and APAC also entered into a quota share reinsurance agreement with APAL whereby these two subsidiaries cede a 25% quota share portion of all business written by them related to anesthesiologists and certain related specialties to APAL. The agreements were entered into in connection with and at the time of FPIC’s acquisition of APAC.
Effective December 31, 2003, FPIC did not renew or extend the quota share reinsurance agreement whereby First Professionals and APAC ceded 25% of their anesthesiologists’ MPL business to APAL. As a result, no further written premiums will be ceded to APAL, effective January 1, 2004 and business ceded under this agreement through December 31, 2003, will be placed in run-off.
Ceded losses and LAE incurred $ (8,001 ) (7,056 ) 2,068
Effective in 2001, APAL formed a new subsidiary, APAL (SPC) Limited, which was established in accordance with Section 235(1) of the Company Law 2nd Revision of Caymanian Law as a segregated portfolio corporation. FPIC’s subsidiary APAC, has developed alternative risk insurance programs, whereby segregated portfolio corporations have been formed to assume workers’ compensation risks. APAC receives a fee for the use of its policy forms and does not retain the underwriting risks or incur the administrative expenses under these programs. Like other reinsurance agreements, APAC does remain liable to the insureds under these programs as the primary insurer in the event APAL (SPC) Limited or other reinsurers under these programs were not to perform. Therefore, APAC maintains collateral in the form of assets in trust and irrevocable letters of credit corresponding with applicable reinsurance recoverable balances.
All but one of these programs were terminated as of December 31, 2003 or prior, and have been placed into run-off. The remaining program will expire on or before June 30, 2004, at which time it will be placed into run-off.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the fronting programs with APAL (SPC) Limited. The corresponding direct business with non-related parties is indicated as a footnote to the table.
Ceded losses and LAE incurred (4) $ (20,014 ) (7,427 ) (3,881 )
Corresponding unearned premiums was ($10,866) and ($8,973) as of December 31, and 2003 and 2002, respectively.
Effective January 1, 2000, First Professionals entered into a 100% quota share reinsurance agreement with PRI to assume PRI’s DD&R risks under its claims-made insurance policies in exchange for cash and investments in the amount of $47.0 million. During 2000, a GAAP valuation of the underlying liability was completed and a deferred credit in the amount of $13.2 million was recognized. The deferred credit, which is being amortized into income over 20 years, represents the difference between the GAAP valuation of the liability and the initial premium received. The liability was calculated using benefit assumptions and elements of pension actuarial models (i.e., mortality, morbidity, retirement, interest and inflation rate assumptions). In connection with the agreement, First Professionals recognized a 5% ceding commission expense, which is being deferred and amortized as premiums are earned under the agreement.
FPIC’s revenues and results of operations are financially sensitive to the revenues and results of operations of PRI. We do not own or have a controlling financial interest in PRI, nor is PRI considered a variable interest entity under FIN 46R and so PRI’s financial statements are not consolidated or included in ours. Instead, PRI is similar to a mutual insurer and the risks and rewards of ownership vest with the policyholders of PRI. PRI, as an MPL insurer, is subject to many of the same types of risks as those of FPIC’s insurance subsidiaries. In addition, PRI is regulated by the New York State Insurance Department and files annual and quarterly statements with the department containing its financial statements, prepared on the statutory-basis of accounting, and other data.
For a summary of all revenues and expenses associated with the PRI management agreement and related brokerage and reinsurance intermediary services performed for it, refer to the selected financial information presented for the reciprocal management segment in Note 20, Segment Information, preceding.
Effective August 1, 2003, PRI engaged an unrelated fronting carrier and no new or renewal business is being written on First Professionals’ policy forms.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the fronting program with PRI. The corresponding direct business with non-related parties is indicated as a footnote to the table.
Corresponding liability for losses and LAE was ($38,454) and ($20,676) as of December 31, 2003 and 2002.
Corresponding unearned premiums was ($1,982) and ($2,126) as of December 31, 2003 and 2002.
Corresponding direct premiums earned were ($16,143), ($11,762) and ($9,587) for the twelve months ended December 30, 2003, 2002 and 2001.
Corresponding direct losses and LAE incurred were $21,076, $10,511 and $10,565 for the twelve months ended December 31, 2003, 2002 and 2001.
See Note 12, Reinsurance, for additional information on the collateral held under these programs.
Corresponding direct premiums earned were ($3,321), ($22,319) and ($20,061) for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
FPIC had two management agreements with APAM to provide investment management and information technology support services, which terminated on December 31, 2003. Total revenues earned by FPIC from these agreements totaled approximately $64, $50 and $50 for the years ended December 31, 2003, 2002 and 2001, respectively.