Positive Insurance Company underwrites medical professional liability coverage for physicians, their corporations, medical groups, clinics and allied healthcare providers. Medical professional liability insurance (“MPLI”) protects physicians and other health care providers against liabilities arising from the rendering of, or failure to render, professional medical services. We offer claims-made coverage, claims-made plus, and occurrence-based policies as well as tail coverage in Pennsylvania, New Jersey, Ohio, Delaware, Maryland, South Carolina, and Michigan. Our policies include coverage for the cost of defending claims. Claims-made policies provide coverage to the policyholder for claims reported during the period of coverage. We offer extended reporting endorsements, or tails, to cover claims reported after the policy expires. Occurrence-based policies provide coverage to the policyholders for all losses incurred during the policy coverage year regardless of when the claims are reported. Although we generate a majority of our premiums from individual and small group practices, we also insure several major physician groups.
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).
PIPE marketed its medical professional liability insurance policies through independent producers to doctors and allied healthcare professionals who practice primarily in Pennsylvania. PIPE also had a license and wrote business in South Carolina.
PIPE was managed by Physicians’ Insurance Program Management Company (“PIPE Management”), a Pennsylvania corporation, pursuant to the terms of an Attorney-in-Fact Agreement between the exchange and PIPE Management. PIPE Management 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 in exchange for 25% of gross written premium. As the attorney-in-fact, PIPE Management 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 with and into Diversus Management in connection with the conversions on March 27, 2019.
The MPLI industry is affected by recurring industry cycles known as “hard” and “soft” markets. A soft market is characterized by intense competition, resulting in lower pricing in order to compete for business. A hard market, generally considered a beneficial industry trend, is characterized by reduced competition that results in higher pricing. From approximately 2001 until approximately 2007, the Pennsylvania MPLI market experienced a hard market cycle. This resulted in the creation of several alternative MPLI providers, such as PPIX, PCA, and PIPE.
The soft market cycle troughed in 2012, and since then, national loss payouts, on average, have steadily increased through 2019. As a result, underwriting criteria in the MPLI industry has started to become more stringent, with opportunities for improved pricing, and we believe the market cycle is currently transitioning to a hard market. At Positive Insurance Company, beginning in April 2020 our renewal book of business has begun to experience price increases of 2.5% through reduced credits, a development which we expect to continue and extend through our policy renewals in 2020. We are also seeing rate increases take place by other carriers in many of the states in which we write business.
Positive Insurance Company derives its revenue primarily from net premiums earned, net investment income, and net realized and unrealized 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 recognized as revenue in subsequent periods over the remaining term of the policy. The policies written by Positive Insurance Company typically have a term of twelve months. Thus, for example, for a policy that is written on July 1, 2019, one-half of the premiums would be earned in 2019 and the other half would be earned in 2020.
We invest our surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid loss and loss adjustment expenses) in cash, cash equivalents, short-term investments, and equity and debt securities. Investment income includes interest and dividends earned. We recognize realized gains when invested assets are sold for an amount greater than their cost or amortized cost (in the case of fixed maturity securities) and recognize realized losses when investment securities are written down as a result of other-than-temporary-impairment or sold for an amount less than their cost or amortized cost, as applicable. Realized gains and losses on sales of fixed maturity and equity securities and other investments and unrealized holding gains and losses on equity securities and other investments are included in realized investment gains (losses), net. Our portfolio of investment securities is managed by our outside investment manager, who has discretion to buy and sell securities in accordance with the investment policy approved by Positive Insurance Company’s Board of Directors.
Losses and loss adjustment expenses (“LAE”) represent the largest expense item and include: (1) claim payments made, (2) estimates for future claim payments and changes in those estimates for prior periods, and (3) costs associated with investigating, defending and adjusting claims, including legal fees.
We evaluate our insurance operations by monitoring certain key measures of growth and profitability. Some of these measurements are “non-GAAP” financial measurements under Securities and Exchange Commission rules and regulations. We utilize certain non-GAAP financial performance measures that are widely 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 loss and LAE ratio, expense ratio, combined ratio, underwriting income (loss), and operating income (loss).
We measure growth by monitoring changes in gross premiums written and net premiums written, and measure underwriting profitability by examining losses and LAE, underwriting expenses and combined ratios. We also measure profitability by examining underwriting income (loss) and operating income (loss).
The expense ratio is the ratio (expressed as a percentage) of other underwriting expenses (attributable to insurance operations) to premiums earned, and measures our operational efficiency in producing, underwriting and administering the Company’s insurance business.
Underwriting income (loss) measures the pre-tax profitability of insurance operations. It is derived by subtracting losses and loss adjustment expenses and other underwriting expenses from earned premiums.
We utilize an independent actuary to assist with the estimation of our losses and LAE reserves on a quarterly basis. Our independent actuary prepares estimates of the ultimate liability for unpaid losses and LAE based on established actuarial methods described below. We review these estimates and supplement the actuarial analysis with information not fully incorporated into the actuarially based estimate, such as changes in the external business environment and changes in internal company processes and strategy. We may adjust the actuarial estimates based on this supplemental information in order to arrive at the amount recorded in the financial statements.
Actual versus Expected Model - The Actual versus Expected Model utilizes the actuarial point ultimate loss and defense containment cost (“DCC”) estimates as of the prior reserve review which are adjusted based on the difference between actual and expected loss development between the prior reserve review and the current evaluation to arrive at an updated actuarial point ultimate loss and DCC estimate. The method is dependent on the loss development factors used to determine the expected losses.
Expected Loss Ratio Method - The Expected Loss Ratio Method utilizes some measure of anticipated losses and does not consider actual losses. An expected loss ratio, a ratio of anticipated losses relative to some measure of exposure, is applied to that measure of exposure to determine estimated ultimate losses for each year. This method provides stability over time because the ultimate loss estimates do not change unless the exposure measure changes. This is offset by a lack of responsiveness to actual loss experience.
Frequency/Severity Method - The Frequency/Severity Method estimates ultimate losses by estimating a frequency and a severity component. For each year, the actuary estimates ultimate claim counts and an ultimate average severity. The actuary then multiplies these two estimates together. The method is useful when the claim count development pattern is more stable than the loss development pattern.
We estimate 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. We then reduce the estimated ultimate losses and LAE by loss and LAE 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, we consider 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.
Changes in the company’s internal claims processing policies and procedures; and
Our actuary is required to exercise a considerable degree of judgment in the evaluation of all of these and other factors in the analysis of losses and loss adjustment expenses, and related range of anticipated losses. Because of the level of uncertainty impacting the estimation process, it is reasonably possible that different actuaries would arrive at different conclusions. The method of determining the reserve range has not changed and the reserve range generated by the actuary is consistent with the observed development of our loss reserves over the last few years.
Positive Insurance Company uses a combination of the Actual versus Expected Method, Bornhuetter-Ferguson Method, Expected Loss Ratio Method, Frequency/Severity Method, and the Incurred Loss Development Method in order to estimate its liability for losses and LAE. Following the conversions and merger which were completed on March 27, 2019, the Company changed its approach by aggregating its data, previously under PPIX, PCA, and PIPE, and performing a single loss reserve analysis, as opposed to three separate loss reserve analyses. The Company used combined development patterns based on PPIX, PCA, and PIPE experience for claims-made development factors, but derived occurrence development factors strictly based on former PPIX
The components of our (favorable) unfavorable development of reserves for losses and LAE for prior accident years by accident year were as follows (dollars in thousand):
We have structured our investment portfolio to provide an appropriate matching of maturities with anticipated claims payments. The fair values of these investments are subject to fluctuation in interest rates. If we decide or are required in the future to sell securities in a rising interest rate environment, then we would expect to incur losses from such sales. As of December 31, 2019, the average duration of our fixed maturity security investments that support the insurance reserves was approximately 3.1 years and the duration of our insurance reserves was about 2.6 years. The difference in the duration of our investments and our insurance reserves reflects our decision to maintain longer asset duration in order to enhance overall yield, while maintaining a high overall credit quality. We estimate that a 100 basis points (bps) increase in interest rates would reduce the valuation of our fixed maturity portfolio by $3,416,769 at December 31, 2019.
Investments in fixed maturity securities are classified as available-for-sale and are stated at fair value. Unrealized holding gains and losses, net of related tax effects, on available-for-sale fixed maturity securities are recorded directly to accumulated other comprehensive income (loss). Investments in equity securities are stated at fair value and unrealized holding gains and losses are credited or charged to net income (loss) as incurred. During 2019 and 2018, we had ownership interests in limited partnership equity hedge funds which were sold in 2019. The partnership interests were measured at fair value using the funds’ net asset values as a practical expedient. Unrealized holding gains and losses on partnership interests were credited or charged to net income (loss) as incurred. Realized gains and losses on sales of equity and fixed maturity securities as well as other investments are recognized into income based upon the specific identification method. Interest and dividends are recognized as earned. We regularly evaluate all of our investments based on current economic conditions, credit loss experience, and other specific developments. If there is a decline in a security’s net realizable value that is other than temporary, it is considered as a realized loss and the cost basis in the security is reduced to its estimated fair value.
The following table shows the fair value and amortized cost/cost of our available-for-sale fixed maturity securities:
The fair value of these securities increased $10,541,373 during 2019, primarily due to the investing of net proceeds from the initial public offering stock issuance and unrealized appreciation driven by declining interest rates. The net unrealized gain on these securities at December 31, 2019 was $2,075,598 or more than 2% of the amortized cost or cost basis. The net unrealized gain included gross unrealized gains of $2,127,857 and gross unrealized losses of $52,259.
For 2019 and 2018, we determined that none of our 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.
Quoted prices for similar assets in active markets, quoted prices for identical or similar assets in nonactive markets (few transactions, limited information, noncurrent prices, high variability over time, etc., inputs other than quoted prices that are observable for the asset (interest rates, yield curves, volatilities, default rates, etc., and inputs that are derived principally from or corroborated by other observable market data)).
We obtain one price for each security primarily from a third-party pricing service (“pricing service”), which generally uses quoted prices or other observable inputs for the determination of fair value. The pricing service normally derives the security prices through recently reported trades for identical or similar securities, making adjustments through the reporting date based upon available observable market information. For securities not actively traded, the pricing service may use quoted market prices of comparable instruments or discounted cash flow analyses, incorporating inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, non-binding broker quotes, benchmark yields, credit spreads, default rates, and prepayment speeds.
Our investment portfolio has experienced significant fluctuations in fair value as a result of the market volatility due to the COVID-19 pandemic. The following tables reflect the changes in our investment portfolio since December 31, 2019.
Certain direct acquisition costs consisting of commissions, premium taxes and certain other direct underwriting expenses that vary with and are primarily related to the successful production of business are deferred and amortized over the effective period of the related insurance policies as the underlying policy premiums are earned. The method followed in computing deferred acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, may require adjustments to deferred acquisition costs. If the estimation of net realizable value indicates that the deferred acquisition costs are not recoverable, they would be written off.
At December 31, 2019, we had a net deferred tax asset of $891,584, resulting from $2,362,499 of gross deferred tax assets reduced by $1,470,915 of deferred tax liabilities. In establishing the appropriate value of this asset, management must make judgments about our ability to utilize the net tax benefit from the reversal of temporary differences and the utilization of operating loss carryforwards that will begin to expire in 2038.
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 our deferred tax assets.
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.
Our premium levels and underwriting results have been, and continue to be, influenced by market conditions. Pricing in the MPLI industry historically has been cyclical. During a soft market cycle, price competition is more significant than during a hard market cycle which makes it difficult to attract and retain properly priced MPLI business. As previously discussed, the markets in which we operate, and the national MPLI markets, have been in a prolonged period of a soft market cycle. However, we have started to see price increases with our policy renewals in 2020 and we believe the market is beginning to harden. Therefore, it is generally likely that insurers will be able to increase their rates or profit margins, as market conditions continue to improve. A hard market typically has a positive effect on premium growth, which can include absolute increases in premiums written.
In 2019, we had a net loss of $(238,951), compared to a net loss of $(5,371,516) in 2018. We also reported operating losses of $(1,269,329) and $(4,160,239) in 2019 and 2018, respectively.
Total revenues for 2019 were $27,965,606, compared to $24,623,479 for 2018. The increase in revenues for 2019, compared to prior year, primarily reflects unrealized gains on equity securities recognized in 2019 in contrast to unrealized losses recorded in 2018. To a lesser extent, the increase in revenues also reflects realized gains on sales of other investments in 2019 and higher net investment income reported in current year. Net premiums earned increased modestly in 2019, compared to 2018.
The comparative changes in premiums written and premiums earned for 2019 and 2018 are reflected in the table below. The increases in direct and net premiums written are primarily due to new business written during 2019, while premiums earned remained relatively consistent year-over-year.
The increase in net investment income primarily reflects the increase in our cash and invested asset positions, due to proceeds from the initial public offering stock issuance in 2019.
Realized net investment gains (losses) for 2019 and 2018 are as follows:
Other underwriting expenses, including changes in deferred acquisition costs, were $12,619,517 for 2019, compared to $12,340,647 for 2018. The amount for 2019 includes expenses incurred by the holding company which did not exist in prior year. Positive Insurance Company pays a management fee to Diversus Management which is equal to a percentage of premiums written. This percentage was 25% in 2018 and was reduced to 12%, effective March 27, 2019. The reduction in the management fee is largely offset by the increase due to holding company expenses in 2019. Positive Insurance Company also had $371,000 and $532,000 in initial public offering and conversion costs that were expensed during 2019 and 2018, respectively, and are included in other underwriting expenses.
We maintained investment and reinsurance programs that are intended to provide sufficient funds to meet our obligations without forced sales of investments. As such, our investment portfolio contains a high degree of liquidity, with relatively short-term and highly liquid assets, to ensure the availability of funds and to meet the demands of claim settlements and operating expenses. We also have an Investment Committee which meets regularly to discuss cash flow projections and our short-term cash needs as well as asset allocation within our investment portfolio.
Furthermore, liquidity requirements are met primarily through operating cash flows and by maintaining a portfolio with maturities that reflect our estimates of future cash flow requirements. Our investment strategy includes setting guidelines for asset quality standards, allocating assets among investment types and issuers, and other relevant criteria for our portfolio. In addition, invested asset cash flows, which include both current interest income received and investment maturities, are structured to consider projected liability cash flows of loss reserve payouts that are based on actuarial models. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying invested assets. Our invested assets are structured to emphasize current investment income while maintaining appropriate portfolio quality and diversity.
The Company 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.
Consolidated Statement of Comprehensive Income (Loss) for the Year Ended December 31, 2019 and Combined Statement of Comprehensive Income (Loss) for the Year Ended December 31, 2018
We have audited the accompanying consolidated balance sheet of Positive Physicians Holdings, Inc (the "Company") as of December 31, 2019, the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows, for the year ended December 31, 2019, and the combined balance sheet as of December 31, 2018, the related combined statements of operations, comprehensive income (loss), stockholders' equity, and cash flows, for the year ended December 31, 2018, and the related notes and financial statement schedules I and V (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America.
The Company accounts for its medical professional liability insurance business as a single reporting segment line of business.
Upon completion of the conversions of PPIX, PCA, and PIPE and the securities offering on March 27, 2019, the Company and Diversus entered into an option agreement whereby either party has the option to cause Diversus, subject to shareholder approval, to merge with and become a wholly owned subsidiary of the Company. Under the terms of the agreement, the option may be exercised by either the Company or Diversus at any time (1) during the period beginning 2 years after completion of the conversions of the exchanges and ending 54 months after the completion of the conversions, or (2) if earlier than 2 years after the completion of the conversions, then such date that the majority stockholder of the Company no longer has the right to appoint a majority of the board of directors of the Company. In connection with any merger, the common stock shareholders of Diversus will receive either cash, common stock shares of the Company, or some combination thereof for their shares of Diversus’ common stock. With respect to the preferred stock shares of Diversus, they will either be paid out in cash or converted into common stock shares of Diversus as if such preferred stock shares were converted into Diversus’ common stock shares immediately prior to the effective date of the merger.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Positive Physicians Holdings, Inc. was formed on May 1, 2018. The accompanying financial statements for 2018 have been prepared on a combined basis and reflect our historical financial information and results of operations of PPIX, PCA, and PIPE as if the conversions and merger took place as of January 1, 2018. Prior to the completion of the initial public offering, the Company, PPIX, PCA, and PIPE were under the common control of Diversus. Additionally, prior to March 27, 2019, the Company did not engage in substantive pre-combination activities, and accordingly, is not considered the acquirer of the net assets of Positive Insurance Company. The acquirer of these net assets is the majority stockholder of the Company. Accordingly, the accompanying financial statements do not reflect any adjustments to fair value as might have been determined had the Company accounted for the acquisition of Positive Insurance Company’s net assets as a business combination.
Our consolidated financial statements include our accounts and those of our wholly owned subsidiary. We have eliminated all inter-company accounts and transactions in consolidation.
In 2018, the Company had ownership interests in limited partnership equity hedge funds, which are reported as other investments in the accompanying combined balance sheet. The partnership interests were measured at fair value using the funds’ net asset values as a practical expedient. Unrealized holding gains and losses on partnership interests were credited or charged to net income (loss) as incurred and are included in realized investment gains (losses), net in the accompanying combined statement of operations. The Company sold these partnership interests during the second half of 2019.
The Company regularly evaluates all of its investments based on current economic conditions, credit loss experience, and other specific developments. If there is a decline in a security’s net realizable value that is other than temporary, it is considered as a realized loss and the cost basis in the security is reduced to its estimated fair value.
We also offer extended reporting coverage at no additional charge in the event of disability, death or retirement after a policyholder reaches the age of 55 and has been a mature-claims policyholder with Positive Insurance Company for at least one year. An extended reporting endorsement policy reserve is required to assure that premiums are not earned prematurely. This reserve is actuarially determined, and the balance is included in unearned premiums in the consolidated and combined balance sheets.
Premium deficiency reserves and the related expenses are recognized when it is probable that expected future benefit payments, loss adjustment expenses, direct administration costs, and an allocation of indirect administration costs under a group of existing contracts will exceed anticipated future premiums and reinsurance recoveries considered over the remaining lives of the contracts, and are recorded as a component of deferred acquisition costs in the accompanying consolidated and combined balance sheets. The Company does not consider anticipated investment income when calculating premium deficiency reserves. As of December 31, 2019 and 2018, the Company did not have any premium deficiency reserves.
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, short-term investments, non-U.S. government bonds, premiums receivable, and balances recoverable from reinsurers. Non-U.S. government bonds are diversified, and no one investment accounts for greater than 5% of our invested assets. Cash and cash equivalents are deposited with financial institutions with balances that fluctuate in excess of federally insured limits. If the financial institutions were not to honor their contractual liability to us, we could incur losses. We are of the opinion that there is low risk because of the financial strength of the respective financial institutions. We are also subject to concentrations of credit risk through short-term money market investments. The credit risk related to short-term money market investments is minimized by our investing in money market funds or repurchase agreements, both secured by U.S. government securities.
Premiums associated with tails are generally earned as written, except for the afore-mentioned extended reporting coverage in the event of disability, death or retirement. Other forms of tails, in which premiums are earned as written, include the following: 1) An insured who terminates a claims-made policy with their prior carrier, and who purchases tail coverage (extended reporting coverage) from their old carrier or obtains retroactive (prior-acts) coverage from a new carrier, or 2) Stand-alone tail coverage in which an insured is offered a tail policy by their prior carrier but seeks a competitive quote from a different carrier. Both types of tail coverage insure against claims reported after the end of the original policy period for incidents that occurred while that policy was in effect.
The Company accounts for income taxes under the asset and liability approach, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated and combined financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the consolidated and combined financial statements and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
The Company records net deferred tax assets to the extent it believes these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversal of existing taxable temporary differences, tax planning strategies, projected future taxable income, and recent financial operations.
PPIX, PCA, and PIPE incurred direct consulting and other costs related to the conversions from reciprocal insurance exchanges to stock forms of ownership and as part of offering securities during the initial public offering which took place on March 27, 2019. Conversion and securities offering costs that were not expected to be reimbursed from the gross proceeds of the offering were expensed as incurred and included in other underwriting expenses in the accompanying consolidated and combined statements of operations.
clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.
With the adoption of ASU 2016-01, a cumulative effect of unrealized holding gains and losses on previously classified available-for-sale equity securities included in accumulated other comprehensive income at January 1, 2018 are to be reclassified to retained earnings. At January 1, 2018, unrealized holding gains in equity securities, net of tax effect, of $1,387,895 were reclassified from accumulated other comprehensive income to retained earnings for the year ended December 31, 2018.
In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. This guidance also requires entities to make new judgments to identify leases. The guidance was effective for annual and interim reporting periods beginning after December 15, 2018 and permitted early adoption. The Company’s adoption of this guidance on January 1, 2019 did not have a significant impact on our financial condition, results of operations or cash flows.
The Company uses fair value measurements to record fair value adjustments to certain assets to determine fair value disclosures. Fixed maturity available-for-sale securities and equity securities are recorded at fair value on a recurring basis. FASB ASC Topic 820 “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The three levels of the fair value hierarchy under ASC Topic 820 are as follows:
The table below sets forth the contractual maturity profile of our investments in fixed maturity securities at December 31, 2019 and 2018. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.
Realized gains and losses are determined using the specific identification method. During the years ended December 31, 2019 and 2018, proceeds from maturities and sales and gross realized gains and losses on securities and other investments are as follows:
The components of net realized investment gains (losses) for the years ended December 31, 2019 and 2018 are as follows:
The components of net investment income for the years ended December 31, 2019 and 2018 are as follows:
At December 31, 2019, we had 47 fixed maturity securities in unrealized loss positions of less than 12 months with a combined gross unrealized loss of $14,161 and 40 securities in unrealized loss positions of 12 months or longer with a combined gross unrealized loss of $38,098.
The following table shows fair value and gross unrealized losses of our fixed maturity investments with unrealized losses that are not deemed to be other-than temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2018:
For the years ended December 31, 2019 and 2018, we determined that none of our fixed maturity 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 table below presents the level within the fair value hierarchy generally utilized by us to estimate the fair value of assets disclosed on a recurring basis at December 31, 2019:
At December 31, 2018, we had ownership interests in limited partnership equity hedge funds. Our partnership interests were measured at fair value using the funds’ net asset values as a practical expedient and are excluded from the fair value hierarchy tables above. At December 31, 2018, the fair value and cost basis of these investments were $4,051,399 and $3,547,687, respectively. During the second half of 2019, we sold our interests in these limited partnership funds and recognized a pre-tax gain of $556,723. There were no sales of these investments in 2018.
Under Pennsylvania law, each insured must maintain MPLI of at least $1,000,000 for each claim and $3,000,000 of annual aggregate coverage. The Company provides primary insurance coverage up to $500,000 per claim and $1,500,000 of annual aggregate coverage. The Pennsylvania Medical Care Availability and Reduction of Error (“MCARE”) Fund provides coverage for any losses above $500,000 per claim up to $1,000,000. In cases where coverage under the Pennsylvania MCARE Fund does not apply, the primary insurance provides coverage up to $1,000,000 per claim and $3,000,000 of annual aggregate coverage. The Company retains the first $300,000 in loss on all Pennsylvania claims and reinsurance covers the excess up to $1,000,000 that is not covered by the Pennsylvania MCARE Fund. We cede to reinsurers any Pennsylvania claims in excess of $1,000,000.
We also purchase additional reinsurance coverage for clash, losses in excess of policy limits and extra contractual obligation claims.
Reinsurance does not legally discharge the insurance company issuing the policy from primary liability for the full amount due under the reinsured policies. A primary factor in the selection of reinsurers from whom we purchase reinsurance is their financial strength. Our reinsurance arrangements are generally renegotiated annually. The insolvency or inability of any reinsurer to meet its obligations to us could have a material adverse effect on our results of operations or financial condition. Our reinsurance providers, the majority of whom are longstanding partners that understand our business, are all carefully selected with the help of our reinsurance broker. We monitor the solvency of reinsurers through regular review of their financial statements and, if available, their A.M. Best ratings. Hannover Re, our current reinsurance partner, has an “A+ (Superior)” rating from A.M. Best. According to A.M. Best, companies with a rating of “A” or better “have an excellent ability to meet their ongoing obligations to policyholders.”
As of December 31, 2019, the Company’s reinsurance recoverable of $7,850,409 was supported by $6,051,000 of collateral. The uncollateralized portion of this balance was recoverable from reinsurers rated “A” or better by A.M. Best.
As of December 31, 2019, the Company had reinsurance recoverable balances due from the following unaffiliated reinsurer in excess of 5% of shareholders’ equity:
On October 9, 2018, Positive Physicians Captive Insurance Company (“PPCIC”), a sponsored captive insurance company, was incorporated in the State of New Jersey and is a wholly owned subsidiary of Positive Insurance Company. 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 Positive Insurance Company. Effective October 16, 2018, the Company entered into a reinsurance agreement with Keystone and that agreement was endorsed in 2019 for continuous annual renewal.
The effect of reinsurance on premiums written, amounts earned, and losses incurred for the years ended December 31, 2019 and 2018 is as follows:
The liability for losses and LAE at December 31, 2019 and 2018 was $63,607,975 and $68,392,333, respectively. For the years ended December 31, 2019 and 2018, $18,588,912 and $19,412,215, respectively, has been paid for incurred claims attributable to insured events of prior years. Original estimates are increased or decreased, as additional information becomes known regarding individual claims. The Company recorded unfavorable development of $136,271 on its prior period reserves for the year ended December 31, 2019. The adverse development consisted of reserve strengthening in the 2018 report year for claims-made policies and, to a lesser extent, the 2012 and 2016 accident years for occurrence policies, but was largely offset by favorable development in the 2015 report year for claims-made policies and 2017 accident year for occurrence policies. For the year ended December 31, 2018, the Company experienced unfavorable development of $4,057,821 primarily related to significant reserve strengthening in the 2016 and 2017 accident years for both claims-made and occurrence policies.
The following information is presented about incurred and paid loss development at December 31, 2019, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities, plus expected development on reported claims included within the net incurred claims amounts.
The information about incurred and paid claims development for the years ended December 31, 2010 to December 31, 2018 is presented as supplementary information and is unaudited.
The reconciliation for the net incurred and paid loss development tables to the liability for losses and LAE at December 31, 2019 in the accompanying balance sheet is as follows:
Positive Insurance Company uses a combination of the Actual versus Expected Method, Bornhuetter-Ferguson Method, Expected Loss Ratio Method, Frequency/Severity Method, and the Incurred Loss Development Method in order to estimate its liability for losses and LAE. Following the conversions and merger which were completed on March 27, 2019, the Company changed its approach by aggregating its data, previously under PPIX, PCA, and PIPE, and performing a single loss reserve analysis, as opposed to three separate loss reserve analyses. The Company used combined development patterns based on PPIX, PCA, and PIPE experience for claims-made development factors, but derived occurrence development factors strictly based on former PPIX experience. Tail policy development factors were derived from the occurrence factors. Management does not believe that the effects of these changes had a material impact on the Company’s estimates. The year-end loss reserve analysis also assumes that the Company will no longer utilize Andrews Outsource Solutions LLC to provide claims processing and risk management services following 2020, a measure which is expected to reduce the amount of LAE incurred in subsequent periods. If this action is not taken, then the Company’s reserves for loss adjustment expenses would increase as a result. There were no other significant changes in the methodologies and assumptions used to develop the liabilities for losses and LAE during the year ended December 31, 2019.
On December 12, 2014, PPIX entered into a loan agreement with a financial institution with proceeds totaling $300,000 to finance the development of a new policy system. The loan is secured by the equipment purchased with the proceeds received. The loan is being repaid on a monthly basis from January 2016 through December 2020 with interest calculated on the unpaid principal balance at a rate of 4% per annum. At December 31, 2019 and 2018, the balance of the note payable was $64,858 and $127,327, respectively, and the Company remains compliant with all loan covenants.
The components of the Company’s income tax provision for the years ended December 31, 2019 and 2018 are as follows:
The Company’s U.S. federal statutory income tax rate applicable to ordinary income was 21% for the years ended December 31, 2019 and 2018. The income tax provision differs from that computed by applying federal statutory rate to loss before income taxes for the years ended December 31, 2019 and 2018; those income tax rate differences are summarized as follows:
The Company has applied the provisions of ASC 740, Income Taxes, for the years ended December 31, 2019 and 2018. ASC 740 prescribes a recognition threshold and measurement attribute with respect to uncertainty in income tax positions. In applying ASC 740, the Company has evaluated its various tax positions taken during the years ended December 31, 2019 and 2018. The Company has determined that based solely on the technical merits, each tax position on a current and deferred basis has a more-likely-than-not probability that the tax position will be sustained by taxing authorities. The Company is not presently under audit by any taxing authority and there are no other uncertainties and events that are reasonably possible in the next year that would cause a significant change in the amount of unrecognized tax benefits.
The Company did not recognize any interest and penalties in the accompanying consolidated and combined statements of operations for the years ended December 31, 2019 and 2018, respectively.
Additionally, as part of the enactment of the Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017, property and casualty insurance companies are required to use Internal Revenue Service (“IRS”) prescribed factors to determine the loss discount. From the date of the passage of the new law, the IRS is using a corporate bond yield curve to determine the discount factors and property and casualty insurance companies are no longer allowed to use their own historical payment patterns to determine their discount factors. Transition rules require that property and casualty insurance companies recalculate the 2017 reserve discount as if the 2018 tax reform rules had been in effect at the time of the passage of the new law, compare it to the actual 2017 reserve discount, and amortize the difference into taxable income over eight years beginning in 2018. As a result of this comparison, the Company recorded as a component of deferred income taxes at December 31, 2017 a resulting tax-effected difference amount of $201,439, for which the pre-tax amount of $959,235 is being amortized into taxable income beginning in 2018. During 2019, the IRS issued additional regulations related to the 2017 reserve discount resulting in an adjusted pre-tax amount of $1,249,684. At December 31, 2019 and 2018, the deferred tax liability related to the TCJA transitional adjustment was $224,943 and $314,446, respectively, and is included as a component of deferred income taxes.
Positive Insurance Company is managed by Diversus Management. Prior to March 27, 2019, Diversus Management, through former attorneys-in-fact of PPIX, PCA, and PIPE, earned management fees at 25% of gross written premiums of the exchanges. Concurrent with the acquisition of PPIX, PCA, and PIPE and the initial public offering on March 27, 2019, Positive Insurance Company and Diversus Management entered into a new management agreement, effective March 27, 2019, whereby Diversus Management provides administrative services to Positive Insurance Company in exchange for fees based on a percentage of Positive Insurance Company’s gross written premium, less return premium. Under the new agreement, Diversus Management earns management fees at 12%. Diversus Management may also earn quarterly performance management fees based on Positive Insurance Company’s combined ratio and net earned premiums. No quarterly performance fees were payable under the terms of the agreement at December 31, 2019.
Management fees for 2019 and 2018 are recorded in other underwriting expenses in the consolidated and combined statements of operations, respectively. Positive Insurance Company incurred management fees for the respective periods, as follows:
In connection with the execution of the new management agreement with Diversus Management, the Company paid Diversus $10,000,000 to execute the agreement. Such payment is presented as “Prepaid management fee” in the accompany consolidated balance sheet at December 31, 2019 and is amortized on a straight-line basis over a period of seven years. During the year ended December 31, 2019, the Company incurred amortization expense of $1,071,429, which is recorded in other underwriting expenses in the consolidated statement of operations.
On September 27, 2019, the Company granted its Chief Executive Officer options to purchase 216,930 shares of common stock at an exercise price of $12.01 per share, which was the closing sale price of the Company’s common stock on the date the options were granted. Of the total options, 108,465 shares will vest in equal monthly installments over a three-and-one-half year period following September 27, 2019, and the remaining 108,465 shares will vest upon the achievement by the Company of certain milestones. All vested option shares shall be exercisable for eight years from the date of vesting. The stock-based compensation expense incurred by the Company during the year ended December 31, 2019 was not significant.
The Pennsylvania MCARE Fund is a special fund established by the Commonwealth of Pennsylvania to ensure reasonable compensation for persons injured due to medical negligence. Healthcare providers who render 50% or more of his or her healthcare business or practice within Pennsylvania are required to obtain statutory excess professional liability coverage with MCARE by paying a certain percentage (assessment) of the prevailing primary premium charged by the Pennsylvania Professional Liability Joint Underwriting Association to MCARE. Positive Insurance Company assesses its policyholders as required by MCARE in addition to collecting the premium assessed. The assessments collected from policyholders are included in accounts payable, accrued expenses, and other liabilities in the accompanying consolidated and combined balance sheets, and no income is recognized by Positive Insurance Company. At December 31, 2019 and 2018, Positive Insurance Company had liabilities of $340,851 and $678,236, respectively, for amounts collected on behalf of MCARE.
Financial statements prepared under SAP focus on solvency of the insurer and generally provide a more conservative approach than under GAAP. These accounting practices differ significantly in the following respects from GAAP: (1) assets must be included in the statutory balance sheet at “admitted asset value,” whereas GAAP requires historical cost or, in certain instances, fair value; (2) “non-admitted assets” must be excluded through a charge to surplus, while on a GAAP basis “non-admitted assets” are included in the balance sheet net of any valuation allowance; (3) acquisition costs, such as commissions, management fees, premium taxes, and other items, have been charged to operations when incurred, whereas GAAP requires capitalization of these expenses, which are amortized over the term of the policies; (4) the carrying value of fixed maturity securities are based on NAIC ratings, whereas GAAP requires fixed maturity securities to be valued based on whether management intends to hold the securities to maturity; (5) changes in deferred income taxes are reported directly to surplus, whereas changes to deferred income taxes are reflected in the statement of income for GAAP; (6) deferred tax assets, net of any valuation allowance, are subject to an admissibility calculation, whereas under GAAP, no such calculation exists; and (7) ceded reinsurance amounts (unearned premiums and estimated unpaid loss recoverables) are shown net of the related liability, whereas they are presented on a gross basis and reflected as an asset for GAAP.
As a result of the COVID-19 pandemic, the Company anticipates that premiums will decrease due to policy endorsements associated with doctors electing to work part time, take a leave of absence or retire. In addition, our insureds may elect to temporarily change specialties. For example, a doctor may choose to drop from orthopedic surgery to office-only status due to the lack of elective surgeries. The Company has received notification for such requests from our policyholders which will go into effect on June 30, 2020.
In terms of collections, prior to the pandemic, the Company’s policy was to cancel any insurance policies for which premiums had not been received within 60 days subsequent to policy effective date, with notice of intent to cancel sent to the insured after 30 days post-inception date. As a result of COVID-19, the Company has updated this policy and suspended cancellations of insurance
contracts resulting from non-payment of premium until June 30, 2020 for invoices due after April 1, 2020. Through May 11, 2020, the amount of premium payment deferrals is about $817,000.
With respect to claims, Positive Insurance Company’s policyholder base mainly consists of physicians, their corporations and medical groups. During the COVID-19 pandemic, on-site visits to doctors have declined and been replaced by an increase in telehealth/virtual office visits. Since the COVID-19 pandemic resulted in government-issued work from home orders, the Company has seen the number of new claims reported begin to decrease.
The Company’s investment portfolio has experienced significant fluctuations in fair value as a result of the market volatility due to the COVID-19 pandemic. The following tables reflect the changes in our investment portfolio since December 31, 2019.
On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) into law. The CARES Act includes certain income tax-related law changes that the Company believes will have a material effect on its deferred income taxes in 2020. The most significant effect on the Company’s deferred income taxes is expected to be due to changes in the Federal net operating loss carryback provisions which will allow the Company to carryback NOLs originating in 2018 and 2019 to prior tax years with corporate income tax rates of 34% (as opposed to forward to future tax years with corporate income tax rates of 21%). The Company estimates that this change will result in additional Federal income tax refunds of approximately $1.1 million during 2020 and will reduce the Company’s NOL by about $3.1 million, or about $650,000 tax-effected.