The Underwriter leases approximately 25,000 square feet of space from Gordon Lawrenceville Realty Associates, LLC ("Gordon") in Lawrenceville, New Jersey, the location of its home office operations. The Underwriter entered into the lease agreement with Gordon as of November 25, 2003, with an effective date of April 27, 2004. The lease agreement was amended on June 22, 2004, and October 1, 2004. The term of the lease is for five years with an option to renew for an additional five years.
(1) On January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142, goodwill is no longer amortized as an expense, but instead is reviewed and tested for impairment under a fair value approach. SFAS No. 142 requires that goodwill be tested for impairment at least annually, or more frequently as a result of an event or change in circumstances that would indicate impairment may be necessary. On January 1, 2002, the Company recorded a $2.4 million impairment related to goodwill, net of $0 tax ($0.18 per diluted share). If SFAS No. 142 were in effect beginning January 1, 2001, the financial statement impact would have been approximately $444,000, net of tax, ($0.03 per diluted share) for the 12 months ended December 31, 2001.
On April 1, 2001, the Company adopted the provisions of EITF No. 99-20, "Recognition of Interest Income and Impairment of Purchased and Retained Beneficial Interests in Securitized Financial Assets." This standard established new guidelines for recognition of income and other-than-temporary decline for interests in securitized assets. EITF 99-20 requires the Company to recognize an other-than-temporary decline if the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent, prior, estimation date. The difference between the book value of the security and its fair value must be recognized as an other-than-temporary decline and the security's yield is adjusted to market yield. This new guidance also adopts the prospective method for adjusting the yield used to recognize interest income for changes in estimated future cash flows since the last quarterly evaluation date. On April 1, 2001, the Company recognized $5.3 million of other-than-temporary declines, net of tax ($0.39 per diluted share) as the cumulative effect of a change in accounting principle.
Basic and diluted loss per share of common stock for the year ended December 31, 2002 is computed using the weighted average number of common shares outstanding during the year of 13,385,124. Basic and diluted loss per share of common stock for the year ended December 31, 2001 is computed using the weighted average number of common shares outstanding during the year of 13,524,959. Basic and diluted loss per share of common stock for the year ended December 31, 2000 is computed using the weighted average number of common shares outstanding during the year of 14,100,043. Basic earnings per share of common stock for the year ended December 31, 1999 is computed using the weighted average number of common shares outstanding during the year of 13,497,110. Diluted earnings per share of common stock for the year ended December 31, 1999 is computed using the weighted average number of common shares outstanding during the year of 13,534,052.
The medical malpractice industry is cyclical in nature. Many factors influence the financial results of the medical malpractice industry, several of which are beyond the control of the Company. These factors include, among other things, changes in severity and frequency of claims; changes to applicable law; regulatory reform; and changes in inflation, interest rates and general economic conditions.
The Company was subjected to a number of adverse developments during fiscal 2001-2003 as a result of unexpected and unprecedented increases in loss severity related to prior years' business. As a result of the net losses reported in 2001, the RBC of two of the Company's then operating subsidiaries, MIIX and LP&C, fell below the standards adopted by the NAIC. Both companies triggered RBC events requiring the filing of a corrective action plan with each state of domicile. As a result, both companies entered solvent runoff during 2002.
In 2001 and 2002, loss and LAE reserves were adjusted to reflect adverse development on several lines of business including New Jersey and other states' physicians, Pennsylvania hospitals and hospital excess. The adjustments were related to increases in severity and frequency. These trends continued in 2003 and were complicated by acceleration in the claims process attributable to tort and judicial reform in Pennsylvania and New Jersey and the impact of the Company's entering voluntary solvent runoff in 2002. Loss and LAE reserves for 2003 were established as a result of an internal actuarial review, an external opining actuarial review and an external actuarial review performed in conjunction with filing of MIIX's Audited Report. As a result of these reviews, prior year gross loss and LAE reserves were adjusted by $353.0 million. The increase was attributable primarily to adverse development and increased severity in the New Jersey and Pennsylvania physician and hospital excess lines of business.
On September 28, 2004, MIIX was placed in rehabilitation. See "Regulation - Order of Rehabilitation." As a result, the discussion below, which is as of December 31, 2003, reflects operations of MIIX that are no longer controlled by the Company. During the summer of 2004, the Company retained financial advisors to assist in
The future viability and wind-down of the Company will be dependent on cash flow from managing the MDAdvantage contract and the operations of Lawrenceville Re.
The determination of loss and LAE reserves involves the projection of ultimate losses through quarterly actuarial analyses of the claims history of the Company and other professional liability insurers, subject to adjustments deemed appropriate by the Company due to changing circumstances. Management relies primarily on such historical experience in determining reserve levels on the assumption that historical loss experience provides a good indication of future loss experience despite the uncertainties in loss trends and the delays in reporting and settling claims. As additional information becomes available, the estimates reflected in earlier loss reserves have been and may continue to be revised. The Company increased prior year gross reserves by $353.0 million, $161.2 million and $117.9 million in 2003, 2002 and 2001, respectively.
Reserves for IBNR claims have consistently represented the majority of total loss and LAE reserves held by the Company. At December 31, 2003 and 2002, gross IBNR reserves composed 60.5% of total gross loss and LAE reserves. As a consequence of runoff and the expiration of all in force policies, new claims being reported are declining rapidly. As the claim inventory matures, the reserves will shift from IBNR to "case" reserves for known claims, with IBNR reserves ultimately approaching zero. Gross loss and LAE reserves on claims-made medical malpractice policies amounted to $401.6 million, or 32.9% of total gross loss and LAE reserves at December 31, 2003, compared to gross loss and LAE reserves on claims-made policies of $395.8 million, or 34.4% of total gross loss and LAE reserves at December 31, 2002.
requested that assets supporting the funds withheld account be placed in a trust. MIIX has established the required trust accounts and moved invested assets into trusts in accordance with these contract provisions. Each of the aggregate excess reinsurance contracts also contains a provision allowing reinsurers to offer additional reinsurance coverage that MIIX is obligated to accept. In September and October 2004, the reinsurers initiated requests for additional premiums from MIIX in accordance with provisions of the contracts. Reinsurers are prohibited from canceling current reinsurance agreements or making additional premium charges to MIIX under the September 28, 2004 Order of Rehabilitation.
In June 2004, MIIX commuted its 1995 aggregate excess reinsurance treaty. The commutation agreement provided for the release of applicable funds held balances and trust fund assets. The reduction to earnings as a result of the commutation was $3.3 million in 2004.
The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reporting amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to income taxes, loss and LAE reserves, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
FINANCIAL REPORTING. The Company has not reported the operations of MIIX as discontinued operations because the Company continues to have significant continuing involvement in the operations of MIIX through November 2004. Employees of the Underwriter continue to service, process and adjudicate claims and perform administrative services subsequent to the September 28, 2004 Order of Rehabilitation. Therefore, the Company will not record MIIX as a discontinued operation until this activity diminishes significantly. As of September 30, 2004, the Company began using the equity method of accounting for its investment in MIIX and has recorded the investment at $-0-.
REINSURANCE. Reinsurance recoverables include the balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk with respect to the individual reinsurers, which participate in its ceded programs to minimize its exposure to significant losses from reinsurer insolvencies. The Company holds collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the domiciliary Departments of Insurance.
PREMIUMS. Premiums are recorded as earned over the period the policies to which they apply are in force. The reserve for unearned premiums is determined on a monthly pro-rata basis. Gross premiums include both direct and assumed premiums earned.
The Company's determination of loss and LAE reserves involved the projection of ultimate loss and ALAE through several actuarial techniques. For a brief description of each of these techniques, refer to "Business - Loss and LAE Reserves."
The liabilities for losses and LAE and the related estimation methods are continually reviewed and revised to reflect current conditions and trends. The resulting adjustments are reflected in the operating results of the current year. While management believes the liabilities for losses and LAE are adequate to cover the ultimate liability, the actual ultimate loss costs may vary from the amounts presently provided and such differences may be material. However, as indicated elsewhere, on September 28, 2004, the New Jersey Department placed MIIX in rehabilitation, which resulted in the New Jersey Department having full control of MIIX operations.
INVESTMENTS. Under the Order of Rehabilitation, which was entered on September 28, 2004, the New Jersey Department has assumed control of the investment portfolio. As a result, the Company presently exercises no control over its investments, the liquidation of those investments, or investment policy. The discussion set forth below and elsewhere in this Form 10-K is as of December 31, 2003, and does not describe the management of the investment portfolio as at present, as the New Jersey Department's approach to the management of that portfolio is not known to the Company. The Company designated its entire investment portfolio as available-for-sale. As such, all investments are carried at their fair values. The fair value of securities is based upon quoted market prices when available. Where market prices or broker quotations are not available, the fair value is estimated based upon discounted cash flow, applying current interest rates for similar financial instruments with comparable terms and credit quality. The estimated fair value of a financial instrument may be significantly different from the amount that could be realized if the security were sold immediately.
Securities available-for-sale, deemed to have declines in fair value that are other than temporary, are written down to fair value and a realized loss recorded in operations. The fixed maturity securities to which these write-downs apply are generally of investment grade quality at the time of purchase but, are subsequently down graded by rating agencies to "below-investment grade." Factors considered by
The Company may not be able to retain the key employees necessary to operate the Company.
The loss of any of its key executives and/or senior managers may materially adversely impact the Company's ability to continue to manage its business.
The Company may not be able to maintain adequate cash flow and liquidity.
In 2002, a stockholder of the Company filed a putative class action suit against the Company, among other plaintiffs, alleging securities fraud, breaches of fiduciary duty, violations of New Jersey antitrust laws and alleged misrepresentations and omissions of material facts in various of the Company's filings with the SEC. See "Legal Proceedings."
YEAR ENDED DECEMBER 31, 2003, COMPARED TO YEAR ENDED DECEMBER 31, 2002
NET PREMIUMS EARNED. Net premiums earned were $(26.1) million in 2003 compared to $100.2 million in 2002, a decrease of approximately $126.3 million. This net decrease is composed of decreased direct and ceded premiums earned. Direct premiums earned decreased $134.9 million, or 84.6%, to $24.6 million in 2003 from $159.5 million in 2002 primarily due to ceasing insurance operations, commutations and cancellation activity during the last nine months of 2002. Direct earned premiums were impacted by the return of approximately $4.9 million associated with the commutation of a large institutional policy during the fourth quarter of 2002. Ceded premiums earned decreased by $8.6 million, or 14.5%, to $50.7 million in 2003 from $59.3 million in 2002 primarily due to lower direct earned premium, offset by additional ceded premiums of $56.3 million associated with the reserve adjustment during 2003 as compared to $44.8 million associated with the reserve adjustment during 2002.
Total negative premiums written in 2003 were $0.6 million, a decrease of $96.8 million from total premiums written of $96.2 million in 2002. The net decrease in total premiums written is primarily due to the Company's cessation of writing or renewing premiums in all states, in accordance with each state's specific non-renewal requirements.
REALIZED INVESTMENT GAINS AND LOSSES. Net realized investment losses were $1.6 million in 2003 compared to net realized investment losses of $3.5 million in 2002. In 2003, realized gains of approximately $20.7 million were recognized primarily due to sales of fixed maturity investments as a result of investment portfolio modifications, offset by $22.3 million of realized losses, including approximately $19.4 million of losses related to other-than-temporary declines in investment values, of which $8.7 million was attributable to Conseco/Greentree Financial corporate bonds and $8.5 million to collateralized bond obligations. In 2002, net realized gains of approximately $13.4 million were recognized primarily due to sales of fixed maturity investments as a result of investment portfolio modifications and recognized approximately $16.9 million of losses related to other-than-temporary declines in investment values, of which $8.9 million was attributable to collateralized bond obligations and $4.8 million was associated with United Airlines corporate bonds. EITF 99-20 established new guidelines for recognition of income and other-than-temporary declines for interests in securitized assets.
OTHER REVENUE. Other revenue decreased $0.3 million, or 4.1%, to $7.1 million in 2003 compared to $7.4 million in 2002. This net decrease is primarily composed of decreases of $2.7 million in finance charge revenue, $1.3 million due to the sale of Hamilton National Leasing Corporation ("HNL") and $0.3 million attributable to
LOSS AND LOSS ADJUSTMENT EXPENSES. Losses and LAE increased $74.4 million, or 37.9%, to $270.9 million in 2003 from $196.5 million in 2002. Losses and LAE were net of ceded losses and LAE of $115.6 million in 2003 and $115.3 million in 2002.
UNDERWRITING EXPENSES. Underwriting expenses decreased $10.9 million, or 32.9%, to $22.2 million in 2003 from $33.1 million in 2002. This decrease is primarily due to the effects of discontinued insurance operations, with reduced commissions, premium taxes and a reduction in compensation and benefits resulting from downsizing actions taken during 2003.
OTHER EXPENSES. Other expenses decreased $2.8 million, or 80.0%, to $0.7 million in 2003 from $3.5 million in 2002. This net decrease is primarily due to the sale of substantially all the assets of the Company's leasing subsidiary, HNL, effective April 30, 2002 and a decrease in the expenses of MIIX Healthcare Group.
RESTRUCTURING CHARGE. The Company announced in March, 2002 that LP&C's operations would be placed into runoff and recorded a restructuring charge of $2.6 million during the first quarter of 2002 relating to the reduction of regional and home office staff and the closing of regional offices in Dallas and Indianapolis. No such event occurred during 2003.
NET PREMIUMS EARNED. Net premiums earned were $100.2 million in 2002 compared to $146.9 million in 2001, a decrease of approximately $46.7 million or 31.8%. This net decrease is composed of decreased direct, assumed and ceded premiums earned. Direct premiums earned decreased $54.4 million or 25.4% to $159.5 million in 2002 from $213.9 million in 2001 primarily due to ceasing insurance operations, commutations and cancellation activity during the last nine months of 2002. Direct earned premiums were impacted by the return of approximately $4.9 million associated with the commutation of a large institutional policy during the fourth quarter of 2002. Assumed premiums earned decreased by $0.4 million or 100.0% to $0 from $0.4 million in 2001 primarily due to nonrenewal of a large poorly performing excess of loss reinsurance contract effective January 1, 2001. Ceded premiums earned decreased by $8.1 million or 12.1% to $59.3 million in 2002 from $67.5 million in 2001 primarily due to lower direct earned premium, offset by additional ceded premiums of $44.8 million associated with the reserve adjustment during 2002 as compared to $40.1 million associated with the reserve adjustment during 2001.
Average invested assets at amortized cost decreased to approximately $1.15 billion in 2002 from $1.26 billion in 2001. The average annual pre-tax yield on the investment portfolio decreased to 5.31% in 2002 from 6.38% in 2001 primarily as the result of lower market yields and an increase in short-duration investments held during 2002 for the reasons set forth above.
REALIZED INVESTMENT GAINS AND LOSSES. Net realized investment losses increased $1.3 million, or 61.2%, to net realized investment losses of $3.5 million in 2002 compared to net realized investment losses of $2.2 million in 2001. In 2002, net realized gains of approximately $13.4 million were recognized primarily due to sales of fixed maturity investments as a result of investment portfolio modifications and recognized approximately $16.9 million of losses related to other-than-temporary declines in investment values, of which $8.9 million was attributable to collateralized bond obligations and $4.8 million was associated with United Airlines corporate bonds. In 2001, $19.7 million of net realized gains were taken primarily from continued repositioning of the portfolio, offset by $21.8 million of losses related to other-than-temporary declines in investment values, including $8.1 million ($5.3 million net of tax) resulting from activity following adoption of EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" effective April 1, 2001. EITF 99-20 established new guidelines for recognition of income and other-than-temporary declines for interests in securitized assets.
OTHER REVENUE. Other revenue decreased $1.0 million, or 11.8%, to $7.4 million in 2002 compared to $8.4 million in 2001. This net decrease is composed of (1) a decrease of approximately $2.4 million due to the sale of substantially all of the assets of the Company's leasing subsidiary, HNL, effective April 30, 2002, (2) an increase of $1.7 million associated with management services and related contracts with MIIX Advantage, which commenced insurance operations on September 1, 2002 and (3) a net decrease of approximately $0.3 million attributable to other non-insurance business activity.
As a result of a reserve study conducted by the Company and the annual external actuarial review, the Company recorded a $20.5 million net adjustment to loss and LAE reserves for the fourth quarter ended December 31, 2002, to maintain the loss and LAE reserve at management's best estimate levels. Loss and LAE reserve for the quarter ended December 31, 2002, included an increase to direct and assumed loss and LAE reserves of $85.1 million reduced by ceded loss and ALAE reserves of $64.6 million. Adjustments to direct and assumed loss and LAE reserves included a net increase in Pennsylvania hospitals of $42.0 million, a net increase to New Jersey physicians business of $34.7 million, a decrease to Pennsylvania physicians of $6.1 million and a net increase to all other states hospitals and physicians business of $10.1 million and $4.4 million, respectively. The net adjustment primarily reflects adverse severity trends and, to a certain extent, an acceleration of claims particularly with respect to Pennsylvania hospital claims and to New Jersey physicians for coverage years prior to 1999.
Through the nine months ended September 30, 2002, reserve adjustments had been made to maintain the loss and LAE reserve at management's best estimate levels. The reserve adjustments recorded for the three months ending September 30, 2002, followed from an internal study conducted by the Company. Loss and LAE reserves for the quarter ended September 30, 2002, included a net increase to direct and assumed loss and ALAE reserves of $30.7 million and a net decrease to ULAE reserves of $24.1 million. Ceded loss and ALAE reserves were increased by $11.2 million. Adjustments to direct and assumed loss and ALAE reserves included a net increase in Pennsylvania hospital reserves of $23.5 million, a net decrease in Pennsylvania physician reserves of $9.5 million, a net decrease in New Jersey physician reserves of $0.8 million, and a net increase in reserves held on all other business, written primarily in Texas and Ohio, of $17.5 million. The net adjustment primarily reflected adverse severity trends, particularly with respect to Pennsylvania hospital claims, somewhat offset by better than expected activity in the 2002 coverage year. The net adjustment to ULAE reserves primarily reflected the greater level of claims activity associated with claims-made business written in recent years. Claims-made business generally has a shorter development tail than occurrence policies, so the duration of anticipated future claim handling activity, and claim activity costs per dollar of indemnity payment, diminished.
Less Than 1 1-3 More Than 3 ------------ ----- ----------- Total Year Years Years ------- ----- ----- -------- Operating leases: Equipment $ 390 $ 181 $ 209 $ 0 Premises 1,748 282 733 733 ------- ------ ----- -------- Total $ 2,138 $ 463 $ 942 $ 733 ======= ====== ===== ========
The Company investments consisted primarily of fixed-maturity securities. The Company's investment strategy sought to maximize after-tax income through holding an investment grade, intermediate term, diversified, taxable bond portfolio, while maintaining an adequate level of liquidity. Approximately $56.5 million was set aside in short-term investments to provide for acceleration of claims. If claim payments continue at current levels these funds will be inadequate and the investment portfolio will be diminished faster than anticipated. Any diminution of the investment portfolio will reduce net investment income. At December 31, 2003, the portfolio had an average credit quality of "AA," an average duration of 3.2 years and an annualized yield of 4.0%.
The tables below provide, as of December 31, 2003 and 2002, information about the Company's fixed maturity investments, which are sensitive to changes in interest rates, showing principal amounts and the average yield applicable thereto by expected maturity date and type of investment. The expected maturities displayed have been compiled based upon the earlier of the investment call date or the maturity date or, for mortgage-backed securities, expected payment patterns based on statistical analysis and management's judgment. Actual cash flows could differ, perhaps significantly, from the expected amounts.
At December 31, 2003, the Company had net unrealized gains on its fixed maturity investment portfolio of $14.9 million. The net unrealized gains were the result of the decline in market interest rates during 2003, 2002 and 2001.
Management does not expect that significant unrealized losses will be realized on the fixed maturity portfolio given the credit quality of the portfolio at December 31, 2003 and the Company's policy of matching asset and liability maturities. Asset and liability matching is an important part of the Company's portfolio management process. The Company utilizes financial modeling and scenario analysis to closely monitor the effective modified duration of assets and liabilities in order to minimize mismatching. The goal of effective asset/liability management is to allow payment of claims and operating expenses from operating funds without disrupting the Company's long-term investment strategy.
At December 31, 2003, approximately 52% of the investment portfolio was concentrated in mortgage-backed and asset-backed securities. Mortgage-backed and asset-backed securities involve similar risks associated with fixed maturity investments: interest rate risk, reinvestment rate risk and default or credit risk. In addition, mortgage-backed and asset-backed securities also possess prepayment risk, which is the risk that a security's originally scheduled interest and principal payments will differ considerably due to changes in the level of interest rates. The Company purchased mortgage-backed and asset-backed securities structured to enhance credit quality and/or provide prepayment stability.