We do not lease any property. All property is leased directly by our parent company, APSG. APSG leases approximately 32,000 square feet of office space in an office project at 1301 S. Capital of Texas Highway, Suite C-300, Austin, Texas as its principal executive offices. Of the total 32,000 square feet leased by APSG, we occupy approximately 20,000 square feet.
The following table sets forth selected historical financial and operating data for the Company. The income statement data set forth below for each of the years in the three-year period ended December 31, 2006 and the balance sheet data as of December 31, 2006 and 2005 are derived from the audited financial statements of the Company included elsewhere herein and should be read in conjunction with, and are qualified by reference to, such statements and the related notes thereto. The income statement data for the year ended December 31, 2003 and the balance sheet data for the year ended December 31, 2004 are derived from the audited financial statements of the Company. The income statement data for the year ended December 31, 2002, and the balance sheet data as of December 31, 2003 and 2002, are derived from unaudited financial statements of the Company which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All selected data are presented in accordance with Generally Accepted Accounting Principals (“GAAP”).
We have been in continuous business since we were formed in 1975. We are licensed to operate in the states of Texas and Arkansas and have been dedicated to providing professional liability insurance protection to our policyholders for the last 30 years.
Prior to the conversion, we operated as a reciprocal insurance exchange, which is an organization under which policyholders (members) effectively exchange insurance contracts and thereby insure each other and become members of the exchange. Since inception, we have been managed by APSG, directly or through a wholly owned subsidiary, subject to the direction of our board of directors.
We principally write professional liability insurance coverage for physician groups, individual physicians and other healthcare providers in the states of Texas and Arkansas. As of December 31, 2006 we insured 4,712 physicians, dentists and other healthcare providers, substantially all of which are in Texas. Most of our coverage is written on a “claims-made and reported” basis. Coverage is provided only for claims that are first reported to the Company during the insured’s coverage period and that arise from occurrences during the insured’s coverage period. We also make extended, or tail, coverage available for purchase by policyholders in order to cover claims that arise from occurrences during the insured’s coverage period, but that are first reported to us after the insured’s coverage period and during the term of the applicable tail coverage.
The accompanying financial statements have been prepared in accordance with GAAP. The preparation of GAAP financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates included in the accompanying financial statements are the reserve for losses and loss adjustment expenses, death, disability and retirement reserves, provision for federal income taxes, reinsurance premiums recoverable/payable and premiums ceded. Other critical accounting policies include revenue recognition, deferred policy acquisition costs and refundable deposits.
We consider the following accounting policies to be critical because they involve significant judgment by management and the effect of those judgments could result in a material effect on the financial statements.
The combination of changing conditions and the extended time required for claim resolution results in a loss estimation process that requires actuarial skill and the application of judgment, and such estimates require periodic revisions. The difficulty in estimating probable future loss payouts includes many factors but some of the more important elements include: the adversarial nature of the legal system may limit access to timely information extending the length of time it may take to reach a settlement or fully litigate a claim; the large amount of frivolous claims sometimes reaching up to 80% of the total filed claims make it important to fully evaluate each claim for its merit; the medical science and expertise required to fully evaluate a claim can be very expensive thus making it harder to fully evaluate the potential claim upon initial receipt; the access to and quality of patient records can impact the probability of estimates; the level of personal emotions can run high when a medical claim involves significant injury or loss of life; and the estimates of economic losses associated with a medical injury can fluctuate widely base upon age, future financial earning capacity and many other criteria that have been subjectively interpreted by the judicial system. Management performs an in-depth review of the reserve for unpaid losses and loss adjustment expenses on a semi-annual basis with assistance from its outside consulting actuary. Management continually reviews and updates the data underlying the estimation of the loss and loss adjustment expense reserves and we make adjustments that we believe the emerging data indicates. Any adjustments to reserves that are considered necessary are reflected in the results of operations in the period the estimates are changed.
Loss and loss adjustment expense represents the largest component of expense of the insurance operations of the Company. In considering the potential sensitivity of the factors and assumptions underlying management’s best estimate of loss and loss adjustment reserves, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a large average cost per claim. For example, in 2006, which ended with 4,712 policyholders, we paid a total of $9,684,000 in paid damages on 94 claims. Even a relatively small change in the number of claims expected to be paid (i.e. frequency) or a relatively small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, our financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, we have closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the average cost per claim, any change in trends such as legislative changes resulting in tort reform, claims handling procedures, economic inflation and other factors could result in a significant change in the reserve estimate. The table immediately below for reserve activity as well as the 10 year development table located in the “Liquidity and Capital Resources and Financial Condition” section of this document shows the effects that changing claim trends have had on our year by year estimates for prior year incurred losses and loss adjustment expenses.
Incurred-net of reinsurance for the current years depicts loss and loss adjustment expense incurred during that year and related to premium earned in that period, also referred to as accident year. Incurred-net of reinsurance for the prior years represents the total of payments and net change in reserve estimates charged or credited to earnings in the current year with respect to liabilities that originated and were established in prior years. As noted in the table above, we decreased our incurred loss and loss adjustment expense for prior year development by $4,461,000 for the year ended December 31, 2006. For the years ended December 31, 2005 and 2004, we increased our incurred loss and loss adjustment expense for prior year development by $15,715,000 and $19,350,000, respectively.
During 2006, our current accident year loss and loss adjustment expenses increased as a result of the increase in the number of claims filed in 2006 and the growth in the number of policyholders as compared to prior year’s levels. The favorable development of prior-year claims during 2006 was the result of a reevaluation of all our open claims and trend assumptions. During 2003, tort reform was passed in Texas effecting medical professional liability insurance, which caused a significant increase in claims filed that year. The full impact of those claims was not fully known at that time. The favorable development of prior-year claims of $4,461,000 was primarily the result of 2004 and 2005 report year loss severity falling below expectations. Additionally, the number of claims closed with indemnity for the 2004 and 2005 report years were less than prior estimates.
During 2004, after careful evaluation of open claims and trend assumptions, we determined that the length of time needed to litigate 2003 pre-tort reform claims would continue to increase due to the potential financial impact of these claims in relation to post-tort reform claims. As a result, we increased the estimate for ultimate losses and loss adjustment expenses for claims incurred in 2003 and prior years by $19,350,000.
We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherently uncertain process involving loss and loss adjustment expense reserve estimates including but not limited to the future development settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid damages in the future may yield a materially different amount than currently reserved - favorable or unfavorable. While management believes that the estimates for loss and loss adjustment expense reserves are adequate as of December 31, 2006, there can be no assurance that our estimates will not change in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
To the extent that estimates for unpaid losses and loss adjustment expenses change, the amount of swing rated reinsurance premiums may also change. The ceded premium estimates are based upon management’s estimates of ultimate losses and loss adjustment expenses and the portion of those losses and loss adjustment expenses that are allocable to reinsurers under the terms of the related reinsurance agreements. Given the uncertainty of the ultimate amounts of losses and loss adjustment expenses, these estimates may vary significantly from the ultimate outcome. In addition to the in-depth review of reserves for unpaid losses and loss adjustment expenses, on a semi-annual basis, we also have our outside consulting actuary review development in the reinsurance layer or excess of $250,000 retention for each open swing-rated treaty year. We review these estimates and any adjustments necessary are reflected in the period in which the change in estimate is determined. Adjustment to the premiums ceded could have a material effect on our results of operations for the period in which the change is made. In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis, give rise to an asset, other amounts receivable under reinsurance contracts or a liability, funds held under reinsurance treaties. Furthermore, each variable premium treaty requires a 24 or 36-month holding period before any cash can be returned to the Company or paid to the reinsurers.
For the year ended December 31, 2006, we recorded favorable net development of $7,743,000 as a result of lower estimated ceded premiums for treaty years 2002 through 2005. In addition, as of December 31, 2006, we have recorded an asset, other amount recoverable under reinsurance contracts of $8,726,000 and a liability, funds held under reinsurance treaties of $4,003,000 which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2006 treaty years as compared to the amounts paid on a provisional basis.
There are several factors that can directly impact the ability to accurately forecast the reinsurance recoverables. Many of the factors discussed above related to the sensitivities of forecasting total loss and loss adjustment expense reserves also apply when analyzing reinsurance recoverables. Since we cede excess losses above $250,000 the trends related to severity significantly impact this estimate. Current individual claims severity can be above or fall below our retention level over the period it takes to resolve a claim. Furthermore, tort reform in Texas has been in effect since the latter part of 2003 and has lowered claim counts but the trends of severity payouts are only beginning to emerge. Additional deviations in the data such as changes in specialties, limits or territories can make forecasting a long tail business such as medical professional liability insurance difficult. Insurance product lines are classified as either short tail or long tail based on the average length between the insured event under a policy and the final resolution of those claims. Short tail claims are reported and settled quickly, resulting in less estimation variability. The longer the time (long tail) before the final resolution, such as medical professional liability, the greater the exposure to estimation risk and hence the greater the estimation uncertainty.
Both Transatlantic Reinsurance and Swiss Reinsurance are AM Best rated A+ (Superior).
Death, Disability, and Retirement Reserves. We have established a death, disability, and retirement reserve for policyholders, which is intended to set aside a portion of the policy premium to account for the coverage provided for the extended reporting period or tail coverage offered by the Company upon the death and/or disability and/or retirement of a policyholder which is provided at no additional cost to the policyholder. The death, disability and retirement reserve is included in unearned premiums.
Revenue Recognition. We issue policies written on a claims-made basis. A claims-made policy provides coverage for claims reported during the policy year. We charge both a base premium and a premium maintenance fee. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro-rata basis over the term of the policy. Premium maintenance fees are charged to offset the costs incurred by the Company to issue and maintain policies. Unearned premiums and maintenance fees are determined on a monthly pro-rata basis. Upon termination of coverage, members may purchase an extended reporting period (tail) endorsement for additional periods of time. These extended reporting period coverage endorsement premiums are earned when written.
As compared to historical levels in 2003 and prior years, current trends indicate that lower claim counts continued throughout 2006. However, claim counts for the year ended December 31, 2006 have increased as compared to the same period in 2005 and 2004. We believe this increase is related to a growth in the number of insureds during 2006. For the 2006 year, 495 claims were reported, as compared to 336 reported claims for 2005 and 382 reported claims for 2004. We expect that personal injury attorneys will increase their claims filings since the environment has stabilized since tort reform and will also explore new ways to assert these claims. Loss adjustment expenses are those expenses incurred in defending claims and primarily consist of attorney’s fees. We anticipate these fees will increase as we incur defense expenses on the higher claim counts due to the increased numbers of insureds.
Since the passage of tort reform, rate adequacy and growth in policy count have allowed us to report significant income from operations and net income, and while we remain optimistic about the results from operations for 2007, these record financial results will not be sustainable long-term. In light of favorable developments in both claim counts and claim severity post-tort reform and increased competition, we lowered our rates on average approximately 9% in 2005 and on average approximately 18% in 2006. We have seen an increase in competition by both existing professional liability carriers as well as new entrants into the marketplace. As a result of this increased competition, we continue to be faced with price pressure on both existing renewals and new business. Many of the new entrants have been aggressive in seeking new business and are willing to compete on price. We will continue to monitor frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted. As a result of these market forces, we will face increased competition throughout 2007, but will continue to price insurance products at rates believed to be adequate for the risks assumed.
Other underwriting expenses for the year ended December 31, 2006 increased by $1,485,000 to $14,253,000 from $12,768,000 for the year ended December 31, 2005. These expenses consist primarily of management fees, commissions to agents, premium taxes and general operating expenses. Legal, auditing and other professional and advisory fees increased by $1,118,000 due to expenses incurred related to the conversion and merger of the Company with APSG. Commissions paid to agents increased $273,000 due to higher effective commission rates during the current year in order to generate new business and retain existing business.
Income from operations increased $10,929,000 from $13,219,000 for the year ended December 31, 2005 to $24,148,000 for the year ended December 31, 2006. Income from operations increased based on the increases in net earned premiums and investment income and a decrease in loss and loss adjustment expenses partially offset by an increase in other underwriting expenses. Net income was $15,751,000 for the year ended December 31, 2006 as compared to $9,031,000 for the year ended December 31, 2005.
Gross premiums and maintenance fees written for the years ended December 31, 2005 and 2004 were $79,301,000 and $84,571,000, respectively. While insured physicians and dentists grew from 3,622 at the end of 2004 to 3,919 at December 31, 2005, the increase in policyholders was offset by an approximate 9% average rate decrease in 2005. During 2005, we were able to grow our number of policies issued while lowering premium rates and still maintain acceptable loss ratios. Due to the new carriers entering the Texas market, there was competitive pressure to lower premium rates. We believe that our 30 years of uninterrupted service is seen as an attractive option for many policyholders continuing to insure their practice with the Company even at a slightly higher premium than new carriers entering the market.
Premiums ceded remained flat at $12,885,000 and $12,878,000 for the years ended December 31, 2005 and 2004, respectively. We enter into reinsurance contracts, which provide coverage for losses in excess of our retention of $250,000. The reinsurance contracts beginning in 2002 through 2005 are swing rated treaties that have various minimum and maximum rates. The actual percentage rate will depend upon the ultimate losses ceded to the reinsurer under the related treaty. Based on our independent actuarial review, as of December 31, 2005, we had recorded $6,802,000 as other amounts receivable under reinsurance contracts for the 2002, 2004 and 2005 treaty years in excess of the current provisional ceding rate and $1,521,000 as funds held under reinsurance treaties for estimated payments due to reinsurers in excess of the provisional ceded payment rate for the 2003 treaty year.
Investment income, net of investment expenses increased to $5,131,000 for the year ended December 31, 2005 from $4,089,000 for the year ended December 31, 2004, as a result of a larger asset base in bonds as well as improving yields in the bond market. The investment philosophy of the Company has been and continues to be to conservatively invest a large portion of its investment portfolio in triple A-rated CMO bonds for the purpose of generating cash flow to match claim activity while maintaining a reasonable investment yield. During 2005 and 2004, we increased our investments in mortgage backed bonds as a result of higher premium and maintenance fees receipts. We maintained a similar percentage of equities in our investment portfolio in 2005 and 2004. We plan to maintain our investments portfolio mix at similar percentages for the near future.
Realized gains on investments were $552,000 in 2005, down from $608,000 in 2004 as a result of sales of equity securities by the investment managers of our equity portfolio.
Loss and loss adjustment expenses were $43,976,000 and $48,655,000 for the years ended December 31, 2005 and 2004, respectively. During each of the last two years, we increased prior year reserves substantially. Prior to the passage of tort reform legislation in 2003, we saw a significant number of cases filed to beat the effective date of the new tort laws. This increase in filings caused a delay in resolving the existing open claims. The process of negotiating and litigating existing claims slowed down dramatically as a result of the surge of new cases. In addition, claims counts, legal expenses and loss severity rose substantially for report years 2000 through 2003. In 2004 and 2005, we experienced a substantial drop in the number of new claims reported from a high of 930 claims in 2003 to 382 for 2004, and 336 for 2005.
During 2004, after careful evaluation of open claims and trend assumptions, we determined that the length of time needed to litigate 2003 pre-tort reform claims would continue to increase due to the potential financial impact of these claims in relation to post-tort reform claims. As a result, we increased the estimate for ultimate losses and loss adjustment expenses for claims incurred in 2003 and prior years by $19,350,000. During 2005, we continued to review the impact of tort reform and while current accident year reported claims were substantially lower, loss costs and legal expenses on prior-year claims continued to trend significantly higher. We determined that the effect of tort reform not only increased the number of claims reported in 2003, but also increased the cost of litigating remaining open cases for other open prior accident years as well. As a result, during 2005, we continued to increase incurred loss and loss adjustment expense reserves related to prior accident years by $15,715,000. Due to this rising loss severity of prior year claims, we have strengthened our reserves, net of reinsurance, from an average open reserve of approximately $57,000 as of December 31, 2004 to over $94,000 as of December 31, 2005. We will continue to aggressively defend its policyholders consistent with its past practices and participate in mediation of settlements and utilize local defense firms, where appropriate, to help reduce the cost of litigation.
Other underwriting expenses directly related to the production of new and renewal premiums are considered as acquisition costs and are capitalized and amortized to expense over the period in which the related premiums are earned. Such costs include commissions, premium taxes, and certain underwriting and policy issuance costs. Deferred acquisition costs are recorded net of ceding commissions. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed in the period the determination is made. During the year ended December 31, 2005 a total of $5,400,000 of expenses (primarily agents’ commissions and premium taxes) were capitalized and $5,300,000 were amortized as expense. During 2004, $5,400,000 was capitalized and $4,800,000 amortized.
Income from operations increased $3,982,000 from $9,237,000 for the year ended December 31, 2004 to $13,219,000 for the year ended December 31, 2005. Total current and deferred income tax expenses incurred for 2005 and 2004 were $4,188,000 and $3,421,000, respectively. Income from operations increased primarily due to a decrease in loss and loss adjustment expenses relative to premiums earned and an increase in net investment income in 2005. Net income was $9,031,000 for the year ended December 31, 2005 compared to $5,815,000 for the year ended December 31, 2004.
The current primary sources of our liquidity are insurance premiums, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. These funds are used to pay losses, loss adjustment expenses, operating expenses, reinsurance premiums and taxes.
From inception of the attorney-in-fact agreement through March 1992, we supplemented our liquidity with refundable deposits made by subscribers, which became part of our surplus. The deposit requirements, as periodically determined and approved by our board of directors, required eligible physicians desiring to purchase insurance through the Company to make refundable deposits. As of December 31, 2006 and 2005, we had refundable deposits outstanding of $10,227,000 and $10,568,000 respectively, which included accrued interest. These deposits are included in the accompanying financial statements as a liability (refundable subscriber deposits) in accordance with SFAS No. 150.
Due to uncertainty related to the timing of the payment of claims, cash from operations for a medical malpractice insurer can vary substantially from period to period. During 2006, 2005 and 2004, we had positive net cash flow from operating activities of $28,448,000, $12,666,000 and $22,645,000, respectively. The positive cash flow during these periods is primarily related to the increased premium and maintenance fee receipts and the decreased claims payments. In addition, cash flows from investment income continue to increase as the investment portfolio has increased significantly during the three year period. While we anticipate claim payouts for the 2007 year to be approximately $51,556,000, we have the ability to fund these claims from current premiums, investment income revenue and if necessary, the sale of bonds from our investment portfolio.
There are no participation agreements or purchase commitments as of December 31, 2006. Our primary liability is the reserves for losses and loss adjustment expenses which are estimates of the ultimate expected payouts on existing reported and estimated unreported claims. These reserves totaled $110,089,000 and $95,372,000 at December 31, 2006 and December 31, 2005, respectively. Our reserves for unpaid losses and loss adjustment expenses are an estimate of future cash flows necessary to fulfill insurance obligations based on insured events that have already occurred, but the amount and timing of the cash flow is uncertain. In addition, we were initially capitalized by refundable deposit contributions from our subscribers. While no new refundable deposits have been required since 1992, we have an obligation to repay these amounts and have classified these as a liability. As of April 1, 2007, the total balance of refundable deposits outstanding was $10,197,900, at which time, pursuant to the conversion and merger, the balance was extinguished in the merger in exchange for shares of APSG Series A redeemable preferred stock. Holders of APSG Series A redeemable preferred stock are entitled to cumulative dividends thereon at the rate of three percent (3%) per annum payable on the remaining redemption value per share, in priority to the payments of dividends on APSG common shares. Holders of Series A redeemable preferred stock have no preemptive rights and have the same voting rights as the holders of APSG common stock. The shares are non-certificated and mandatorily redeemable. They will be redeemed ratably at $1,000,000 per year, with all remaining outstanding shares being redeemed by December 31, 2016.
As of December 31, 2006, we had the following contractual obligations:
(1) The contractual obligations for refundable deposits changed effective April 1, 2007. Upon the merger, these deposits were converted into mandatorily redeemable preferred stock and will be redeemed ratably at $1,000,000 per year with a 3% dividend, with all remaining outstanding shares being redeemed no later than December 31, 2016.
Members’ equity has increased from $19,242,000 at December 31, 2005 to $34,718,000 at December 31, 2006.
In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN No. 48 is effective in the first quarter of fiscal 2007. We do not believe the adoption of FIN No. 48 will have a material effect on the Company’s results of operations, financial position or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early application is encouraged, provided that the reporting entity has not yet issued financial statements for an interim period within that fiscal year. Management estimates that the initial application of SFAS No. 157 will not be material.