We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be five to ten years in length. We currently lease a total of approximately 70,000 square feet of space in East Lansing, Michigan; Chicago, Illinois; Louisville, Kentucky; Boca Raton, Florida; Eden Prairie, Minnesota; and Albuquerque, New Mexico. We also own various real estate investment properties as part of our investment portfolio. We are currently in the process of trying to sublease our office space in Chicago, Boca Raton and Eden Prairie.
The weighted average shares outstanding for the years ended December 31, 2003, 2002 and 2001, were 8,520,335, 9,339,739 and 11,071,529 basic common shares, respectively. As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, no effect of awards or options were calculated as the impact would have been anti-dilutive. The weighted average shares outstanding for the period from December 13, 2000, the date of the conversion, to December 31, 2000 were 11,134,981 basic common shares and 11,260,797 common shares assuming dilution. There were no cash dividends declared during the periods presented.
We are a leading provider of medical professional liability insurance coverage, writing this coverage in 12 states throughout the country. This insurance coverage protects physicians and other health providers from claims filed against them for alleged acts of medical malpractice. Medical professional liability insurance represented 76% of our direct premiums written in 2003. In addition, during 2003, we wrote workers’ compensation insurance in 11 states, insuring a variety of business classes. During 2003, we also participated in a health insurance program, writing small business employee health insurance through a single preferred provider organization located in Western Michigan. In the fourth quarter of 2003, the Company began to implement plans to exit the workers’ compensation and health insurance lines of business. In late 2003 and early 2004, we received downgrades in our financial strength rating from A.M. Best. These downgrades, and their potential impact on our business, are discussed more fully in “Item 1 - Business - A.M. Best Company Rating, which information is incorporated herein by reference.”
Most of the insurance policies we write have a one year policy term. The written premiums associated with policies we write are earned ratably over the year in which we provide insurance coverage. This means that rate increases that we implement will not be fully earned for up to 24 months as policyholders who renewed immediately prior to the rate increase will not be charged the higher rate for up to 12 months, and then those premiums will take another 12 months to be fully earned.
as a portion of the salaries related to our underwriting staff, vary with and are primarily related to the production of new and renewal business. These costs are deferred and amortized over the related period in which we earn the premiums associated with the business written. Other costs that do not vary with the production of new and renewal business are charged to income as incurred.
The most significant factor contributing to the increase in medical professional liability premiums in recent years is the increase in paid losses. To combat rising loss costs, we have initiated several actions including:
Ceased writing occurrence-based policies in all markets with the exception of Michigan, Indiana and New Mexico.
Anticipated losses will generally be the primary determinant of premium rates. We establish medical professional liability premium base rates for particular medical specialties within a given state and sometimes for a specific geographic region within a state. We also offer discounts or add surcharges for particular policyholder characteristics, such as claims history or participation in any risk-management programs. Our premium rates are based on anticipated losses on claims and related expenses, expected investment income, our surplus needs, and the desire to earn a reasonable profit for shareholders. In most states, however, insurance regulators have the authority to approve or deny proposed premium rate changes.
SCW sells insurance written by several companies. However, the commissions it receives on premiums it writes for the Company typically account for 65% to 75% of its revenues. Direct premiums written for us by SCW during 2003, 2002 and 2001 totaled $75,270,000, $70,810,000 and $68,896,000, respectively, representing 29.4%, 26.6% and 29.9% of direct premiums written during such years. Commission expense we incurred related to SCW approximated $5,962,000, $5,560,000 and $4,660,000 in 2003, 2002 and 2001, respectively.
Prior to Mr. Cheeseman’s retirement, there were various safeguards to protect the Company from actual or potential conflicts of interest arising from this relationship. Mr. Cheeseman was prohibited from acting as a director, officer or employee of SCW and, pursuant to Company policy, did not participate in day-to-day discussions between the Company and SCW or in decisions about whether to underwrite business proposed to be written by SCW prior to his retirement. Moreover, we applied and continue to apply the same underwriting rules to business written by SCW as we apply to business written by other agencies. These underwriting rules are generally filed with the regulatory agencies in the various states in which we do business and are established solely by the Company in order to control the quality of business submitted by all agents, including SCW. We also monitor our loss experience on the business written by our agents, including SCW. Since his retirement from APCapital, Mr. Cheeseman has taken a more active role in the activities of SCW.
In January 2004, we completed a new 5-year contract with SCW. The agreement provides for American Physicians to be the exclusive medical professional liability carrier SCW represents in the state of Michigan, subject to limited exceptions, such as a further downgrade of our A.M. Best rating. However, we continue to have the right to appoint other agents. SCW may continue to represent other insurance companies in other states. The contract provides for SCW to be paid commissions consistent with the marketplace. The terms of the new agency agreement were determined by negotiations between our management staff, SCW’s management, and under the review of independent consultants, and ultimately approved by our board of directors. In rendering its approval, the board of directors considered the fairness of the agreed rates and determined that they were fair to the Company based, upon other things, an evaluation of market rates and agreements between the Company and its other agents.
Our Consolidated Financial Statements include estimated reserves for unpaid losses and loss adjustment expenses related to our various insurance lines of business. We have actuaries on our staff that analyze and develop projections of ultimate payments that will be made to settle all losses incurred as of each balance sheet date, and the related loss adjustment expenses. Our actuaries utilize standard actuarial techniques to project ultimate losses based on our paid and incurred loss information and claim count, as well as industry data. These projections are done using the Company’s data, including the number of claims reported and paid, and the average severity of reported and paid claims, as well as industry data. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. A key projection used in the actuarial estimation of ultimate losses takes an average payment (severity) times a projected total number of claims (frequency). Accordingly, any changes in the
It often takes several years for medical professional liability claims to be resolved, three to six years on average from the time the loss is reported. As a result, the ultimate payment can be difficult to project due to changes in legal and other economic environmental factors during the intervening period. In addition, changes in the Company’s case reserving philosophy, such as those executed by the Company over the last two years, can introduce additional uncertainty into the actuarial estimation process, as a strengthening of case reserves results in higher reported losses, which increases the average severity of claims used in actuarial projections. Therefore, careful consideration must be made when evaluating the strengthening of case reserves to ensure that the impact on ultimate projected losses is not under or overstated.
Investments represent our largest asset and are the primary source of funds to pay insurance claims. All of our fixed maturity securities are classified as available-for-sale, which are those securities that would be available to be sold in the future in response to our liquidity needs, changes in market interest rates and asset-liability management strategies. Available-for-sale securities are reported at their estimated fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income, net of deferred taxes. Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method relating to investments acquired at other than par value.
Equity securities are carried at quoted market values. The fair value of fixed maturity securities is based on market quotations provided to us by our third-party custodian who engages independent third party pricing sources that use valuation models. The valuation models used by the independent third party pricing sources use indicative information such as ratings, industry, coupon, and maturity along with publicly traded bond prices to determine security specific spreads, and the ultimate fair value of the non-publicly traded fixed maturity securities. Real estate is carried at the lesser of historical cost, less accumulated depreciation or estimated fair value as determined by recent appraisals, offers from prospective independent third-party buyers, or the undiscounted future cash flows associated with the property. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
We periodically review our investment portfolio for any potential credit quality or collection issues and for any securities with respect to which we consider any decline in market value to be other than temporary. Investments which are considered to be other than temporarily impaired (“OTTI”) are written down to their estimated net realizable value as of the end of the period in which the OTTI was noted. Subsequent recoveries in the fair value of impaired securities are not reported in income, but rather as unrealized gains, net of tax, in comprehensive income. Inherent in our evaluation of a particular security are assumptions and estimates about the operations of the issuer, and its future liquidity and earnings potential. Some of the factors considered in evaluating whether a decline in market value is other than temporary are:
Company’s investment in Delta enhanced equipment trust certificates is carried in the Consolidated Balance Sheets, included elsewhere in this report, at a value of $5.4 million. In December of 2003, the Frontier bonds, as part of bankruptcy proceedings, were converted to equity securities of Frontier’s parent company, Global Crossings. We received a total of 15,865 shares of Global Crossing common stock based on the amount of bonds held by the Company. These shares had an initial fair value of $35 per share, which resulted in a realized gain of approximately $245,000 upon the conversion.
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. Accounting for deferred taxes in accordance with GAAP requires us to make a qualitative analysis of our deductible temporary differences, past financial history and future earnings projections to determine how much of a deferred tax asset can be recognized. The standard for measuring whether or not a gross deferred tax asset can be recognized is “more likely than not” based on all available evidence. In making this evaluation, historical losses weigh more heavily than future earnings projections due to uncertainties inherent in making such projections. Accordingly based on our recent loss experience, we have determined that sufficient taxable income may not exist in the periods of reversal, and have recorded a deferred tax asset valuation allowance for the entire net deferred tax asset as, under the accounting guidance, there is no reasonable basis to support carrying some of the individual deferred tax assets and not others. The establishment of the valuation allowance is recorded as federal income tax expense in the accompanying Consolidated Statements of Income, included elsewhere in this report. Once the Company has re-established a pattern of profitability, the deferred tax asset valuation allowance may be reduced upon evaluation of the availability of future taxable income. See Note 11 of the Notes to Consolidated Financial Statements for further discussion of the deferred tax valuation allowance and its impact on our financial condition and results of operations. Such information is incorporated herein by reference.
DAC, we have made certain assumptions regarding future costs associated with the business written, such as costs to maintain the policies and the ultimate projected loss and loss adjustment expense payments associated with these policies. In addition, we have considered future investment income in determining the recoverability of DAC, which requires certain assumptions regarding the timing of payments of future loss and loss adjustment expenses, as well as the yield on our investment portfolio. Based on our analysis as of December 31, 2003, the DAC carried on the Consolidated Balance Sheets, included elsewhere in this report, of $10.4 million, was deemed to be fully recoverable. While we believe that our assumptions and estimates related to the recoverability of DAC are reasonable, historically, our accident year loss ratios have developed unfavorably. In the event that future unfavorable adjustments to loss reserves occur, the likelihood of our being able to recover these deferred costs will diminish, and the possibility of a write-off of a portion or all of our DAC in future periods will increase.
Net premiums earned decreased during 2003, as compared to 2002, primarily as a result of the restructuring of our workers’ compensation book of business that began in 2002. In the fourth quarter of 2003, we announced our intention to exit the workers’ compensation and health insurance lines of business, which is anticipated to cause a decrease in our net premiums earned in 2004.
The increase in interest expense during 2003 was the result of the issuance of $30.9 million of debentures in May of 2003.
Our general and administrative expenses increased during 2003 primarily as a result of increased legal, audit, and other professional fees pertaining to compliance with the new Sarbanes-Oxley legislation, and related SEC rules, and legal and investment banking fees incurred in the fourth quarter pursuant to the Board of Directors’ evaluation of alternatives to maximize shareholder value after the loss reported in the third quarter.
The increase in net premiums earned was the result of rate increases initiated in 2001 on our medical professional liability line, and is discussed more fully in that segment’s results of operations.
The increase in underwriting expenses was the result of additional commissions and premium taxes on higher premium volumes in 2002 as compared to 2001.
In accordance with the provisions of SFAS No. 142, the Company did not record any amortization expense during the year ended December 31, 2002. Amortization expense for the year ended December 31, 2001 was $2.5 million and related primarily to goodwill acquired in connection with the purchase of the Stratton-Cheeseman Management Company in 1999. See Note 4 to the Consolidated Financial Statements for further discussion regarding amortization expense and the effect of SFAS No. 142 on the Company’s operating results. Such information is incorporated herein by reference.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our medical professional liability insurance operations for the years ended December 31, 2003, 2002 and 2001.
The increase in incurred loss and loss adjustment expenses was primarily the result of $43 million of adverse development on prior year loss and loss adjustment expense reserves in the third quarter of 2003. This unfavorable development is discussed more fully under “Item 1 - Business - Loss and Loss Adjustment Expense Reserves.” The cross-referenced information is incorporated herein by reference.
2002 Compared to 2001. The increase in direct premiums written was primarily the result of premium rate increases and reduced discounts instituted by the Company in late 2001 and continued through 2002, partially offset by our exit from the Florida market, which began in December of 2002. Insured physician counts were relatively flat from December 31, 2001 to December 31, 2002.
During 2002 and 2001, we experienced adverse development on prior year loss reserves. The 2002 adverse development, approximately $4.5 million, emerged primarily in our Florida and Ohio markets where loss frequency and severity have both exceeded our original expectations. The 2001 adverse development on prior year loss reserves, approximately $22.7 million, was the result of a significant increase in reported losses in the second half of 2001. Losses on prior accident years increased in our Ohio, Florida and Kentucky markets and were caused primarily by a dramatic increase in loss severity. The accident year loss ratio was 106.1% for the year ended December 31, 2002, compared to 121.9% for 2001. The decrease in the accident year loss ratio is the direct result of premium rate increases, and reduced discounts taken in 2002.
2003 Compared to 2002. Workers’ compensation direct premiums written decreased during 2003 as a result of the restructuring of this book of business initiated in 2002 and the subsequent decision to exit this line completely in 2003. We expect direct premiums written related to this line to decrease further in 2004 as we complete our exit from this line.
In June 2002, the Company filled several executive and management positions in its workers’ compensation segment. These positions were filled to improve the overall performance of this segment, reduce risk exposures and improve profitability. However, during 2003, the workers’ compensation market remained very competitive and the growth of this line did not keep pace with expectations. As a result, in the third quarter of 2003, management made the decision to exit this line of business.
Management has determined that non-renewing our workers’ compensation policies is the most effective way to achieve the exit of this line of business. As a result, APCapital ceased discussions to sell its workers’
The restructuring of this book of business, combined with rate increases and improved claims management, have translated into lower calendar year and accident year loss ratios, which were 81.3% and 84.5%, respectively, for the year ended December 31, 2003 compared to 86.8% and 86.8%, respectively, for the same period of 2002. The benefits of the improved claims management and rate increases, however, were partially offset by an increase in loss adjustment expenses related primarily to salaries, in the first half of 2003, of the executives and managers the Company hired to restructure the workers’ compensation book of business, as well as assessments related to workers’ compensation business in the state of Minnesota.
Salary and employee relations costs related to the management team during the first half of 2003, combined with the decreases in net premiums earned, were the primary reasons for the increases in the underwriting expense ratios.
2002 Compared to 2001. Workers’ compensation net premiums earned increased for the year ended December 31, 2002 compared to 2001, primarily as a result of continuing to earn premiums written in 2001, which exceeded those written in 2000 due to policy growth in 2001, primarily in our Minnesota, Illinois and Indiana markets.
The decrease in the workers’ compensation underwriting expense ratio resulted primarily from the 8.8% growth in net premiums earned for the year ended December 31, 2002 as compared with 2001, as underwriting expenses remained relatively flat.
Effective December 31, 2003, we gave notice to the third-party that administers our health plan of our intent to exit the health insurance market. In accordance with the contract between the Company and the third-party administrator (“TPA”), we are required to give a 180 day notice of our intent to terminate the agreement between us and the TPA. Therefore, we will continue to write health policies through June 30, 2004; however, we intend to follow strict underwriting and pricing guidelines during this period.
The decrease in the incurred loss and loss adjustment expense ratio was primarily the result of improved underwriting and premium rate increases.
2002 Compared to 2001. The increase in direct premiums written was the result of rate increases, of up to 25%, implemented in 2002, as well as moderate membership growth in the fourth quarter of 2002.
Health net premiums earned increased less than direct premiums written as, in June 2002, we discontinued assuming health premiums from a pool that we had previously participated in.
The increase in incurred losses and loss adjustment expenses was primarily the result of increased health care costs and membership growth during the fourth quarter of 2002. These increases were mostly offset by an increase in net premiums earned, causing the loss ratio to remain relatively flat.
Beginning January 1, 2001, we began non-renewing all personal and commercial lines policies. The negative net premiums earned for 2003 and 2002, $(239,000) and $(432,000), respectively, primarily represent retrospective premium adjustments related to certain personal and commercial reinsurance treaties. Net premiums earned in 2001 were $5.7 million as a result of continuing to earn premiums on policies written in 2000, prior to non-renewing all policies.
2003 Compared to 2002. The Corporate and Other segment consists of the operations of our holding company and its non-insurance subsidiaries. For this segment, loss before federal income taxes, minority interests and cumulative effect of a change in accounting principle for the year ended December 31, 2003 was $3.4 million compared to $1.0 million for the same period of 2002. The increase was primarily attributable to higher general and administrative expenses as a result of increased legal, audit, and other professional fees pertaining to compliance with the new Sarbanes-Oxley legislation and related SEC rules. As well as legal and investment banking fees incurred in the fourth quarter pursuant to the Board of Directors’ evaluation of alternatives to maximize shareholder value after the loss reported in the third quarter, as well as interest expense as a result of the issuance of floating rate junior subordinated deferrable interest debentures discussed in Note 9 of the Notes to Consolidated Financial Statements. Such information is incorporated herein by reference. The increase in these expenses was partially offset by an increase in other income.
Our holding company’s only material assets are the capital stock of American Physicians and its other subsidiaries, and a portion of the proceeds from recently issued junior subordinated deferrable interest debentures (“debentures”). APCapital’s ongoing cash flow will consist primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. The payment of dividends to APCapital by its insurance subsidiaries is subject to limitations imposed by applicable law. APCapital’s primary uses of cash, on both a short and long-term bases include periodic interest payments, operating expenses, and the repayment of the debentures. In January 2004, APCapital made a $25 million surplus contribution to its subsidiary American Physicians. The purpose of the contribution was to increase American
Physicians’ statutory capital and surplus, which is a critical factor in the financial stability rating process by insurance rating agencies such as A.M. Best. After the contribution, APCapital’s cash and cash equivalent resources totaled approximately $2.8 million, which will be held at the holding company for future debt service costs. The $2.8 million of cash and cash equivalents held at the holding company is adequate to service interest payments on the debentures for approximately one and a half years.
In May 2003, the Company issued debentures totaling $30.9 million. These debentures bear interest at a variable rate based on the London Interbank Offered Rate (“LIBOR”), payable quarterly, and mature in 30 years. Substantially all of the proceeds from the debenture issuance were contributed to American Physicians. See Note 9 of the Notes to Consolidated Financial Statements for a description of the debentures and the transactions in which they were issued. Such information is incorporated herein by reference.
The Company also completed an additional debenture issuance in the fourth quarter of 2003 that was subsequently unwound prior to year end with such debentures being redeemed at par. The net effect of the issuance and redemption did not have a material effect on our results of operations, financial condition or liquidity.
At December 31, 2003, the Company had $102.1 million of cash and cash equivalents available and an investment portfolio of $732.0 million. The portfolio includes $35.0 million of bonds maturing in the next year to meet short-term cash flow needs. On a long-term basis, fixed income securities are purchased on a basis intended to provide adequate cash flows from future maturities to meet future policyholder obligations and ongoing cash needs to fund operations. As of December 31, 2003, our fixed maturity portfolio included $372.0 million of bonds that mature in the next one to five years and $138.5 million that mature in the next five to ten years. In addition, at December 31, 2003, we have $62.5 million of mortgage-backed securities that provide periodic principal repayments. See Note 5 of the Notes to Consolidated Financial Statements for further information regarding the anticipated maturities of our fixed maturity securities. Such information is incorporated herein by reference.
The following table shows reported claim counts, open claim counts, the average net case reserve per open claim, and the average claim payment on claims that were closed with a payment for our medical professional liability segment at or for the years ended December 31, 2003, 2002 and 2001.
Also see “Part I - Item 1. Business - Loss and Loss Adjustment Expense Reserves” for a longer-term view on the development of our prior year loss reserves. The cross-referenced information is included herein by reference.
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers. In addition, the Company has historically provided workers’ compensation and health insurance; however, in 2003 the Company initiated plans to exit these lines. Medical professional liability, workers’ compensation and health insurance direct premiums written accounted for approximately 76%, 15% and 9% of the Company’s total direct premiums written.
We write business throughout the United States of America, with an emphasis on markets in the Midwest. During 2003, approximately 67% of direct premiums written by the Company occurred in Midwestern states.
Equity securities are carried at quoted market values. Fair values of fixed maturities and equity securities are determined on the basis of dealer or market quotations or comparable securities on which quotations are available.
Investments are evaluated for other than temporary impairment (“OTTI”) using both quantitative and qualitative methods that include, but are not limited to (a) an evaluation of the Company’s ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, (b) the recoverability of principal and interest related to the security, (c) the duration and extent to which the fair value has been less than cost for equity securities, or amortized cost for fixed maturity securities, (d) the financial condition, near-term and long-term earnings and cash flow prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions, and (e) the specific reasons that a
security is in a significant unrealized loss position, including market conditions that could affect access to liquidity.
Write-downs for OTTI are recorded as realized losses in the period the security is considered impaired. Subsequent declines in market value of an impaired security are recorded as realized losses in the period of decline. The Company does not record realized gains for subsequent recoveries in the market value of an impaired security until the security is sold or otherwise disposed of.
Real estate is carried at the lower of historical cost, less accumulated depreciation, or fair value, based on estimated undiscounted future cash flows. Real estate of $27,105,000, net of accumulated depreciation of $2,444,000, and $27,380,000, net of accumulated depreciation of $1,839,000, in 2003 and 2002, respectively, is included in other investments on the balance sheet. At December 31, 2003 and 2002, $8,008,000 of real estate was non-income producing.
Real estate limited partnerships are accounted for based on the cost method, or the equity method for partnerships where the Company is able to exercise significant influence over the operating and financial policies of the partnership. Real estate limited partnerships are included in other investments on the balance sheet and had a carrying value of $1,164,000 and $1,901,000 at December 31, 2003 and 2002, respectively.
receivables is generally offset by the liability for unearned premiums; however, an allowance for doubtful accounts of approximately $550,000 and $1.0 million at December 31, 2003 and 2002, respectively, is included in the premium receivable balance, primarily for receivable balances that may not be collectable and have no associated unearned premiums.
Reinsurance premiums and losses related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Reinsurance recoverables and prepaid reinsurance premiums are accounted for in accordance with SFAS No. 113, “Accounting and Reporting for Reinsurance.” Premiums ceded to other companies have been reported as a reduction of premium income. Reinsured losses incurred are reported as a reduction of gross losses incurred. The reserve for unpaid losses and loss adjustment expenses is presented gross of recoverables from reinsurers, which are included in the amounts recoverable from reinsurers.
The Company’s reinsurers are reviewed for financial solvency, at least quarterly. This review includes, among other quantitative and qualitative factors, a ratings analysis of each reinsurer participating in a reinsurance contract. Included in reinsurance recoverables on the accompany Balance Sheets is a $17.5 million recoverable from Gerling Global Reinsurance Corporation (“Gerling Global”) at December 31, 2003. In 2002, Gerling Global’s parent company put Gerling Global’s United States subsidiary into run off resulting in a series of A.M. Best rating downgrades for Gerling. The Company has not experienced delays in payments from Gerling Global and believes that Gerling Global’s surplus and cash flow are adequate to meet its current obligations to the Company. Based on the assessment of the financial strength and liquidity of Gerling Global, the Company has determined that a valuation allowance against this recoverable is not needed at December 31, 2003.
The Company uses the intrinsic value-based method to account for all stock-based employee compensation plans and has adopted the disclosure alternative of SFAS No. 123 “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“SFAS No. 148”). The Company’s policy regarding stock options is to issue options with an exercise price equal to the market price on the date of grant. Accordingly, no compensation expense has been recognized for options granted in 2003, 2002, and 2001. The Company, however, does recognize compensation expense related to restricted stock grants, equal to the fair market value as of the date of grant, as there is no consideration due from employees for these awards at the date they vest. This expense is recognized on a straight-line basis over the period of vesting, with future compensation expense reflected as a reduction of shareholders’ equity in the accompanying Consolidated Balance Sheets.
As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, no effect of options or other stock awards was calculated as the impact would be anti-dilutive.
Net loss per share is computed by dividing net loss by the weighted average number of shares of common stock and common stock equivalents (stock options and stock grants) outstanding during each year. As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, no effect of options or other stock awards was calculated as the impact would have been anti-dilutive (See Note 18).
In November 2002, the FASB issued FASB Interpretation (“FIN”) No. 45. “Guarantor’s Accounting and Disclosure Requirements for Guarantees of Indebtedness of Others” (“FIN No. 45”). This interpretation clarifies disclosures required to be made by a guarantor in its interim and annual financial statements and requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The provisions of FIN No. 45 pertaining to the recording of a liability are effective for all guarantees entered into, or modified, after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 31, 2002. APCapital has issued guarantees in connection with its establishment of non-consolidated subsidiary trusts and issuance of debentures. The amounts due under the guarantees are also recorded as liabilities in the Company’s Consolidated Financial Statements in accordance with the structure of the transaction. See Note 9 for further details on the nature of the guarantees and the transactions that gave rise to the guarantees. Also see Note 19 for disclosures regarding other guarantees the Company has issued.
accompanying Consolidated Statements of Income and Consolidated Balance Sheets represents the remaining 51% of the net loss and shareholders’ equity of PIC.
PIC was formed in March of 2003 with the intent of writing as much medical professional liability insurance as PIC’s capital and surplus levels could reasonably support. At December 31, 2003, PIC’s total assets were approximately $8.6 million and direct premiums written by PIC were approximately $3.8 million for the year ended December 31, 2003. The Company has no future obligations with respect to its investment in PIC, nor do creditors of PIC have any recourse to the general credit of the Company. Accordingly, the maximum exposure to loss as a result of the Company’s involvement with PIC, is approximately $2.7 million, which represents the initial pro-rata equity contribution of $2,450,000 plus the remaining unamortized balance of an intangible asset of $289,000 related to a covenant not to compete.
SFAS No. 130, “Reporting Comprehensive Income”, requires unrealized gains or losses on the Company’s available-for-sale securities to be included in other comprehensive income, net of tax. Net realized investment gains (losses) on securities held as of the beginning of the year totaling $3,109,000 in 2003, $459,000 in 2002, and $(4,103,000) in 2001 had net unrealized appreciation of $2,106,000 at the beginning of 2003, $620,000 at the beginning of 2002, and $100,000 at the beginning of 2001.
Effective January 1, 2002, the Company adopted SFAS No. 142. In accordance with the guidance given in SFAS No. 142, the Company completed its transitional impairment testing of all goodwill and other intangible assets as of January 1, 2002. At that date, the only goodwill or other intangible asset recorded by the Company was $13.9 million of net goodwill associated with the purchase of Stratton-Cheeseman Management Company in 1999. Based on the results of the impairment testing, the recorded net goodwill of $13.9 million was written off as the fair value, as determined by various fair value estimation approaches, including multiples of projected future net income and market capitalization of the Company’s reporting units, did not support the carrying value of previously recorded goodwill. The goodwill impairment was recorded as a cumulative effect of a change in accounting principle, net of a deferred income tax benefit of $4.9 million.
As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, diluted loss per share is not presented as the effect of awards or options would be anti-dilutive.
The changes in the carrying amount of goodwill for the years ended December 31, 2003 and 2002 were as follows:
In 2003, the Company acquired intangible assets related to certain non-compete agreements in connection with its investment in PIC and a covenant not to compete from the former President and Chief Executive Officer (“CEO”) of the Company. The gross carrying amount and accumulated amortization of these intangible assets for the year ended December 31, 2003 was $1.8 million and $261,000, respectively. Amortization expense related to intangible assets was $261,000 for the year ended December 31, 2003. The estimated amortization expense related to these intangible assets is expected to be $914,000 and $625,000 for the years ended December 31, 2004 and 2005, respectively. There will be no amortization expense related to these intangible assets beyond December 31, 2005.
During the years ended December 31, 2003, 2002 and 2001, the Company recorded losses of $1.3 million, $770,000 and $5.9 million, respectively, on investments whose decline in market value was considered other than temporary. Net realized gains for the year ended December 31, 2003 are reduced by a $1.3 million charge for an “other than temporary impairment” (“OTTI”) on enhanced equipment trust certificates issued by Delta Airlines. Net realized losses for the years ended December 31, 2002 and 2001 include an OTTI charge of $520,000 and $5.9 million, respectively for the write down of Frontier bonds, as well as $250,000 impairment loss on investment real estate in 2002. In December of 2003, the Frontier bonds, as part of bankruptcy proceedings, were converted to equity securities of Frontier’s parent company, Global Crossings. The Company received 15,865 shares of Global Crossing common stock based on the amount of bonds held by the Company. These shares had an initial fair value of $35 per share, which resulted in a realized gain of approximately $245,000 upon the conversion.
The amortized cost and estimated fair value of debt securities at December 31, 2003, by contractual maturity, was:
The carrying amount of bonds that were on deposit with various state regulatory authorities as of December 31, 2003 and 2002 was $8,311,000 and $8,541,000, respectively.
Proceeds on the sales of investments in bonds totaled $43,754,000 in 2003, $45,337,000 in 2002, and $27,400,000 in 2001.
Changes in deferred policy acquisition costs for the years ended December 31, 2003, 2002, and 2001 are summarized as follows:
Depreciation expense associated with property and equipment for the years ended December 31, 2003, 2002 and 2001 was $2.0 million, $1.5 million, and $1.4 million, respectively. Net realized losses on the sale or disposal of property and equipment for the years ended December 31, 2003, 2002 and 2001 were $7,000, $293,000 and $528,000, respectively.
During the years ended December 31, 2003, 2002 and 2001, management made adjustments to prior year’s loss reserves, specifically, accident years 1999 through 2002. The unfavorable development totaled $43.4 million in 2003, $5.6 million in 2002, and $29.0 million in 2001. As a percentage of net reserves as of the beginning of the year, these adjustments represented 8.0%, 1.1% and 7.0%, respectively.
In the second half of 2001, the Company encountered a large increase in reported losses, primarily in its Florida, Ohio and Kentucky professional liability markets. This increase in reported losses was the result of an over 20% increase in the average severity of claims reported in 2001. The 2001 adjustment was also unusually large because the Ohio and Florida markets were relatively new for the Company, making initial reserve estimates very difficult to predict. These higher than expected loss trends continued into 2002, but at a much lower level. As a result, the Company also increased prior year loss reserves in 2002, primarily in its Ohio and Florida markets.
During the third quarter of 2003, the Company experienced a sharp increase in the severity of paid losses in our medical professional liability segment, which indicated a much higher trend in claims severity. As a result, actuarial projections resulted in higher ultimate severities of loss on currently existing claims related to the 1999 through 2002 accident years, which resulted in management increasing its estimate of incurred but not reported claims related to the 1999 through 2002 accident years by approximately $43.0 million in the third quarter of 2003.
The unfavorable development in the third quarter of 2003 was primarily related to the Company’s Ohio ($16.4 million), Florida ($16.0 million) and Kentucky ($15.0 million) markets, partially offset by positive development in the Michigan market. The Company announced its exit from the Florida market in 2002 and also discontinued writing occurrence-based policies in the Ohio and Kentucky markets in 2002. There was no significant unfavorable development noted on prior year medical professional liability loss reserves during the fourth quarter of 2003.
Management believes that the estimate of the ultimate liability for losses and loss adjustment expenses at December 31, 2003 is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Company’s actual incurred loss and losses and loss adjustment expenses will not conform to the assumptions inherent in the estimation of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying Consolidated Balance Sheets.
In May 2003, the Company formed American Physicians Capital Statutory Trust I and APCapital Trust II (the “Trusts”) by contributing equity of $464,000 to each trust. The trusts were formed for the purpose of issuing mandatorily redeemable trust preferred securities (“TPS”). Each trust issued $15 million of TPS to another trust formed by an institutional investor. The trusts received a total of $29.1 million in net proceeds, after the deduction of a total of approximately $906,000 of commissions paid to the placement agents in the transactions. These commissions were ultimately paid by APCapital, and have been capitalized and are included in other assets on the accompanying Consolidated Balance Sheet. Issuance costs will be amortized over five years as a component of amortization expense.
The Debentures are unsecured obligations of the Company and are junior in the right of payment to all future senior indebtedness of the Company. The Company estimates that the fair value of the debentures approximates the gross proceeds of cash received at the time of issuance.
The provision for income taxes for the years ended December 31, 2003, 2002 and 2001 consists of:
At December 31, 2003 and 2002, the components of the net deferred federal income tax asset were as follows:
At December 31, 2003, the Company had the following net operating loss carryforwards:
American Physicians merged with New Mexico Physicians Mutual Liability Company and State Mutual Insurance Company in 1997.
repurchased during the years ended December 31, 2003, 2002 and 2001, the cost of shares repurchased, the average price per share repurchased during those periods, as well as the cumulative inception to date totals.
In addition to the above amounts, certain employees related to the workers’ compensation line of business have been retained to manage the run-off of this line. The employee separation costs related to these individuals will be recognized prospectively over the future service period. At December 31, 2003, total future employee separation costs are estimated to be approximately $300,000.
The former President and CEO of the Company is a majority owner of SCW Agency Group, Inc., formerly Stratton Cheeseman & Walsh, Inc. (“SCW”), an agency that sells the Company’s medical professional liability insurance in Michigan, Illinois, Kentucky, Florida and Nevada and workers’ compensation insurance in Michigan, Kentucky and other states. Direct premiums written by the agency during 2003, 2002, and 2001 totaled $75,270,000, $70,810,000, and $68,896,000, respectively, representing, 29.4%, 26.6%, and 29.9% of direct premiums written during such years. Commission expense incurred related to SCW approximated $5,962,000, $5,560,000, and $4,660,000 in 2003, 2002, and 2001, respectively.
The Company also has a non-interest bearing note receivable from SCW related to the establishment of a sales force in the state of Nevada. This note is to be repaid through a reduced commission rate on premium written by SCW in the state of Nevada over a period of time not to exceed ten years. Any unpaid amounts at the end of ten years will be forgiven. At December 31, 2003 and 2002 the Company’s non-interest bearing receivable from SCW was approximately $286,000 and $310,000, respectively. At December 31, 2003 and 2002, the Company has established an allowance in the amount of $286,000 and $300,000, respectively, in the event that the receivable balance owed by SCW is not repaid as a result of a reduction or elimination of premiums written in Nevada. Accordingly, the net receivable at December 31, 2003 and 2002 was $0 and $10,000, respectively.
In 2001, a representative from a law firm providing legal services to the Company was appointed an officer of the Company. Legal services provided by this firm to the Company during 2003, 2002 and 2001 were $390,000, $410,000 and $370,000, respectively.
Certain executive officers, board members and employees have been granted options to purchase shares of APCapital common stock. Options granted during 2003, 2002 and 2001 vest in annual installments of 33%, 33%, and 34% on the first through the third anniversaries, respectively, of the date of grant. All options expire on the tenth anniversary of the grant date.
In December 2000, the Company also granted 200 shares of restricted stock to each full-time employee for a total grant of 39,600 shares at $13.50 per share. These shares vested at a rate of 20%, 35% and 45%, in 2001, 2002, and 2003, respectively. During 2003, a total of 51,210 shares vested under the terms of the stock award programs, including 17,600 shares that were vested in connection with the retirement of the Company’s former President and CEO, effective December 31, 2003. During 2002 and 2001, a total of 26,580 and 18,110 shares, respectively, vested under terms of these stock award programs. A total of 2,685, 5,530 and 21,700 shares were forfeited as a result of employee terminations prior to vesting during 2003, 2002 and 2001, respectively. The vesting of stock awarded to officers, directors and employees resulted in a total compensation expense of $565,000, $421,000 and $265,000 in 2003, 2002, and 2001, respectively.
In 2003, the Company recognized a tax benefit of $261,000 related to the incremental tax benefit of restricted stock that vested during the year and stock options that were exercised during the year. This incremental tax benefit was credited to additional paid-in-capital.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2003, 2002 and 2001:
As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, no effect of awards or options were calculated as the impact would be anti-dilutive.
The Company participates in various guaranty associations in the states in which it writes business, which protect policyholders and claimants against losses due to insolvency of insurers. When an insolvency occurs, the associations are authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar years. The Company accrues for its portion of assessments in accordance with American Institute of Certified Public Accountants’ Statement of Position 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments.” Assessments to date are not significant; however, the ultimate liability for future assessments is not known. Accordingly, the Company is unable to predict whether such future assessments will materially affect the financial condition or results of operations of the Company.
On both December 30, 2003, and February 20, 2004, separate putative shareholder class action complaints were filed in the United States District Court for the Western District of Michigan against the Company, its former President and Chief Executive Officer, and its Chief Financial Officer. The complaints allege violations of federal securities laws for certain disclosures made by the Company between February 13, 2003 and November 6, 2003, regarding its operating results and the adequacy of its reserves, and each seeks money damages in an unspecified amount. The Company denies the allegations and intends to vigorously defend the lawsuits. On each of March 2, 2004 and March 3, 2004, motions were filed by various shareholders seeking orders consolidating the two lawsuits, naming the moving shareholders as lead plaintiff and naming lead counsel. On March 9, 2004, the parties filed a stipulation and proposed order consolidating the two cases by dismissing the first suit with prejudice and appointing a lead plaintiff and lead counsel. The Company has preserved its right to challenge the propriety of certifying the case as a class action. The Court has not acted on this filing. While management believes that meritorious defenses to the allegations exist, the ultimate disposition of this litigation could have a material adverse impact on the Company’s financial position, liquidity and results of operations.
American Physicians’ investment in PIC is not consolidated, but rather, accounted for based on the equity method of accounting.
Expense allocations are based primarily on loss and loss adjustment expenses by line of business and certain other estimates for underwriting expenses. Investment income, investment expense, amortization expense and interest expense are allocated to the segments based on that segment’s “ownership” percentage of the assets or liabilities underlying the income or expense. General and administrative expenses are all attributed to the holding company and are included in corporate and other. Restructuring expenses are allocated to the segments based on the nature of the restructuring.
The financial information that management reviews in making decisions about resources to be allocated to the segments and assess their performance, is summarized as follows:
The unaudited operating results by quarter for 2003, 2002, and 2001 are summarized below:
In accordance with the transition guidance given in SFAS No. 142, the goodwill impairment charge, net of tax, that was determined in the fourth quarter of 2002 has been recorded in the first quarter of 2002 as SFAS No. 142 was adopted effective January 1, 2002 (Notes 2 and 4)
American Physicians Capital, Inc. (APCapital) is an insurance holding company incorporated under Michigan law on July 6, 2000.
APIndemnity (Bermuda) Ltd. - a Bermuda company that provides a rent-a-captive vehicle for clients and prospects.
In January 2004, APCapital contributed $25 million to its insurance subsidiary, American Physicians.