The following discussion is intended to provide a more comprehensive review of the Company’s operating results and financial condition as well as the operating results and financial condition for PPIX, PCA, and PIPE than can be obtained from reading the Financial Statements alone. The discussion should be read in conjunction with the Financial Statements and the notes thereto included in “Item 8. Financial Statements and Supplementary Data” of the Company and “Item 15. Exhibits” for the financial statements and the notes thereto of PPIX, PCA, and PIPE. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K constitutes forward-looking information that involves risk and uncertainties. Please see “Forward-Looking Information” for more information.
Professional Casualty Association was an unincorporated, reciprocal insurance association organized on April 16, 2003 and formed for the purpose of insuring its subscribers against loss due to the imposition of legal liability. PCA provided medical professional liability insurance consisting of claims-made, tail occurrence and occurrence policies to its subscribers (policyholders). PCA was managed by Professional Third Party, LP (“PTP”) a wholly-owned subsidiary of Diversus, pursuant to the terms of an Attorney-in-Fact Agreement between PCA and PTP.
PIPE was an unincorporated exchange organized on March 14, 2005, and was licensed by the Commonwealth of Pennsylvania as a reciprocal insurance exchange. PIPE provided medical professional liability insurance consisting of claims-made, tail occurrence and occurrence policies to its subscribers (policyholders).
For the year ended December 31, 2018, PIPE had direct premiums written of $3.4 million, net premiums earned of $3.4 million, and a net loss of $(0.8) million. At December 31, 2018, PIPE had total assets of $25.0 million and a surplus of $11.2 million. For the year ended December 31, 2017, PIPE had direct premiums written of $3.6 million, net premiums earned of $3.1 million, and a net loss of $(60,000). At December 31, 2017, PIPE had total assets of $26.6 million and a surplus of $12.3 million. The loss in PIPE direct premiums written of $0.2 million in 2018 is attributable to non-renewals of policies and limited new business growth. The loss in PIPE direct premiums written of $0.6 million in 2017 is attributable to non-renewals of policies and limited new business growth.
PIPE Management was a Pennsylvania corporation formed to operate as the attorney-in-fact for PIPE pursuant to the terms of an attorney-in-fact agreement between PIPE Management and PIPE. Pursuant to the terms of the agreement, PIPMC provided salaries and benefit expenses of the employees, rent and other occupancy expenses, supplies, and data processing services to PIPE and paid certain expenses on behalf of PIPE for 25% of gross written premium. PIPE Management, as the attorney-in-fact of PIPE, had the power to direct the activities of PIPE that most significantly impact PIPE’s economic performance. Diversus acquired 100% of the ownership interests of PIPE Management on November 23, 2015. SIS, PTP, and PIPE Management merged into Diversus Management in connection with the conversions.
Positive Insurance Company derives its revenue primarily from premiums earned, net investment income and net realized gains (losses) from investments.
Premiums earned are the earned portion of net premiums written. Gross premiums written include all premiums recorded by an insurance company during a specified policy period. Insurance premiums on MPLI policies are recognized in proportion to the underlying risk insured and are earned ratably over the duration of the policies. At the end of each accounting period, the portion of the premiums that is not yet earned is included in unearned premiums and is realized as revenue in subsequent periods over the remaining term of the policy. The policies written by PPIX, PCA, and PIPE typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2018, one-half of the premiums would be earned in 2018 and the other half would be earned in 2019.
We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to reviewing our financial performance based on results determined in accordance with GAAP, we utilize certain financial performance measures that are used in the property and casualty insurance industry and that we believe are valuable in managing our business and for comparison to our peers. These financial performance measures are the expense ratio, losses and loss adjustment expense ratio, combined ratio, and the ratio of net written premiums to statutory surplus.
We measure growth by monitoring changes in gross premiums written and net premiums written, and measure underwriting profitability by examining losses and loss adjustment expense, underwriting expense and combined ratios. We also measure profitability by examining underwriting income (loss), net income (loss) and return on equity.
The losses and loss adjustment expenses ratio is the ratio (expressed as a percentage) of losses and loss adjustment expenses incurred to premiums earned. Positive Insurance Company measures the loss ratio on a policy year and calendar year loss basis to measure underwriting profitability. A policy year loss ratio measures losses and loss adjustment expenses for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premiums earned during that year. A calendar year loss ratio measures losses and loss adjustment expenses for insured events occurring during a particular year and the change in loss reserves from prior policy years as a percentage of premiums earned during that year.
The combined ratio is the sum of the losses and loss adjustment expenses ratio and the expense ratio and measures overall underwriting profit. If the combined ratio is below 100%, we are making an underwriting profit. If our combined ratio is at or above 100%, we are not profitable without investment income and may not be profitable if investment income is insufficient.
Underwriting income (loss) measures the pre-tax profitability of insurance operations. It is derived by subtracting losses and loss adjustment expense, amortization of deferred policy acquisition costs, and underwriting and administrative expenses from earned premiums. Each of these items is presented as a caption in the respective statements of operations of PPIX, PCA and PIPE.
We use net income (loss) to measure our profit and return on average equity to measure our effectiveness in utilizing equity to generate net income. In determining return on average equity for a given year, net income (loss) is divided by the average of the beginning and ending equity for that year.
We maintain reserves for the payment of claims (indemnity losses) and expenses related to adjusting those claims (loss adjustment expenses). The loss reserves consist of case reserves, which are reserves for claims that have been reported to us, and reserves for claims that have been incurred but have not yet been reported and for the future development of case reserves.
In addition to case reserves, we maintain estimates of reserves for IBNR. These reserves include estimates for the future development of case reserves. Some claims may not be reported for several years. As a result, the liability for unpaid losses and loss adjustment reserves includes significant estimates for IBNR.
We accrue liabilities for unpaid losses and loss adjustment expenses based upon estimates of the ultimate amount payable. We project our estimate of ultimate losses and loss adjustment expenses by using the following actuarial methodologies:
Bornhuetter-Ferguson Method (Paid and Incurred) - The Bornhuetter-Ferguson Method is a blended method that explicitly takes into account both actual loss development to date and expected future loss emergence. This method is applied on both a paid loss development method and an incurred loss development method. This method uses the selected loss development patterns from the two loss development methods to calculate the expected percentage of loss unpaid (or unreported). The expected future loss component of the method is calculated by multiplying earned premium for the given exposure period by a selected a priori (i.e. deductive) loss ratio. The resulting dollars are then multiplied by the expected percentage of unpaid (or unreported) loss described above. This provides an estimate of future paid (or reported) losses that is then added to actual paid (or incurred) loss data to produce estimated ultimate loss.
Diversus Management estimates IBNR reserves by first deriving an actuarially based estimate of the ultimate cost of total losses and loss adjustment expenses incurred as of the financial statement date. Diversus Management then reduces the estimated ultimate losses and loss adjustment expenses by losses and loss adjustment expense payments and case reserves carried as of the financial statement date. The actuarially determined estimate is based upon indications from one of the above actuarial methodologies or uses a weighted average of these results. The specific method used to estimate the ultimate losses will vary depending on the judgment of the actuary as to what is the most appropriate method for the MPLI business. Finally, Diversus Management considers other factors that impact reserves that are not fully incorporated in the actuarially based estimate, such as changes in the external business environment and changes in internal company processes and strategy.
Our actuary determined a range of reasonable reserve estimates shown in the tables below, which reflect the uncertainty inherent in the loss reserve process. This range does not represent the range of all possible outcomes. We believe that the actuarially-determined ranges represent reasonably likely changes in the loss and loss adjustment expense estimates, however actual results could differ significantly from these estimates. The range was determined after a review of the output generated by the various actuarial methods utilized. The actuary reviewed the variance around the select loss reserve estimates for each of the actuarial methods and selected reasonable low and high estimates based on its knowledge and judgment. In making these judgments the actuary typically assumed, based on its experience, that the larger the reserve the less volatility. In addition, when selecting these low and high estimates, the actuary considered:
Changes in the exchange’s internal claims processing policies and procedures; and
The width of the range in reserves arises primarily because specific losses may not be known and reported for some period and the ultimate losses paid and loss adjustment expenses incurred with respect to known losses may be larger than currently estimated. The ultimate frequency or severity of the claims can be very different than the assumptions we used in our estimation of ultimate reserves for these exposures.
Although the range of loss estimates is determined by the exchange’s actuary, the selection of the ultimate loss is based on information unique to each policy year and the judgment and expertise of PPIX’s management.
The table below summarizes the impact on PPIX’s equity from changes in estimates of unpaid losses and loss adjustment expenses as of December 31, 2018 (dollars in thousands) (unaudited):
If the liability for losses and loss adjustment expenses reserves were to adversely develop to the high end of the range, approximately $3.6 million of anticipated future payments for the losses and loss adjustment expenses would be required to be paid, thereby affecting cash flows in future periods as the payments for losses are made.
Although the range of loss estimates is determined by the exchange’s actuary, the selection of the ultimate loss is based on information unique to each policy year and the judgment and expertise of PCA’s management.
At December 31, 2018 and December 31, 2017, PCA’s total liability for losses and loss adjustment expenses was $22.2 million and $18.6 million, respectively. During the years ended December 31, 2018 and 2017, PCA experienced unfavorable and favorable developments of $(6.1) million and $0.4 million, respectively. The favorable development of $0.4 million during the year ended December 31, 2017 was primarily related to re-estimation of unpaid losses and loss adjustment expenses on all claims-made policy years. The unfavorable development of $(6.1) million during the year ended December 31, 2018 was primarily related to reserve strengthening in the 2015 ($400,000) occurrence policy year, the 2016 ($500,000) tail policy year and the 2017 ($400,000) and 2014 through 2017 ($4,500,000) claims-made policy years. A majority of these changes in indications were related to PCA’s new claims management team and a change in reserving philosophy of setting reserves at the expected value as soon as possible when the liability is acknowledged.
As discussed earlier, the estimation of PCA’s reserves is based on several actuarial methods, each of which incorporates many quantitative assumptions. The judgment of the actuary plays an important role in selecting among various loss development factors and selecting the appropriate method, or combination of methods, to use for a given policy year. PCA did not determine the ranges of expected variability around the actuarially determined central estimate.
If the liability for losses and loss adjustment expenses were recorded at the high end of the actuarially-determined range, the losses and loss adjustment expenses would increase by $2.3 million. This increase in reserves would have the effect of increasing net loss and decreasing equity as of December 31, 2018 by $1.8 million. If the liability for losses and loss adjustment expense reserves were recorded at the low end of the actuarially-determined range, the liability for losses and loss adjustment expense reserves at December 31, 2018 would be reduced by $0.9 million with a corresponding decrease in net loss and an increase in equity of $0.7 million.
If the liability for losses and loss adjustment expenses were to adversely develop to the high end of the range, approximately $2.3 million of anticipated future payments for the losses and loss adjustment expenses would be required to be paid, thereby affecting cash flows in future periods as the payments for losses are made.
Although the range of loss estimates is determined by the exchange’s actuary, the selection of the ultimate loss is based on information unique to each policy year and the judgment and expertise of PIPE’s management.
The table below summarizes the impact on PIPE’s equity from changes in estimates of unpaid losses and loss adjustment expenses as of December 31, 2018 (dollars in thousands) (unaudited):
Under ASC Topic 820, we base fair values of assets on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in FASB ASC Topic 820. Fair value measurements for assets where there exists limited or no observable market data and, therefore, are based primarily upon the exchange’s or other third-party’s estimates, are often calculated based on the characteristics of the asset, the economic and competitive environment and other such factors. Management uses its best judgment in estimating the fair value of financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts we could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of the financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end. Additionally, changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future valuations.
In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest-level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.
The table below presents the level within the fair value hierarchy generally utilized by PPIX to estimate the fair value of assets disclosed on a recurring basis at December 31, 2018 (in thousands) (audited):
The table below presents the level within the fair value hierarchy generally utilized by PPIX to estimate the fair value of assets disclosed on a recurring basis at December 31, 2017 (in thousands) (audited):
For the years ended December 31, 2018 and 2017, PPIX determined that none of its securities were other-than-temporarily impaired. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest-level input that is significant to the fair value measurement in its entirety. PCA’s assessment of the significance of a particular item to the fair value measurement in its entirety required judgment, including the consideration of inputs specific to the asset or liability.
The table below presents the level within the fair value hierarchy generally utilized by PCA to estimate the fair value of assets disclosed on a recurring basis at December 31, 2018 (in thousands) (audited):
The table below presents the level within the fair value hierarchy generally utilized by PCA to estimate the fair value of assets disclosed on a recurring basis at December 31, 2017 (in thousands) (audited):
For the years ended December 31, 2018 and 2017, PCA determined that none of its securities were other-than-temporarily impaired. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
The fair value and unrealized losses for PIPE’s securities that were temporarily impaired as of December 31, 2018 and December 31, 2017 are as follows:
PIPE evaluated each security and took into account the severity and duration of the impairment, the current rating on the bond, and the outlook for the issuer according to independent analysts. PIPE found that the declines in fair value are most likely attributable to increases in interest rates, and there is no evidence that the likelihood of not receiving all of the contractual cash flows as expected has changed.
For the years ended December 31, 2018 and 2017, PIPE determined that none of its securities were other-than-temporarily impaired. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
We exercise significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. These judgments require us to make projections of future taxable income. The judgments and estimates we make in determining our deferred tax assets, which are inherently subjective, are reviewed on a continual basis as regulatory and business factors change. Any reduction in estimated future taxable income may require us to record a valuation allowance against its deferred tax assets.
On December 22, 2017, the Tax Cuts and Jobs Act (the “TCJA”) was signed into law. Most of the provisions of this bill affect corporate taxes paid in 2018 and beyond including reducing the top corporate tax rate from 34% to 21%. Under GAAP, however, deferred income taxes are estimated based upon expected tax rates enacted prior to the date of the financial statements. Accordingly, PPIX measured its deferred income taxes at December 31, 2018 and December 31, 2017 using a tax rate of 21%. The effect on surplus was a decrease of approximately $81,000 for the year ended December 31, 2017.
Although most of the provisions of the TCJA does not affect corporate taxes paid until 2018 and beyond, under GAAP, deferred income taxes are estimated based upon expected tax rates enacted prior to the date of the financial statements. Accordingly, PCA measured its deferred income taxes at December 31,2018 and December 31, 2017 using a tax rate of 21%. The effect on surplus was a decrease of $63,000 for the year ended December 31, 2017.
At December 31, 2018 and December 31, 2017, PCA had no material unrecognized tax benefits or accrued interest and penalties. Federal tax years 2015 through 2017 are open for examination.
PIPE had gross deferred tax assets of $0.4 million and $0.3 million at December 31, 2018 and 2017, respectively. A valuation allowance is required to be established for any portion of the deferred tax asset for which PIPE believed it is more likely than not that it will not be realized. PIPE believed it is more likely than not that all of the deferred tax assets will be realized. Accordingly, no valuation allowance had been established at December 31, 2018 and December 31, 2017.
At December 31, 2018 and December 31, 2017, PIPE had no material unrecognized tax benefits or accrued interest and penalties. Federal tax years 2015 through 2017 are open for examination.
Our results of operations are influenced by factors affecting the MPLI industry in general. The operating results of the United States MPLI industry are subject to significant variations due to competition, changes in regulation, rising medical expenses, judicial trends, fluctuations in interest rates and other changes in the investment environment.
Direct written premium for the year ended December 31, 2018 was $15.6 million as compared to $15.3 million for the year ended December 31, 2017, or a 2% increase. Direct premium earned for the year ended December 31, 2018 was $15.8 million as compared to $14.6 million for the year ended December 31, 2017, or a 9% increase. Ceded premium earned for the year ended December 31, 2018 was $2.7 million as compared to $2.3 million for the year ended December 31, 2017, or an increase of 20%.
Net investment income for the year ended December 31, 2018 was $0.3 million as compared to $1.0 million for the year ended December 31, 2017. The average monthly net investment income decreased from $87,000 during the year ended December 31, 2017 to $28,000 during the year ended December 31, 2018. For the year ended December 31, 2018, PPIX adopted an accounting standard which requires that unrealized gains or losses for equity securities previously classified as available-for-sale securities for 2017 be recorded against earnings of the exchange. The effect of adopting the accounting standard was to reduce net investment income by $0.8 million or a reduction of the average monthly net investment income amount for 2018 by $70,000. With the exclusion of adopting the new accounting standard, the average monthly net investment income would have been $98,000 and the return on average cash and invested assets would have been 2.30% for the year ended December 31, 2018.
PPIX’s fixed maturity investments and equity investments are available-for-sale because it would, from time to time, make sales of securities that are not impaired, consistent with its investment goals and policies. At December 31, 2018, PPIX had gross unrealized losses on fixed maturity securities of $794,000 as compared to a gross unrealized losses on fixed maturity securities of $250,000 at December 31, 2017. Most of these unrealized losses were attributable to fluctuations in interest rates. PPIX evaluated each security and took into account the severity and duration of the impairment, the current rating on the bond, and the outlook for the issuer according to independent analysts. PPIX believed that the foregoing declines in fair value in its existing portfolio are most likely attributable to fluctuations in interest rates, and there is no evidence the entire amortized cost basis will not be recovered.
PPIX’s losses and loss adjustment expenses ratio was 51.0% for the year ended December 31, 2018 as compared to 63.0% for the year ended December 31, 2017.
Total underwriting and administrative expenses, including amortization of deferred policy acquisition costs, were $6.9 million for the year ended December 31, 2018 as compared to $5.8 million for the year ended December 31, 2017. PPIX had $229,000 and $0 in initial public offering and conversion costs that were expensed in 2018 and 2017, respectively, and are included in underwriting and administrative expenses. Administrative costs are directly tied to the amount of premiums written by PPIX in a given period, because the fees payable to SIS were equal to 25% of the premiums written by PPIX.
For the year ended December 31, 2018, PPIX had pre-tax loss of $(164,000) as compared to a pre-tax loss of $(281,000) for the year ended December 31, 2017.
We are required to participate in Pennsylvania Property and Casualty Insurance Guaranty Fund (PIGA), which was formed to pay claims on policies issued by insolvent Pennsylvania domiciled property and casualty insurers. Each Pennsylvania domiciled property and casualty insurer pays PIGA an annual assessment based on its premiums written in Pennsylvania. PPIX incurred assessment fee expense (income) of $44,000 and $(28,000) for the years ended December 31, 2018 and 2017, respectively.
At December 31, 2018, PPIX had total assets of $63.6 million as compared as compared to $67.2 million at December 31, 2017. The decrease in total assets of $3.6 million is primarily attributable to a decrease in total cash and invested assets by $3.5 million from December 31, 2017 to December 31, 2018 due to timing of investment in securities and net unrealized losses recognized in 2018 as compared to net unrealized gains recognized in 2017. The decrease in total assets was offset by more premiums written in 2018 as compared to 2017 and an increase in premiums receivable by $0.4 million. Reinsurance receivables also decreased by $0.4 million, which are attributable mainly to the timing of payments from reinsurers.
At December 31, 2018, PPIX had total liabilities of $46.8 million as compared to $49.7 million at December 31, 2017. The decrease in total liabilities of $2.9 million between December 31, 2017 to December 31, 2018 is primarily attributable to a $3.4 million decrease in the liability for losses and loss adjustment expenses, a $0.2 million decrease in unearned and advance premiums, and a decrease in reinsurance payable of $0.3 million, which were offset by a $0.5 million surplus note executed by PPIX during the year ended December 31, 2018.
PPIX generated sufficient funds from its operations and maintained a high degree of liquidity in its investment portfolio to meet the demands of claim settlements and operating expenses. The primary sources of funds were premium collections, investment earnings and maturing investments.
PPIX maintained investment and reinsurance programs that are intended to provide sufficient funds to meet its obligations without forced sales of investments. PPIX maintained a portion of its investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds.
The Company’s principal source of liquidity will be dividend payments from Positive Insurance Company. Positive Insurance Company will be restricted by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to the Company. Positive Insurance Company may pay dividends to us after notice to, but without prior approval of, the Pennsylvania Insurance Department in an amount not to exceed the greater of (i) 10% of the surplus of Positive Insurance Company as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or (ii) the statutory net income of Positive Insurance Company for the period covered by such annual statement. Dividends in excess of this amount are considered “extraordinary” and are subject to the approval of the Pennsylvania Insurance Department.
The amount available for payment of dividends from Positive Insurance Company after the conversions without the prior approval of the Pennsylvania Insurance Department is approximately $3.7 million based upon the estimated pro forma statutory surplus of Positive Insurance Company. Prior to its payment of any dividend, Positive Insurance Company will be required to provide notice of the dividend to the Pennsylvania Insurance Department. This notice must be provided to the Pennsylvania Insurance Department 30 days prior to the payment of an extraordinary dividend and 10 days prior to the payment of an ordinary dividend. The Pennsylvania Insurance Department has the power to limit or prohibit dividends if Positive Insurance Company is in violation of any law or regulation. These restrictions or any subsequently imposed restrictions may affect our future liquidity.
Upon completion of the offering on March 27, 2019, the Company is a public company and is subject to the proxy solicitation, periodic reporting, insider trading and other requirements of the Exchange Act and to most of the provisions of the Sarbanes-Oxley Act of 2002. As a result, the Company anticipates incurring significant increases in expenses related to accounting and legal services that will be necessary to comply with such requirements. We estimate that the cost of initial compliance with the requirements of the Sarbanes-Oxley Act will be approximately $350,000 and that compliance with the ongoing requirements of the Exchange Act and the Sarbanes-Oxley Act will result in an increase of approximately $200,000 in annual operating expenses.
Market risk is the risk that a company will incur losses due to adverse changes in the fair value of financial instruments. We have exposure to three principal types of market risk through our investment activities: interest rate risk, credit risk and equity risk. Our primary market risk exposure is to changes in interest rates. We have not entered, and do not plan to enter, into any derivative financial instruments for hedging, trading or speculative purposes.
Interest rate risk is the risk that a company will incur economic losses due to adverse changes in interest rates. Each exchange’s exposure to interest rate changes primarily results from its significant holdings of fixed rate investments. Fluctuations in interest rates have a direct impact on the fair value of these securities.
The average duration of the fixed maturity securities in the investment portfolios of PPIX, PCA, and PIPE at December 31, 2018 was 3.34 years, 3.13 years, and 3.90 years, respectively. Each exchange’s fixed maturity securities investments included U.S. government bonds, securities issued by government agencies, obligations of state and local governments and governmental authorities, and corporate bonds, most of which are exposed to changes in prevailing interest rates and which may experience moderate fluctuations in fair value resulting from changes in interest rates. Each exchange carried these investments as available for sale. This allowed the exchange to manage its exposure to risks associated with interest rate fluctuations through active review of its investment portfolio by its management, its investment adviser and its board of directors.
Fluctuations in near-term interest rates could have an impact on each exchange’s results of operations and cash flows. Certain of these securities may have call features. In a declining interest rate environment these securities may be called by their issuer and replaced with securities bearing lower interest rates. If we are required to sell these securities in a rising interest rate environment we may recognize losses.
As a general matter, each exchange attempted to match the durations of its assets with the durations of its liabilities. Each exchange’s investment objectives included maintaining adequate liquidity to meet its operational needs, optimizing its after-tax investment income, and its after-tax total return, all of which were subject to the exchange’s tolerance for risk.
The table below shows the interest rate sensitivity of PPIX’s fixed maturity investments measured in terms of fair value (which is equal to the carrying value for all of its investment securities that are subject to interest rate changes) at December 31, 2018 (unaudited):
The table below shows the interest rate sensitivity of PIPE’s fixed maturity investments measured in terms of fair value (which is equal to the carrying value for all of its investment securities that are subject to interest rate changes) at December 31, 2018 (unaudited):
Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. Each exchange addressed this risk by investing primarily in fixed maturity securities that were rated at least “A” by Moody’s or an equivalent rating quality. Each exchange also independently, and through its outside investment manager, monitored the financial condition of all of the issuers of fixed maturity securities in the portfolio. To limit its exposure to risk, each exchange employed diversification rules that limited the credit exposure to any single issuer or asset class.
PCA’s results of operations were influenced by factors affecting the MPLI industry in general. The operating results of the United States MPLI industry are subject to significant variations due to competition, regulation and changes in regulation, rising medical expenses, judicial trends, fluctuations in interest rates and other changes in the investment environment.
The major components of PCA’s operating revenues and net income are as follows (dollars in thousands):
Direct written premium for the year ended December 31, 2018 was $6.3 million as compared to $7.7 million for the year ended December 31, 2017, or a 18% decrease. Direct premium earned for the year ended December 31, 2018 was $7.9 million as compared to $8.9 million for the year ended December 31, 2017, or a 11% decrease. Ceded premium earned for the year ended December 31, 2018 was $0.8 million as compared to $1.4 million for the year ended December 31, 2017, or a 43% decrease.
PCA’s fixed maturity investments are available-for-sale because it would, from time to time, make sales of securities that are not impaired, consistent with its investment goals and policies. At December 31, 2018, PCA had gross unrealized losses on fixed maturity securities of approximately $531,000 as compared to gross unrealized losses on fixed maturity securities of approximately $160,000 at December 31, 2017. Most of these unrealized losses were attributable to an increase in interest rates. PCA evaluated each security and took into account the severity and duration of the impairment, the current rating on the bond, and the outlook for the issuer according to independent analysts. PCA believed that the foregoing declines in fair value in its existing portfolio are most likely attributable to short-term market trends, and there is no evidence the entire amortized cost basis will not be recovered.
PCA’s losses and loss adjustment expenses ratio was 140.5% for the year ended December 31, 2018 as compared to 53.6% for the year ended December 31, 2017.
The favorable development of $0.4 during the year ended December 31, 2017 was primarily related to re-estimation of unpaid losses and loss adjustment expenses on all claims-made policy years. The unfavorable development of $6.1 million during the year ended December 31, 2018 was primarily related to the 2015 to 2017 policy years based on changes in reserve indications from December 31, 2017. The unfavorable development of $(6.1) million during the year ended December 31, 2018 was primarily related to reserve strengthening in the 2015 ($400,000) occurrence policy year, the 2016 ($500,000) tail policy year and the 2017 ($400,000) and 2014 through 2017 ($4,500,000) claims-made policy years. A majority of these changes in indications were related to PCA’s new claims management team and a change in reserving philosophy of setting reserves at the expected value as soon as possible when the liability is acknowledged.
As discussed in “Critical Accounting Policies”, the MPL line of business is prone to variability in the loss reserving process due to the extended period of time during which claims can be made. Adjustments to our original estimates resulting from claims are not made until the period in which there is reasonable evidence that an adjustment to the reserve is appropriate.
For the year ended December 31, 2018, PCA had an income tax benefit of $(1.5) million as compared to an income tax expense of $0.2 million for the year ended December 31, 2017. PCA’s effective tax rate for the years ended December 31, 2018 and 2017 was 21% and 34%, respectively.
For the year ended December 31, 2018, PCA had a net loss of $(4.5) million as compared to net income of $0.3 million for the year ended December 31, 2017.
Each Pennsylvania domiciled property and casualty insurer pays PIGA an annual assessment based on its direct premiums written in Pennsylvania. PCA incurred assessment expense (income) of $(11,000) and $22,000 for the years ended December 31, 2018 and 2017, respectively.
payments made from December 31, 2017 to December 31, 2018, and net unrealized losses recorded for 2018 as compared to net unrealized gains for 2017. Reinsurance receivables, which are attributable mainly to the timing of payments from reinsurers, decreased by approximately $0.1 million from December 31, 2017 to December 31, 2018, while premiums receivable decreased by $0.3 million from December 31, 2017 to December 31, 2018, all of which were offset by an increase in deferred income taxes of $1.0 million from December 31, 2017 to December 31, 2018.
For the year ended December 31, 2018, cash flows from operating activities were $(3.3) million as compared to $(5.6) million for the year ended December 31, 2017. This smaller negative cash flows from operating activities was primarily caused by the timing of paid losses and less premiums written in 2018 as compared to 2017. Cash flows from investing activities were $0.2 million for the year ended December 31, 2018 as compared to $4.5 million for the year ended December 31, 2017, primarily reflecting the time needed to reinvest funds from maturing securities. Cash flows from financing activities for the year ended December 31, 2018 was $0 as compared to $(0.5) million for the year ended December 31, 2017. For the year ended December 31, 2018, there were no cash flows from financing activities.
PCA had no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, results of operations, liquidity, capital expenditures, or capital reserves.
The major components of PIPE’s operating revenues and net income are as follows (dollars in thousands):
Direct premium written for the year ended December 31, 2018 was $3.4 million as compared to $3.6 million for the year ended December 31, 2017, or a 6% decrease. Direct premium earned for the year ended December 31, 2018 was $3.7 million as compared to $3.8 million for the December 31, 2017, or a 3% decrease. Direct ceded premium earned for the year ended December 31, 2018 was $0.3 million as compared to $0.6 million for the year ended December 31, 2017, or a decrease of 51%.
Net investment income for the year ended December 31, 2018 was $0.4 million as compared to $0.5 million for the year ended December 31, 2017. The average monthly net investment income decreased from $43,000 during the year ended December 31, 2017 to $30,000 during the year ended December 31, 2018. For the year ended December 31, 2018, PIPE adopted an accounting standard which requires that unrealized gains or losses for equity securities previously classified as available-for-sale securities for 2017 be recorded against earnings of the exchange. The effect of adopting the accounting standard was to reduce net investment income by $0.3 million or a reduction of the average monthly net investment income amount for 2018 by $35,000. With the exclusion of adopting the new accounting standard, the average monthly net investment income would have been $55,000 and the return on average cash and invested assets would have been 2.76% for the year ended December 31, 2018.
PIPE had net realized gains of $39,000 for the year ended December 31, 2018 as compared to net realized gains of $51,000 for the year ended December 31, 2017.
PIPE’s losses and loss adjustment expenses ratio was 86.4% for the year ended December 31, 2018 as compared to 57.9% for the year ended December 31, 2017.
For the year ended December 31, 2018, PIPE had an income tax benefit of $(0.4) million as compared to an income tax expense of $101,000 for the year ended December 31, 2017. PIPE’s effective tax rate for the years ended December 31, 2018 and 2017 was 21% and 34%, respectively.
For the year ended December 31, 2018, PIPE had a net loss of $(0.8) million as compared to a net loss of $(60,000) for the year ended December 31, 2017.
At December 31, 2018, PIPE had total liabilities of $13.8 million as compared to $14.4 million at December 31, 2017. The decrease in total liabilities of $0.6 million is primarily attributable to a $198,000 decrease in the liability for losses and loss adjustment expenses, a $505,000 decrease in unearned and advance premiums, and a decrease in due to affiliates of $37,000, which were offset by an increase in reinsurance payable of $30,000 during the year ended December 31, 2018.
At December 31, 2018, PIPE had total equity of $11.2 million as compared to $12.3 million at December 31, 2017. The change in equity during the year ended December 31, 2018 is related to comprehensive loss of $(1.1) million. The change in equity during the year ended December 31, 2017 is related to comprehensive income of $32,000.
The following table summarizes, as of December 31, 2018 (unaudited), PIPE’s future payments under contractual obligations and estimated claims and claims related payments for continuing operations.
Cash flows from continuing operations for the years ended December 31, 2018 and 2017 were as follows (dollars in thousands):
Positive Physicians Holdings, Inc. (“Company”) is a newly created Pennsylvania domiciled holding company formed to be the stock holding company for Positive Physicians Insurance Company (“PIC”) following the conversions of Positive Physicians Insurance Exchange, Professional Casualty Association, and Physicians’ Insurance Program Exchange from reciprocal insurance exchanges to stock insurance companies pursuant to the Pennsylvania Medical Professional Liability Reciprocal Exchange-to-Stock Conversion Act (“Conversion Act”). The Company was incorporated under the laws of the Commonwealth of Pennsylvania on May 1, 2018. The Company has had no significant operations and has not engaged in any business to date.
Positive Physicians Insurance Exchange (“PPIX”) was a subscriber-owned, reciprocal insurance exchange. PPIX received its Certificate of Authority on April 20, 2004 from the Commonwealth of Pennsylvania Insurance Department (“Department”) and commenced operations on July 1, 2004. On May 1, 2011, the PPIX expanded its operations and was issued a Certificate of Authority by the New Jersey Department of Banking and Insurance. PPIX continued to expand its operation and was issued Certificates of Authority by the Delaware Department of Insurance, Ohio Department of Insurance, and Maryland Department of Insurance on February 13, 2013, March 25, 2013, and April 30, 2014, respectively. PPIX’s primary business is to provide medical professional liability insurance consisting of claims-made, tail occurrence, and occurrence policies to its subscribers. The members of PPIX consisted exclusively of PPIX’s subscribers. Underwriting is based on the applicants’ specialty, location, and claims history. PPIX was managed by Specialty Insurance Services, LLC (“SIS”), a Pennsylvania limited liability company, pursuant to the terms of an Attorney-In-Fact Agreement between PPIX and SIS, effective March 10, 2004. Pursuant to the terms of the amended agreement, SIS provided underwriting and administrative services to PPIX based on a percentage not to exceed 25% for gross written premium, less return premium.
On October 9, 2018, Positive Physicians Captive Insurance Company, a sponsored captive insurance company, was incorporated in the State of New Jersey and became a wholly-owned subsidiary of PPIX. PPCIC was licensed under the New Jersey Captive Insurance Act on October 16, 2018. PPCIC has one protected unincorporated cell, Keystone Captive Group (“Keystone”). Keystone is owned by an insured of the Exchange. Effective October 16, 2018, the Exchange entered into a reinsurance agreement with Keystone.
Professional Casualty Association (“PCA”) was an unincorporated, subscriber-owned exchange organized on April 16, 2003. PCA received its Certificate of Authority on June 26, 2003 and was licensed by the Department as a reciprocal insurance exchange. Additionally, PCA was licensed as an admitted carrier on November 2, 2015 by the Michigan Department of Insurance and Financial Services. PCA’s primary business is to provide medical professional liability insurance consisting of claims-made, tail occurrence, and occurrence policies to its subscribers. The members of PCA consisted exclusively of PCA’s subscribers. Underwriting is based on the applicants’ specialty, location, and claims history. PCA was managed by Professional Third Party, LP (“PTP”) pursuant to the terms of an Attorney-In-Fact Agreement between PCA and PTP, effective April 16, 2003. Pursuant to the terms of the agreement, PTP provided salaries and benefit expenses of the employees, rent and other occupancy expenses, supplies, and data processing services to PCA and pays certain expenses on behalf of PCA in exchange for 25% of the gross written premium.
Physicians’ Insurance Program Exchange (“PIPE”) is an unincorporated, subscriber-owned, exchange organized on March 14, 2005. The Exchange received its Certificate of Authority on August 24, 2005 and was licensed by the Department as a reciprocal insurance exchange. Additionally, PIPE was licensed as an admitted carrier on October 15, 2013 by the South Carolina Department of Insurance. PIPE’s primary business is to provide medical professional liability insurance consisting of claims-made and occurrence basis policies to health care providers practicing in the Commonwealth of Pennsylvania. The members of PIPE consisted exclusively of PIPE’s subscribers.
Underwriting is based on the applicants’ specialty, location and claims history. PIPE was managed by Physicians’ Insurance Program Management Company (“PIPMC”) pursuant to the terms of an Attorney-In-Fact Agreement between PIPE and PIPMC, effective August 24, 2005. Pursuant to the terms of the agreement, PIPMC provided salaries and benefit expenses of the employees, rent and other occupancy expenses, supplies, and data processing services to PIPE and pays certain expenses on behalf of PIPE for 25% of gross written premium.
Diversus, Inc. (“Diversus”) is a Delaware domiciled holding company which was formed to aggregate specialty insurance business in the medical professional insurance market. Diversus was initially formed in Bermuda as DSN Holdings, Ltd. on December 28, 2012. SIS, PTP, and PIPMC are wholly-owned subsidiaries of Diversus. SIS, PTP, and PIPMC had the power to direct the activities that most significantly impact the economic performance of PPIX, PCA, and PIPE, respectively. Diversus Management, Inc. (“DMI”), a wholly-owned subsidiary of Diversus, provided services to PPIX, PCA, and PIPE. As the Company is scheduled not to have any full-time employees, after completion of the conversions and the offerings, DMI will manage the daily operations of the Company and its wholly-owned subsidiary, PIC, which will be the successor to PPIX, PCA, and PIPE. DMI currently provides the staff and resources to SIS, PTP, and PIPMC under intercompany arrangements. The attorneys-in-fact will be merged into DMI and will cease to exist as separate entities upon completion of the conversions and offerings as discussed in Note 3 and 4.
Insurance Capital Group, LLC (“ICG”) is a Delaware domiciled holding company that was organized on January 8, 2018, for the purpose of acquiring and making investments in businesses across targeted sectors, with a focus on sponsored insurance company demutualization’s and other complex conversion transactions.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in these financial statements and notes. Actual results could differ from these estimates and such differences could be material.
The Conversion Act requires the reciprocal insurance exchange to adopt a plan of conversion that grants each eligible subscriber nontransferable subscription rights to purchase a portion of the capital stock of the converted stock company. Such rights, in the aggregate, must give the eligible subscribers the right, prior to the right of any other person, to purchase 100% of the capital stock of the converted stock company. The Conversion Act also requires that the plan of conversion provide that if the eligible subscribers do not purchase all the shares being offered, the remaining shares must be sold in a public offering or a private placement with the approval of the Department.
On June 1, 2018, SIS adopted a plan of conversion by which PPIX would convert from a reciprocal insurance exchange to a stock insurance company by merging with and into PPIX Conversion Corp. Following the conversion, PPIX Conversion Corp. became a wholly-owned subsidiary of the Company. The affirmative vote of at least two-thirds of the votes cast by subscribers of PPIX as of June 1, 2018, is necessary to approve the plan of conversion at a special meeting of the subscribers which was held on March 25, 2019.
On June 1, 2018, PTP adopted a plan of conversion by which PCA would convert from a reciprocal insurance exchange to a stock insurance company by merging with and into PCA Conversion Corp. Following the conversion, PCA Conversion Corp. became a wholly-owned subsidiary of the Company. The affirmative vote of at least two-thirds of the votes cast by subscribers of PCA as of June 1, 2018, is necessary to approve the plan of conversion at a special meeting of the subscribers which was held on March 25, 2019.
In connection with the completion of the conversions, all of the outstanding shares of common stock shares of PPIX Conversion Corp., PCA Conversion Corp., and PIPE Conversion Corp. are to be issued to the Company, and they will then become wholly-owned stock subsidiaries of the Company. Contemporaneously with the completion of the conversions and the mergers, PCA Conversion Corp. and PIPE Conversion Corp. will merge with and into PPIX Conversion Corp., which will change its name to Positive Physicians Insurance Company. PIC will then be the Company’s sole subsidiary.
On February 5, 2019, the Department approved the conversion plans of PPIX, PCA, and PIPE. The conversions from reciprocal insurance exchanges to stock insurance companies took place on March 27, 2019. On the same date, PCA Conversion Corp. and PIPE Conversion Corp. merged with and into PPIX Conversion Corp. and the resulting company was renamed was Positive Physicians Insurance Company.
As part of the conversions of PPIX, PCA, and PIPE, the Company is scheduled to offer between 3,570,000 shares and 4,830,000 shares of its common stock at a price of $10 per share. The offering is to commence in two phases: (1) subscription offering and (2) community offering.
Holders of Diversus’s common stock are permitted to purchase that number of shares that have a purchase price equal to 33% of the purchase price such stockholder paid for such stockholder’s shares of Diversus’ common stock. Holders of Diversus’s preferred stock are permitted to purchase that number of shares that have a purchase price equal to 10% of the purchase price such stockholder paid for such stockholder’s shares of Diversus’ preferred stock. However, the stockholders of Diversus (excluding Enstar) collectively cannot purchase more than 5% of the total number of shares available after giving effect to the shares sold in the subscription offering and no Diversus stockholder (other than Enstar) may purchase, together his or her affiliates, more than 25,000 shares of the Company’s common stock.
On June 8, 2018, the Company entered into the standby stock purchase agreement with ICG. Subject to the terms and conditions of the standby stock purchase agreement, ICG has agreed to purchase from the Company at a price of $10 per share such number of shares as is necessary in the community offering phase for the minimum of 3,570,000 shares to be sold as required under the plan of conversion. ICG, however, has the right to purchase additional shares from the Company up the offering maximum of 4,830,000 shares. ICG, as the standby purchaser, has agreed to permit Enstar to purchase 30% of the shares that ICG would otherwise purchase in the offering pursuant to a governance agreement entered between ICG and Enstar.
During 2018, each of the exchanges paid a management fee equal to 25% of its gross written premium to its respective attorney-in-fact. The Company and PIC have entered into a management agreement with DMI that will be effective upon completion of the conversions and the offerings. The new management agreement will be for a term of seven years and will automatically be renewed for one year at each anniversary date of the agreement so that the remaining term of the agreement will always between six to seven years. However, the management agreement may be terminated by either party under certain circumstances. Underwriting decisions will be made by the officers of PIC. Additionally, the board of directors of PIC will have enhanced oversight and approval rights over the services provided and decisions made by DMI on PIC’s behalf. The new management agreement is subject to approval by the Department.
Under the new management agreement, PIC will incur a base management fee based upon a percentage of its gross written premium, less return premium. Beginning in 2019, the fee will be reduced from the 2018 rate of 25% of gross written premium to 12%. The base management fee percentage will subsequently decline to 11% for 2020 and 10% for 2021. At January 1, 2022, the base management fee percentage will thereafter be set at 9%. If by December 31, 2019, Holdings has not acquired one or more additional insurance entities with additional annual gross written premium of at least $10,000,000 and that become subject to the management agreement, the reduction in fees scheduled for 2020 will be deferred by one year. The agreement also provides for a performance management fee reflecting the profitability of PIC based upon the ratio of PIC’s losses and loss adjustment expenses and other underwriting expenses to net earned premium. In consideration for the new management agreement that provides for reduced management fees, the Company will make a one-time payment of $10,0000,000 from the proceeds of the offering to Diversus.
Payment of dividends on the Company’s common stock is subject to the determination of the Company’s board of directors. Additionally, Pennsylvania law sets the maximum amount of dividends that may be paid by PIC during the twelve-month period after notice to, but without prior approval of, the Department. This amount cannot exceed the greater of (1) 10% of the Company’s surplus as reported on the most recent annual statement filed with the Department, or (2) the Company’s statutory net income for the period covered by the annual statement as reported on such statement.