Following is the selected financial data of the Company for the five years ended December 31, 2002. This data should be read in conjunction with the audited consolidated financial statements and notes thereto appearing under Item 8 of this Form 10-K.
Amounts derived from the audited consolidated financial statements of Midwest Holding included in Item 8 of this Form 10-K.
The financial statements of Midwest Holding and its subsidiaries are presented on a consolidated basis. In future references in this analysis, which should be read together with the 2002 audited consolidated financial statements and notes thereto appearing under Item 8 of this Annual Report on Form 10-K, Midwest Holding and its subsidiaries are referred to collectively as the Company unless the reference pertains to a specific entity.
The majority of the Company’s assets are invested in investment-grade bonds, common stocks, an international equity limited partnership, a real estate investment trust and short-term investments. These investments totaled $255,702,000 and $247,293,000 at December 31, 2002 and 2001, respectively, which represented 84% and 86% of total assets. The Investment Committee of the Board of Directors establishes the Company’s investment policy. The main objectives of the current investment policy are the preservation of assets, maximizing pretax total portfolio return and assuring adequate liquidity to meet operational requirements, particularly the payment of insurance claims. Additional information regarding the Company’s investments can be found under the Investments section in Item 1 and Note 4 of the audited consolidated financial statements in Item 8 of this Annual Report on Form 10-K.
The Company’s cash flow from operations was $24,677,000 in 2002 versus $(8,829,000) in 2001 and $1,544,000 in 2000. Growth in new business volume of approximately $18,759,000 and premium rate increases of approximately 18% on average per renewed account caused greater cash receipts in 2002. Lower policyholder dividend payments also contributed to the positive cash flow. Increased reinsurance costs due to volume growth and reinsurance rate increases partially offset the above positive cash flows. The 2001 cash flow from operations was unfavorably impacted by an increase in claim payments, policyholder dividend payments and premium adjustments paid to reinsurers on reinsurance contracts for prior years. These negative cash flows were partially offset by an increase in premium volume. The 2000 cash flow from operations was favorably impacted by premium adjustments received from reinsurers on reinsurance contracts for prior years and federal tax refunds received from the Internal Revenue Service for the 1992 to 1996 tax years. These positive cash flows in 2000 were partially offset by the payment of policyholder dividends.
New business and premium rate increases continued in 2002, driving greater cash receipts from policyholders. The exit of two main competitors, The St. Paul Companies and PHICO, from Midwest Medical’s core markets has created many new opportunities to write business. Other competitors are generally raising rates aggressively or exiting certain segments of the medical malpractice market, which has also created additional opportunities for Midwest Medical to write business. Due to these market conditions, an estimated $50,000,000 of medical malpractice insurance premium became available in Midwest Medical’s five core states during 2002.
Of that amount, Midwest Medical analyzed approximately $35,000,000, of which approximately $18,000,000 was actually written and bound. Midwest Medical is selective in the new business it writes to ensure premiums reasonably compensate it for the risks assumed. Increasing reinsurance costs and claims severity has caused, and will likely continue to cause, Midwest Medical to raise premium rates in the near term. Midwest Medical, however, has generally not had to raise rates to the same degree as other insurers in many parts of the United States medical malpractice insurance market.
More than $65,000,000 of premium has been returned to policyholders since 1993 through policyholder dividends or retrospective premium credits. The policyholder dividend program replaced the retrospective premium credit program beginning in 1999. Policyholder dividends are generally paid in four equal quarterly installments in the year following their declaration by the Board of Directors. In 2002, Midwest Medical paid the $4,050,000 of policyholder dividends declared in 2001 by its Board of Directors. In 2001, Midwest Medical paid the $8,108,000 of policyholder dividends declared in 2000 by its Board of Directors.
During 2002, Medical Solutions negotiated a $1,930,000 installment loan to finance the purchase of an unlimited license agreement to resell electronic practice management and electronic medical records software. The loan calls for 36 monthly payments of $58,634 with an effective interest rate of 5.9%. Cash from the loan is provided as the four installment payments on the
unlimited license agreement are made. During 2002, Medical Solutions paid two installments on the unlimited license agreement totaling $1,315,000 and, therefore, received two loan installments for the same amount. The remaining two installment payments totaling $615,000 were made in the first quarter of 2003. Servicing of the debt will be principally from internally generated operating funds.
The Company believes that its cash and investments, combined with cash generated from operations, will be sufficient to meet its present and reasonably foreseeable operating, capital and debt service requirements. Additional external debt financing is not anticipated. The Company does maintain a $5,000,000 secured line of credit with its bank in the event of an urgent cash need. The Company had no material capital expenditure commitments as of December 31, 2002 other than the two remaining installment payments totaling $615,000 on Medical Solutions’ unlimited license agreement
During 2000, Midwest Holding completed a stock restructure that exchanged and redeemed all outstanding Class A Common Shares. Under the terms of the stock restructure, Class A shareholders received $66 for each Class A share owned, plus one Class C share. The stock restructure paid approximately $9,541,000 to Class A shareholders for the redemption of their Class A shares. An $8,500,000 loan from Midwest Medical to Midwest Holding largely funded these payments. Midwest Medical primarily used proceeds from sales of domestic equity securities to provide the loan. The loan was a noninterest-bearing note and was retired in May 2001 by Midwest Holding through a dividend received from Midwest Medical. More details about the stock restructure, Class A and Class C Common Stock are found in Note 3 to the audited consolidated financial statements under Item 8 of this Annual Report on Form 10-K.
Shareholders’ equity decreased $15,872,000 during 2002. The decrease consisted of a net loss from operations of $(3,556,000) and net unrealized losses in the fair value of investments, net of deferred taxes, of $(12,316,000). The decline in equity market values caused $(8,600,000) of net unrealized losses in the common stock portfolio and an additional $(2,042,000) of net unrealized loss in the international equity limited partnership. The increases and decreases in shareholders’ equity are further described in the consolidated statements of changes in shareholders’ equity found in the accompanying audited consolidated financial statements found under Item 8 of this Annual Report on Form 10-K.
The estimated reinsurance premium applicable to the two reinsurance agreements covering the years 1992-1994 and 1995-1997, which is based in part on reinsured claims experience, increased $316,000 in 2002 compared to an increase of $3,125,000 in 2001. This resulted in a net increase in premiums earned between years of $2,809,000.
Premiums from reporting endorsements that provide policyholder tail coverage increased earned premium by approximately $1,686,000 in 2001.
Due primarily to the increase in premiums written, current year reinsurance costs were $1,685,000 greater in 2001 compared to 2000. This decreased 2001 net premiums earned.
Net investment income decreased $937,000 in 2002 from 2001 and increased $101,000 in 2001 from 2000. Lower yields on fixed maturity and short-term investments due to the declining interest rate environment principally caused the decrease in net investment income in 2002. The increase in yield from the additional purchase of the real estate investment trust and lower investment expenses due to the decline in market values of equity securities caused the increase in net investment income in 2001. This was partially offset by lower yields on fixed maturity and short-term investments due to the decline in interest rates during 2001.
The Company employs four outside professional advisors to manage its investment portfolio: one each to manage fixed income securities, large-cap domestic equity securities, the international equity limited partnership and the real estate investment trust. The managers operate within the Company’s adopted investment policy as approved by the Investment Committee of the Board of Directors. The Investment Committee meets with outside investment managers, along with the Company’s outside investment consultant quarterly. Future levels of realized capital gains or losses are difficult to predict as investment managers purchase and sell securities in response to changing market conditions and investment policy guidelines.
Other revenues increased $1,145,000 from $2,637,000 in 2001 to $3,782,000 in 2002. Medical Solutions’ revenue growth, primarily from the value-added reselling of electronic practice management (EPM) and electronic medical records (EMR) systems, drove most of the increase. The sale, installation and support of EPM and EMR systems generated $895,000 of new revenues in 2002. Medical Solutions’ generated an additional $70,000 of revenue growth from technology consulting services and Benefits’ added $177,000 of revenue growth primarily from commission income earned on new employer accounts.
Other revenues decreased $1,386,000 from $4,023,000 in 2000 to $2,637,000 in 2001. Most of this decrease is due to the $1,716,000 recorded by Midwest Medical in 2000 for interest on federal tax refunds. Also contributing to the decrease is the elimination of finance charges on 2001 premium billings to Midwest Medical policyholders. Finance charges of $556,000 were included in other revenues for 2000. Offsetting these decreases were a $691,000 increase in Medical Solutions’ revenues primarily from technology consulting services and a $479,000 increase in Benefits’ revenues primarily from commission income earned on new accounts.
Underwriting, acquisition and insurance expenses increased $1,359,000 from $8,844,000 in 2001 to $10,203,000 in 2002. Greater premium volume drove a $2,107,000 increase in commission payments and a $586,000 increase in premium taxes. The expense for state guaranty fund assessments increased $239,000 principally from the insolvency of PHICO. These increases were partially offset by greater ceding commissions earned by Midwest Medical of approximately $1,670,000 resulting from the increase in premiums ceded to the excess component of the treaty reinsurance contract for the current year.
Income taxes decreased $342,000 resulting in an income tax benefit of $(2,564,000) for 2002 compared to an income tax benefit of $(2,222,000) for 2001. The effective tax benefit rates for 2002 and 2001 were 41.9% and 34.5%, respectively. The increase in the income tax benefit is primarily due to Midwest Medical receiving a $443,000 tax refund in the third quarter of 2002. This refund resulted from amending the 1997 tax return to address issues carried over from the 1992-1996 Internal Revenue Service examination.
The liability for unpaid losses and loss adjustment expenses represents management’s best estimate of the ultimate cost of all such amounts that are unpaid at the balance sheet dates. The liability is based on both case-by-case estimates and statistical analysis and projections using the historical loss experience of Midwest Medical and gives effect to estimates of trends in claim severity and frequency. Midwest Medical utilizes an independent actuary in establishing its liability for unpaid losses and loss adjustment expenses. Establishing an appropriate liability is an inherently uncertain process as the ultimate liability may be greater or less than the amount provided. Any increase in the amount, including liabilities for insured events of prior years, could have a material adverse effect on the results of operations for the period in which any adjustment is made.
Although management believes the Company has the ability to hold its fixed maturity investment portfolio to maturity, all investments, including fixed maturities, are classified as “available for sale,” as management may take advantage of opportunities to increase total return through sales of selected securities in response to changing market conditions. As a result, the Company’s investments are carried at fair value, with unrealized holding gains and losses reflected as a component of other comprehensive income, net of applicable deferred taxes. Fair values for fixed maturities and equity securities are based on quoted market prices or independent pricing services. The international equity limited partnership is recorded at its net asset value and the real estate investment trust is recorded at appraised value.
the length of time and the extent to which fair value has been less than amortized cost
whether dividends have been reduced or eliminated or scheduled interest payments on debt securities have not been made
Income taxes are accounted in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. Accounting for income taxes involves estimating the Company’s current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheets. Management must then assess the likelihood that the deferred tax assets will be recovered from future taxable income. To the extent that a recovery is believed to be not likely, management is required to establish a valuation allowance. To the extent a valuation allowance is established or changed in a period, an expense or benefit is recognized within the provision for income taxes in the consolidated statements of income.
Midwest Medical purchases reinsurance in order to reduce its liability on individual risks and to enable it to write business at limits it otherwise would be unable to accept. Reinsurance contracts are principally excess-of-loss contracts, which indemnify Midwest Medical for losses in excess of a stated retention limit up to the policy limits. Reinsurance costs are recorded as a reduction of premium, which is referred to as ceded premium.
Midwest Medical, with the assistance of its reinsurance broker, analyzes the credit quality of its reinsurers. To date, Midwest Medical has not experienced any material difficulties in collecting reinsurance recoverables. No assurances can be given, however, regarding the future ability of any of Midwest Medical’s reinsurers to meet their obligations. To the extent any reinsurer is unable to meet their obligations, Midwest Medical would become liable for the reinsuring company’s losses under the reinsurance agreement. This possibility is mitigated by collateral that Midwest Medical holds in the form of letters of credit under the related reinsurance agreement. Midwest Medical can draw upon the letters of credit in the event the applicable reinsuring company is unable to pay its obligation.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued)
In accordance with Section 10A of the Securities Exchange Act of 1934, as amended by Section 202 of the Sarbanes-Oxley Act of 2002, non-audit services approved by the Audit Committee of the Board of Directors at its December 2002 and February 2003 meetings and to be performed by Ernst & Young LLP, the Company’s independent auditors, are (1) tax compliance and planning services and (2) business risk assessment services.
We have audited the accompanying consolidated balance sheets of Midwest Medical Insurance Holding Company and Subsidiaries (the Company) as of December 31, 2002 and 2001 and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Midwest Medical Insurance Holding Company and Subsidiaries at December 31, 2002 and 2001 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The Company’s consolidated financial statements include the accounts of Midwest Medical Insurance Holding Company (Midwest Holding) and its wholly owned subsidiaries, Midwest Medical Insurance Company (Midwest Medical), MMIC Benefits, Inc. (Benefits), Midwest Medical Solutions, Inc. (Medical Solutions) and MMIC Business Office Solutions, Inc. (Office Solutions). All transactions between Midwest Holding and its subsidiaries have been eliminated in consolidation, with the exception of the distribution of capital to Midwest Holding by Midwest Medical in the form of dividends for periods prior to 2001.
Hereafter, Midwest Holding, Midwest Medical, Benefits, Medical Solutions and Office Solutions shall be collectively referred to as the Company unless the reference pertains to a specific entity.
In January 1998, Medical Solutions purchased the assets of MedPower Information Services, Inc. Medical Solutions then contributed those assets to its newly formed, wholly owned subsidiary, MedPower Information Resources, Inc. MedPower was subsequently sold, effective July 31, 2001. MedPower processed and electronically submitted medical claims for a network of more than 100 provider entities (see Note 2).
Other investments consist of less than 20% equity interests in a nontraded real estate investment trust and an international equity limited partnership. The real estate investment trust is recorded at appraised value and the international equity limited partnership is recorded at its net asset value.
Premiums received are recorded as earned ratably over the lives of the policies to which they apply. A portion of premiums received is deferred to recognize Midwest Medical’s obligation to provide reporting endorsement coverage without additional premium upon the death, disability or retirement of policyholders. This amount is recorded as an unearned premium reserve and represents the actuarially determined present value of future benefits to be provided less the present value of future revenues to be received.
Midwest Medical implemented a policyholder dividend program in 1999. Policyholder dividends are accrued when approved by the Board of Directors and are recorded as a separate component of losses and expenses in the consolidated statements of income.
Midwest Medical cedes reinsurance in order to reduce its liability on individual risks and to enable it to write business at limits it otherwise would be unable to accept. Reinsurance contracts are principally excess-of-loss contracts, which indemnify Midwest Medical for losses in excess of a stated retention limit up to the policy limits.
As mentioned in Note 1, the Company sold all of the capital stock of MedPower to ClaimLynx, Inc., effective July 31, 2001. Proceeds from the sale were $150,000. The Company recorded a $240,000 loss on the sale, net of an income tax benefit of $124,000. No significant assets or liabilities of MedPower remain. The Company’s consolidated statements of income separately disclose, as discontinued operations, the operating results and sale of MedPower, net of tax. Prior periods have been restated accordingly.
Midwest Holding has issued two classes of Common Stock. Each physician insured receives one share of Class C stock at no cost upon commencing coverage with Midwest Medical. The share of stock must be returned to the Company upon termination of insurance coverage. There is no payment to the shareholder upon return of Class C shares. Each share entitles the owner to one vote on matters that are subject to shareholder vote or approval. In the event of liquidation, sale, or similar transaction involving Midwest Holding or Midwest Medical, Class C shareholders would participate in the proceeds according to a distribution formula developed by the Board of Directors. This formula takes into account the underwriting risk classification and years of coverage of each shareholder.
Prior to 2001, each physician insured received Class A shares upon commencing coverage with Midwest Medical. These shares had identical voting and liquidation rights to the current Class C shares. The Board of Directors of Midwest Holding approved a tender offer for the exchange and redemption of substantially all Class A shares owned by Class A shareholders of record on April 30, 2000. Pursuant to the offer, Class A shareholders who tendered their shares received $66 for each Class A share owned, plus one Class C share. The tender offer was conducted from May 2000 until closing effective July 31, 2000. Remaining shares outstanding after closing of the tender offer were subsequently acquired pursuant to individual offers under identical terms. All outstanding Class A Common Shares of Midwest Holding were exchanged and redeemed as of December 31, 2000. During 2000, payments of $9,541,000 were made to Class A shareholders for stock redemptions related to these offers.
The cost (amortized cost for fixed maturities) and fair value of available-for-sale investments are as follows:
During 2002, the Company recorded realized investment losses for declines in value that were deemed other-than-temporary on fixed maturity securities totaling $1,613,000.
Midwest Medical continually evaluates emerging trends in the development of loss liabilities. Based on this analysis, management periodically adjusts its estimates of ultimate losses. The unfavorable development on 2001 reserves is primarily a factor of an increase in claims severity as well as the Minnesota legislative action extending the statute of limitations from two to four years.
The Company is organized into five legal entity business segments consisting of Midwest Holding, Midwest Medical, Benefits, Medical Solutions and Office Solutions. The business and accounting policies of the reportable segments are described in Note 1 to the consolidated financial statements. Management evaluates the performance of each business segment based primarily on profit or loss from operations. With the exception of the international equity limited partnership and foreign stocks and bonds held as investments by Midwest Medical, all business transactions are conducted in the United States. The following financial information summarizes the results of operations and total assets reported by the business segments for the years ended 2002, 2001 and 2000.
Intersegment eliminations for revenues and expenses are primarily for management and administrative services provided by Midwest Holding. Eliminations for assets consist primarily of investments in wholly owned subsidiaries, intersegment receivables for management fees and reclassifications between assets and liabilities primarily for taxes.
Intersegment eliminations for revenues and expenses are primarily for management, administrative and investment services provided by Midwest Holding. Eliminations for assets consist primarily of investments in wholly owned subsidiaries, intersegment receivables for management fees and reclassifications between assets and liabilities primarily for taxes.
The Company made income tax payments of $7,000, $655,000 and $2,298,000 in 2002, 2001 and 2000, respectively.
The components of the net deferred income tax asset (liability) as of December 31 are as follows:
The Company is required to establish a valuation allowance for any portion of the deferred income tax assets that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred income tax assets and therefore, no valuation allowance has been established.
Midwest Medical is authorized to issue policies with limits not to exceed $12,000,000 for each claim and $14,000,000 in the aggregate under each policy in any one policy year. Limits in excess of $12,000,000 for each claim and $14,000,000 annual aggregate are available to physicians and clinics through reinsurance placed on a facultative basis by Midwest Medical. Midwest Medical’s reinsurance program is structured in two components: “basic” and “excess.” Under the basic component, Midwest Medical generally retains the first $1,000,000 of each claim and reinsures the next $1,000,000 through a treaty under which premiums are based on a flat rate and could be subject to adjustment through a profit-sharing provision. Under the excess component, Midwest Medical acts as an intermediary and cedes the full amount of the risk for policies with limits of $2,000,000 for each claim and $4,000,000 in the aggregate up to $12,000,000 for each claim and $14,000,000 in the aggregate. The reinsurance premium for the excess component is a percentage of the preceding layer of coverage gross of any ceding commission paid by reinsurers to Midwest Medical. For the years 1995 through 2000, Midwest Medical generally retained the first $750,000 of each claim and reinsured the remainder through a treaty under which premiums are subject to adjustment based on experience.
Substantially all employees of Midwest Holding are covered by a noncontributory defined contribution pension plan. Contributions to the plan are based upon each covered employee’s salary. Substantially all employees at Midwest Holding are also covered by a 401(k) plan that provides a 50% match on employee contributions subject to certain limitations. Total contributions charged to expense for the years ended December 31, 2002, 2001 and 2000 were $830,000, $717,000 and $583,000, respectively.
Midwest Holding provides an unfunded Supplemental Executive Retirement Plan (SERP) which is a nonqualified, defined benefit retirement plan covering certain Midwest Holding officers. Benefits are based upon years of service and compensation. Although the plan is technically unfunded, Midwest Holding invests in specified assets which are designed to coordinate with the projected obligation under the SERP. The net periodic pension cost for this plan was $651,000, $636,000 and $574,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The liability recognized in the consolidated balance sheets at December 31, 2002 and 2001 related to this plan was $4,035,000 and $3,561,000, respectively.
Midwest Holding also provides medical benefits to retirees through a defined benefit postretirement plan which covers substantially all employees. The net periodic postretirement benefit cost for the years ended December 31, 2002, 2001 and 2000 was $70,000, $38,000 and $36,000, respectively. As of December 31, 2002 and 2001, the net postretirement benefit plan liability was $151,000 and $86,000, respectively.
The Company leases office space and equipment under lease agreements that expire at various intervals over the next five years and are subject to renewal options at market rates prevailing at the time of renewal. Rental expense for all leases was $1,315,000 and $1,093,000 for 2002 and 2001, respectively. At December 31, 2002, future minimum payments under noncancelable leases are as follows (in thousands):
The National Association of Insurance Commissioners (NAIC) revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual became effective January 1, 2001. Midwest Medical’s domiciliary state of Minnesota adopted the provisions of the revised manual. The revised manual has changed, to some extent, prescribed statutory accounting practices and resulted in changes to the accounting practices that Midwest Medical used to prepare its statutory-basis financial statements. Although the implementation of Codification had a negative impact on Midwest Medical’s statutory-basis capital and surplus, management believes Midwest Medical remains in compliance with all regulatory and contractual obligations.
The following is a reconciliation of net (loss) income and shareholders’ equity under U.S. GAAP with that reported for Midwest Medical on a statutory basis: