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 45,000 square feet of space in
The weighted average shares outstanding for the years ended December 31, 2004, 2003, 2002 and 2001, were 8,455,299, 8,520,335, 9,339,739 and 11,071,529 basic common shares, respectively. The diluted weighted average shares outstanding as of December 31, 2004 were 8,721,286. 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.
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. The discussion that follows contains certain forward-looking statements relating to our anticipated future financial condition, operating results, cash flows and our current business plans. When we use any of the words “will,” “should,” “likely,” “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward looking statements. These forward-looking statements represent our outlook only as of the date of this report. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are detailed under “Item 1 - Business - Uncertainties Relating to Forward Looking Statements” and elsewhere in this report and from time to time in other reports we have filed with the Securities and Exchange Commission. The cross-referenced information is incorporated herein by reference.
We are a leading provider of medical professional liability insurance coverage, writing this coverage in 13 states throughout the country, although we focus on the upper Midwest and New Mexico. 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 95% of our direct premiums written in 2004. In the fourth quarter of 2003, the Company began to implement plans to exit our other lines of insurance, workers’ compensation and health. We began non-renewing these other insurance policies in 2004. 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.
Paid and incurred losses give different pictures of our loss experience, and examining both can help provide a better understanding of our losses. Paid losses are the cash payments we make in a given year, irrespective of the year in which the claim giving rise to the payment occurred or was reported. Most payments made in a given year are for claims that were reported in previous years because of the extended amount of time required to resolve a claim through litigation or settlement. Incurred losses in any given year reflect our expectations of the amount that will ultimately be paid on claims reported in that year. Incurred losses in a single year, will also reflect any adjustment we make to the expected amounts that must be paid on claims reported during previous years, as well as any changes in our estimates for IBNR.
Underwriting expenses represent costs associated with issuing new and renewal business as well as ongoing policy maintenance expenses. Some of these costs, such as commissions and premium taxes, as well 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
The rising cost of medical professional liability insurance has been prominent in the media in recent years. Several factors have contributed to the recent premium rate increases such as an increase in paid losses, decreased investment income due to lower prevailing interest rates, reduced competition and increased reinsurance rates.
Ceased writing occurrence-based policies in all markets with the exception of Michigan, Indiana and New Mexico;
Implemented on-site risk management assessments on all new business in Ohio, Kentucky and Illinois;
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.
Accurately predicting losses on medical professional liability claims is difficult for several reasons. First, most medical professional liability claims take several years to resolve. This often lengthy resolution period reflects the time needed for the discovery of the medical malpractice, which is often not reported to the insured immediately, the filing of a claim, determining, through settlement or trial, the payment responsibilities, if any, associated with the claim, and the payment of the claim. As a result, we often must estimate the ultimate cost to settle a claim, including related expenses, several years in advance of payment. Second, the range of the ultimate potential loss can vary significantly for individual claims with similar characteristics, making it difficult to predict the ultimate loss associated with any single claim. Third, the ultimate projected loss is based, in part, on actuarial methodologies using relevant historical data, which in some cases may be limited. We review our estimates quarterly, and as facts and patterns emerge that provide us with more relevant information related to projection of ultimate expected loss costs, we adjust our estimates related to the liability for unpaid loss and loss adjustment expenses, with the change in estimates resulting in either an increase or decrease in incurred loss and loss adjustment expenses for the current period.
As with other types of property and casualty insurance, medical professional liability insurance policies are subject to policy limits. The limits of liability purchased by our medical professional liability policyholders differ by state. In Michigan and New Mexico, the most common limits purchased are $200,000 of coverage per claim and $600,000 of aggregate coverage per year. In all other states in which we write business, the most common policy limits purchased are $1 million/$3 million, and we write no policies with limits in excess of $2 million/$4 million.
The principal agency through which we write medical professional liability insurance is SCW Agency Group, Inc. and its wholly owned subsidiaries, collectively referred to as SCW. SCW is principally owned by William B. Cheeseman, our former president and chief executive officer and director. Mr. Cheeseman received no cash or other compensation, dividends or other distribution from SCW while he was employed by the Company. His only benefit from his ownership interest in SCW while he was an employee of the Company was the potential appreciation of his investment in SCW. If SCW increases the amount of business it writes for us, SCW will earn more commission revenue from us. To the extent the increase in commission revenue we pay SCW increases SCW’s profits, Mr. Cheeseman’s ownership interest may appreciate. Following his retirement from APCapital on December 31, 2003, Mr. Cheeseman took a more active role in SCW as an employee of that company. Mr. Cheeseman ceased to be a director of APCapital following its 2004 annual meeting of shareholders.
totaled $74,372,000, $75,270,000, and $70,810,000, respectively, representing 34.8%, 29.4%, and 26.6% of the Company’s direct premiums written during such years. Commission expense we incurred related to SCW approximated $5,776,000, $5,962,000, and $5,560,000 in 2004, 2003 and 2002, respectively.
Based on financial information made available to us, we estimate SCW’s net profits on the commission revenue earned from us in 2004 to be approximately $1.2 million. We have not attempted to independently audit or verify the information SCW has furnished, although we have no reason to believe it is inaccurate. For purposes of this disclosure, we have estimated the net profits that SCW earned on the revenue received from us by calculating the profit percentage that SCW’s net profits bears to its total revenue in 2004 and applying that percentage to the revenue earned from us.
In January 2004, we completed a new 5-year contract with SCW. The agreement provides for American Physicians to continue to be the exclusive medical professional liability carrier SCW represents in the state of Michigan, subject to limited exceptions, such as a 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 states other than Michigan. 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 and 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 on an evaluation of market rates and agreements between the Company and its other agents, among other considerations.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect amounts reported in the accompanying Consolidated Financial Statements and related Notes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in the Company’s earnings in the period those estimates changed. The following policies are those we believe to be the most sensitive to estimates and judgments. Our significant accounting policies are more fully described in Note 1 to our Consolidated Financial Statements. Such information is incorporated herein by reference.
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 current case reserving philosophy 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.
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, or 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:
The duration and extent to which the fair value has been less than cost for equity securities, or amortized cost for fixed maturity securities;
The following table shows the aging of unrealized losses included in our investment portfolio as of December 31, 2004:
During 2004 we recorded gross realized losses on the sale of investment securities and investment real estate of approximately $5.2 million. Approximately $1.6 million of this loss was realized on the sale of investment real estate. As a result of our desire to divest our real estate holdings, and thereby reduce our risk related to fluctuations in the real estate market, we were willing to accept a lower offer on the properties, which ultimately resulted in the recorded loss. The remaining loss of approximately $3.6 million relates to fixed-maturity securities, $1.4 million, and equity securities, $2.2 million. The realized loss on our equity securities was primarily the result of the unusually high turnover in our equity portfolio during 2004, which resulted in numerous sales that generated small dollar losses. The losses on our fixed maturity portfolio were primarily related to certain securities that we held, which had a rate of interest that was inversely related to the London Interbank Offered Rate. These securities were maintained as part of our overall interest rate risk management program in the event that interest rates began to decline. However, interest rates have risen since we acquired the securities, and they were no longer deemed necessary. In light of the rise in interest rates, the market value of the bonds had declined, which resulted in the loss upon the sale.
In addition to the divestiture of investment real estate properties, we also made other changes in our investment portfolio during 2004 with the intent of reducing our exposure to credit and interest rate risk. These changes included liquidating our high-yield bond portfolio and other non-investment grade -fixed maturity securities, as well as the start of the liquidation of our equity portfolio in the fourth quarter of 2004.
In accordance with industry practice, we cede to other insurance companies some of the potential liability under insurance policies we have underwritten. This practice, called reinsurance, helps us reduce our net liability on individual risks, stabilize our underwriting results and increase our underwriting capacity. As payment for sharing a portion of our risk, we are also required to share a part of the premium we receive on the related policies. We determine the amount and scope of reinsurance coverage to purchase each year based upon an evaluation of the risks accepted, consultations with reinsurance brokers and a review of market
In May 2004, we commuted our ceded reinsurance treaties with Gerling. We recognized the $13.5 million received from Gerling as reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) in the current year. We also eliminated our reinsurance recoverable from Gerling (thereby increasing losses and loss adjustment expenses incurred) to recognize the effect of releasing Gerling from its obligations under the treaties. The net effect of the commutation was an increase in losses and loss adjustment expenses of $4.4 million, partially offset by an $837,000 increase in net premiums earned.
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. Deferred tax assets are recorded for differences that create deductible temporary differences and loss and credit carryforwards, and deferred tax liabilities are recorded for differences that create taxable temporary differences. Deductible temporary differences occur when the recognition of an expense for tax purposes is deferred or revenue accelerated. Taxable temporary differences represent expenses that have been accelerated for tax purposes or revenues that have been deferred. Future realization of the tax benefit of an existing deductible temporary differences or carryforwards ultimately depends on the availability of sufficient taxable income within the appropriate period. The relevant accounting guidance identifies four sources of taxable income that may be available to realize the tax benefit of deductible temporary differences and carryforwards:
During 2004, we liquidated our $50 million high-yield bond investment portfolio for a pre-tax gain of $1.6 million. In addition, we liquidated the majority of our other non-investment grade securities for a pre-tax gain of $2.6 million. The liquidation of our high-yield bonds and other non-investment grade securities has reduced the overall risk level associated with our investment portfolio, but is likely to decrease future investment income as we reinvest in lower-risk, lower-yielding securities. Offsetting the above-mentioned gains was a $2.5 million charge for the write-off of capitalized software costs associated with an information system project involving a computer system to administer medical professional liability policies and claims and a pre-tax realized loss on the sale of investment real estate of $1.6 million. The information system project, which began in the fall of 2002, was not producing the anticipated results and management decided to discontinue the project. In addition, we recorded a $1,050,000 impairment charge related to other investment real estate properties.
Incurred loss and loss adjustment expenses were $177.8 million in 2004, a decrease of $75 million compared to 2003. This decrease was the result of the $43.4 million of unfavorable development on prior year loss reserves recorded in 2003. Prior year unfavorable loss reserve development in 2004 was $6.2 million, which consists of unfavorable development related to the other insurance line of business, and a $4.4 million increase in incurred losses from the commutation of our reinsurance treaties with Gerling in 2004, partially offset by favorable development on the medical professional liability line of business. The Gerling commutation is more fully described in Note 10 of the Notes to Consolidated Financial Statements. The consolidated calendar year loss ratio for the 2004 year was 88.6%, consisting of 3.0% on prior accident years and 85.6% on the current accident year. In 2003, the current year accident loss ratio was 93.2%, with a prior year loss ratio of 19.3%, for a total calendar year loss ratio of 112.5%. Our incurred loss and loss adjustment expenses are analyzed more fully in the discussions of our individual operating segment results.
The increase in amortization expense during 2004 relates to an intangible asset arising from a two-year covenant not to compete with the Company’s former CEO and President upon his retirement effective December 31, 2003. See Note 4 of the Notes to Consolidated Financial Statements for further information regarding intangible assets. Such information is incorporated herein by reference.
Other expenses for 2004 consist of contract termination costs incurred in connection with the sub-lease of approximately 10,000 square feet of office space in Chicago. During 2003, we incurred restructuring expenses related to employee separation costs as a result of terminations in connection with our exit from the other insurance segment. As we continue our exit from our other insurance lines in 2005 and beyond, we anticipate incurring approximately $89,000 of additional employee separation costs in future periods.
The yield on our investment portfolio was 5.55% for 2003 compared to 5.98% for 2002. The lower yield in 2003 was the result of a general decline in interest rates combined with a higher cash balance during the first part of the year, which produces a significantly lower yield than longer-term more productive assets. We delayed investing a portion of the cash flow generated during the first half of 2003 due to the very low interest rate environment and our reluctance to lock-in longer-term interest rates at prevailing levels. In addition, we recorded a $1.8 million loss on one of our real estate limited partnerships that was accounted for on the equity method.
The federal income tax expense recorded in 2003, as compared to the benefit recorded in 2002, was the result of the establishment of the deferred tax valuation allowance as described above.
2004 Compared to 2003. Direct premiums written for the medical professional liability segment increased in 2004 as we continued to implement rate increases in all markets and increased our market share in New Mexico. This was partially offset by our reduced exposure in the Florida market, the discontinuance of Ohio and Kentucky occurrence-based policies and reduced policies in force in Illinois. Our physician policy count at December 31, 2004 has decreased approximately 8.8% from December 31, 2003. This decline was the result of increased price competition in selected markets and strict underwriting standards. We remain committed to applying strict underwriting standards and adequate pricing. The average premium per policy in-force has increased from approximately $16,300 at December 31, 2003 to approximately $18,500 at
We believe that the current pricing environment for medical professional liability insurance is favorable. We expect medical professional liability direct premiums written to increase moderately in the future as the Company is granted additional rate increases by regulatory authorities. However, we anticipate that rate increases in 2005 may not be as significant as those granted in prior years.
The decrease in incurred loss and loss adjustment expenses was primarily the result of $44.3 million of adverse development on prior year loss and loss adjustment expense reserves recorded in 2003, and $2.7 million of favorable development in 2004. The favorable development in 2004 was due to lower than expected paid severity, most notably in the Ohio and Michigan markets. These developments are discussed more fully under “Item 1 - Business - Loss and Loss Adjustment Expense Reserves.” The cross-referenced information is incorporated herein by reference.
2003 Compared to 2002. Direct premiums written for the medical professional liability segment increased in 2003 primarily as a result of rate increases in virtually all markets, partially offset by our non-renewal of policies in our Florida market. Our insured physician count at December 31, 2003 has decreased approximately 12% from December 31, 2002 due to our exit from the Florida market, the discontinuance of Ohio and Kentucky occurrence-based policies and the elimination of poor risks in other markets. The average premium per policy in-force has increased from approximately $13,400 at December 31, 2002 to approximately $16,300 at December 31, 2003, an increase of 21.6%. The decrease in direct premiums written in Florida, as a result of the non-renewal of policies in that state was partially offset by direct premiums written of approximately $3.8 million by PIC. during 2003.
Our net premiums written and earned during 2003 did not increase as much as direct premiums written primarily due to an increase in the cost of reinsurance, which resulted in additional ceded written and earned premiums.
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.
The increase in underwriting expenses was the result of increased salaries and employee relations costs as we added to our claims and underwriting personnel. In addition, higher premium volumes resulted in increased commissions and premium taxes.
2004 Compared to 2003. The direct premiums written for other insurance lines decreased during 2004 as we continue our exit from the workers’ compensation and health lines of business. We non-renewed all workers’ compensation policies as of their anniversary date in 2004 and began non-renewing health policies effective July 1, 2004. The number of covered lives on our health business has continued to decrease throughout 2004 to 2,596 as of December 31, 2004, compared to 6,554 at December 31, 2003. We expect to complete the non-renewal of all other policies by the end of the third quarter of 2005.
The decrease in underwriting expenses is primarily the result of reduced salary and employee benefit costs as a result of the departure of the other insurance management team in the last nine months of 2003. Also, as a result of the decreased premium volume, there was a decrease in corporate and shared services salary, employee benefit and other costs allocated to the other insurance lines segment. As we continue our exit from these lines, these underwriting expenses should continue to decrease.
2003 Compared to 2002. 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, and legal and investment banking fees incurred in the fourth quarter pursuant to the Board of Directors’ evaluation of strategic alternatives to maximize shareholder value after the loss reported in the third quarter of 2003, as well as interest expense as a result of the issuance of floating rate junior subordinated deferrable interest debentures. The increase in these expenses was partially offset by an increase in other income.
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. We also enter into financing transactions from time to time to acquire
At December 31, 2003, the Company was indebted is to its former President and Chief Executive Officer in the amount of $6.0 million in connection with the purchase of Stratton-Cheeseman Management Company. As a result of his retirement, effective December 31, 2003, the note payable became due, and was paid in its entirety in January 2004.
As of September 17, 2004, American Physicians Assurance entered into a stock purchase agreement with various shareholders of PICW, to acquire a substantial minority interest in PICW. The stock purchase agreement, as amended in November 2004, states that American Physicians will purchase 4,782 shares of PICW common stock at a purchase price of $3,800 per share in cash, or approximately $18.1 million. The closing of the purchase is subject to various conditions, including the receipt of approval from Wisconsin’s Office of the Commissioner of Insurance. If the transaction is completed, American Physicians will own approximately 24% of PICW’s outstanding shares.
At December 31, 2004, we had $190.9 million of cash and cash equivalents available and an investment portfolio of $667.2 million. The portfolio includes $75.3 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, 2004, our fixed maturity portfolio included $230.7 million of bonds that mature in the next one to five years and $104.8 million that mature in the next five to ten years. In addition, at December 31, 2004, we have $128.4 million of mortgage-backed securities that provide periodic principal repayments. We currently maintain a relatively short investment posture with $191 million in cash and other cash equivalents. Over the next three to six months, we intend to deploy these cash resources in various other securities, including taxable municiples, investment-grade corporate bonds and mortgage-backed securities. 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, 2004, 2003 and 2002.
Our invested assets consist primarily of fixed maturity and equity securities, which are carried in the Consolidated Balance Sheets, included elsewhere in this report, at their estimated fair value, and investment real estate and investment real estate limited partnerships. At December 31, 2004, our investment portfolio included net unrealized gains of approximately $24.1 million, a decrease of $21.5 million compared to December 31, 2003. Net unrealized gains are reported, net of tax, in the shareholders’ equity section of the Consolidated Balance Sheets and represented approximately 4.0% and 14.7% of consolidated shareholders’ equity at December 31, 2004 and 2003, respectively. Generally, the estimated fair value of our fixed maturity securities is inversely related to current interest rates. Therefore, as interest rates rise, our net unrealized gains will fall. See “
We have completed an integrated audit of American Physicians Capital, Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, statements of shareholders’ equity and comprehensive income and of cash flows present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Also, we have audited management’s assessment, included in the accompanying “Management’s Report on Internal Control Over Financial Reporting,” appearing under item 9A, that American Physicians Capital, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, because the Company did not maintain effective controls over underwriting and claims processes performed at its New Mexico location, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of December 31, 2004, the Company did not maintain effective controls over underwriting and claims processes performed at its New Mexico location. The control deficiency at this location relates to deficiencies in the processing and recording of premiums, paid losses, loss adjustment expenses and the related case reserves at December 31, 2004. Specifically, the deficiencies identified included a lack of segregation of duties, insufficient management monitoring and oversight of the underwriting and claims processes, and a lack of adequate documentation to provide evidence of the performance of key controls. The policy and claim administration systems support the underwriting and claims processing at the New Mexico location. These systems lack controls necessary to ensure all premiums and claims transactions are properly processed and accumulated. In addition, access is not restricted to ensure unauthorized individuals do not have access to add, change or delete the underlying premiums or claims data. The control deficiency did not result in any adjustments to the 2004 annual or interim consolidated financial statements. However, this control deficiency could result in a misstatement of premiums, paid losses, loss adjustment expenses and the related case reserves that would result in a material misstatement to the annual or interim financial statements that would not be prevented or detected. Accordingly, management has determined that this control deficiency constitutes a material weakness. Because of this material weakness, we have concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on criteria in Internal Control - Integrated Framework. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the December 31, 2004, consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of American Physicians Capital, Inc. (“APCapital”), its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation (“APS”), APConsulting LLC, APDirect Sales, LLC, Alpha Advisors, Inc., APIndemnity (Bermuda) Ltd., APManagement Ltd. and American Physicians Assurance Corporation (“American Physicians”). In addition, the accounts of Physicians Insurance Company, a 49% owned subsidiary, have been consolidated in the accompanying Consolidated Financial Statements. All significant intercompany accounts and transactions are eliminated in consolidation.
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. These lines are now included in the other insurance lines segment. Medical professional liability and other insurance direct premiums written accounted for approximately 95% and 5%, respectively, of the Company’s total direct premiums written in 2004.
With the exception of certain interest-only certificates that have a rate of interest that is inversely related to, but derived from the London Interbank Offered Rate, all of the Company’s fixed maturity and equity securities are classified as available-for-sale, which are those securities that would be available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates and asset-liability management strategies. Available-for-sale securities are reported at 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. The interest-only certificates are described more fully under the heading “Derivative Financial Instruments” below.
Equity securities, which are principally private placements, are carried at market value based on the securities’ estimated net realizable value. The net realizable value of private placement equity securities is determined by the Company’s third-party equity investment manager based on the estimated consideration that would be received if the security were sold in the next nine months. Fair values of fixed maturity securities
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.
Investment real estate is carried at the lower of historical cost, less accumulated depreciation, or fair value, based on estimated discounted future cash flows. Real estate of $6,109,000 and $27,105,000, net of accumulated depreciation of $1,597,000 and $2,444,000, at December 31, 2004 and 2003, respectively, is included in other investments on the balance sheet. At December 31, 2004 and 2003, $1,438,000 and $8,008,000 of real estate was non-income producing, respectively.
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 ($243,000) and $1,164,000 at December 31, 2004 and 2003, respectively.
Cash equivalents consist principally of commercial paper and money market funds. They are stated at cost, which approximates fair value, and have original maturities of three months or less. At December 31, 2004, the Company has a required compensating balance with a financial institution in the amount of $3,000,000, which legally restricts the availability of this cash for the Company’s use.
Premiums written are earned using the daily pro rata method over the period of risk. Premiums receivable include $50,514,000 at December 31, 2004 and $58,694,000 at December 31, 2003 of premium installments. Receivable balances consist principally of written premiums from physicians in the states of Michigan, Ohio, Illinois and New Mexico. The Company’s exposure to credit risk associated with receivables is generally offset by the liability for unearned premiums; however, an allowance for doubtful accounts of approximately $205,000 and $550,000 at December 31, 2004 and 2003, respectively, is included in the premium receivable balance, primarily for receivable balances that may not be collectable and have no associated unearned premiums.
Property and equipment are recorded at cost. Depreciation is computed for assets on a straight-line basis over the following periods: building - 40 years, furniture - 10 years, and computer equipment and software - 5 years. Upon the sale or retirement of property and equipment, balances are removed from the respective accounts and any gain or loss on the disposal of the asset is included in income, as a realized gain or loss.
The reserves for unpaid losses and loss adjustment expenses are estimated using the Company’s claim experience. These estimates are subject to the effects of trends in loss severity and frequency. When a claim is reported to the Company, a “case reserve” is established for the estimated amount of the ultimate claim payment, as well as the expected costs to be paid in connection with the defense or settlement of the claim. These estimates reflect an informed judgment based upon insurance reserving practices appropriate for the relevant type of insurance, and based on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are periodically reviewed and adjusted as necessary as more information becomes available. Reserves for claims “incurred but not reported” provide for the future reporting of claims already incurred, and development on claims already reported. The reserve for claims incurred but not reported is actuarially estimated based on historical loss trends. With the exception of reserves for extended reporting period claims, the Company does not discount reserves to recognize the time value of money.
The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of future premiums associated with this coverage. The amount of this reserve is $14.0 million at December 31, 2004 and 2003, which includes a discount of approximately $5.9 million related to the present value calculation. The reserve for extended reporting period claims is included in unpaid loss and loss adjustment expenses on the balance sheet. Changes in this reserve are charged or credited to income.
Insurance premium income is recognized on a daily pro rata basis over the respective terms of the policies in-force, generally one month for health insurance policies and one year for all other policies. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.
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. At December 31, 2004, the Company has not established an allowance for any potentially uncollectible recoverable amounts. See Note 10 for recoverable amounts from individually significant reinsurers.
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. The Company has reviewed its deferred federal income tax assets for recoverability based on the availability of future taxable income when the deductible temporary differences are expected to reverse, and has determined, based on the reported net losses in two of the last three years, that
sufficient taxable income may not exist in the periods of reversal. Accordingly, the Company has recorded a deferred tax asset valuation allowance for the entire net deferred tax asset. The establishment of the valuation allowance in 2003 was recorded as federal income tax expense in the accompanying Consolidated Statements of Income. In 2004, changes in the valuation allowance were allocated to federal income tax expense (which is included as a component of net income), components of comprehensive income, or other components of shareholders’ equity, depending on the nature of the temporary differences that created the change in the valuation allowance. See Note 11 for additional information regarding income taxes.
The Company’s investment in PIC, in March 2003, was made in conjunction with its decision to exit the Florida medical professional liability market starting in December 2002. The intent was for PIC to write as much medical professional liability insurance business as its capital and surplus levels would reasonably support, thereby limiting the Company’s exposure from its obligation under Florida State law to offer tail coverage to policyholders as we non-renewed their policies.
At December 31, 2004 and 2003, PIC’s total assets were approximately $12.9 and $8.6 million respectively, and its net premiums earned were $2.3 million and $610,000 for the years ended December 31, 2004 and 2003, respectively. 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.
On December 31, 2004, the Company consummated a transaction in which PIC’s other investor assumed ownership of 100% of PIC’s outstanding common stock. In exchange for its 49% ownership interest, American Physicians received a $3 million interest-bearing note receivable. The note receivable is to be paid in monthly installments beginning in January 2005, and continuing for seven years thereafter. The note is collateralized by 100% of the outstanding common stock of PIC. Because the note received in exchange for American Physicians ownership interest is secured by the common stock of PIC, the exchange was deemed not to be a sale in accordance with GAAP, but was rather accounted for as a secured borrowing with pledge of collateral. Accordingly, the Company continues to consolidate PIC in accordance with the original assessment made under FIN No. 46 R.
In 2003, the Emerging Issues Task Force (“EITF”) issued EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The guidance contained in EITF 03-1 has been delayed by FASB Staff Position (“FSP”) EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1 ‘The meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.’ ” The delay of the effective date will be superseded with the final issuance of proposed FSP EITF Issue 03-1-a, “Implication Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1” which was subject to comments through October 29, 2004.
The disclosures requirements of EITF 03-1 continue to be effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under Statements 115 and 124. The impact of FSP EITF 03-1-a on the Company’s financial position or results of operations cannot be determined at this time. However, under the proposed guidance, decreases in the market value of certain investments could have a material adverse impact on the Company’s future results of operations.
In December 2004, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R is effective as of the beginning of the first interim or annual period that begins after June 15, 2005, and requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award i.e., the requisite service period, which is usually equal to the vesting period. In accordance with the transitional guidance given in the statement, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service period has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123 for either recognition or pro forma disclosure requirements.
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
At December 31, 2004, gross unrealized gains and losses include $340,000 and ($246,000), respectively of gains and losses related to the derivative securities described in Note 1. Gross unrealized gains and losses at December 31, 2003 included $432,000 and $0, respectively, related to these securities. The gains and losses related to these securities, ($338,000) in 2004 and $432,000 in 2003, have been included in investment income in accordance with SFAS No. 133. See Note 1 for further discussion of these securities and the embedded derivative instruments.
The following table shows the Company’s gross unrealized investment losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004.
Note that the table above excludes approximately ($246,000) of unrealized loss related to derivative securities. These losses have been excluded, as any changes in the fair value of the related securities is included in income. See Note 1 - “Derivative Financial Information.”
Each individual security in the table above has been evaluated and declines in the market value have been deemed to be temporary in nature.
The amortized cost and estimated fair value of debt securities at December 31, 2004, by contractual maturity, were:
Proceeds on the sales of investments in bonds totaled $154,890,000 in 2004, $43,754,000 in 2003, and $45,337,000 in 2002. Gross gains of $7,484,000, $3,189,000 and $2,153,000 were realized on the sales of investments in bonds for the years ended 2004, 2003 and 2002, respectively. Gross losses of $1,348,000, $206,000 and $1,741,000 were realized on the sales of investments in bonds for the years ended 2004, 2003 and 2002, respectively.
The Company determined that the capitalized deferred acquisition costs associated with the other insurance lines segment were not recoverable at September 30, 2004, and accordingly, wrote-off $300,000 of capitalized costs as of that date. No additional costs associated with this segment were capitalized after that date.
Depreciation expense associated with property and equipment for the years ended December 31, 2004, 2003 and 2002 was $1.9 million, $2.0 million, and $1.5 million, respectively. Net realized losses on the sale, disposal, or impairment of property and equipment for the years ended December 31, 2004, 2003 and 2002 were $3.4 million, $7,000 and $293,000, respectively.
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2004, 2003, and 2002 was as follows:
During the years ended December 31, 2004, 2003 and 2002, management made adjustments to prior year’s loss reserves. The unfavorable development totaled $6.2 million in 2004, $43.4 million in 2003, and $5.6 million in 2002. As a percentage of net reserves as of the beginning of the year, these adjustments represented 1.1%, 8.0% and 1.1%, respectively.
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and plus 4.20% for the second trust issuance, payable quarterly. The interest rate is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 12.50%. The weighted average interest rates of 5.59% (Trust I issuance) and 5.73% (Trust II issuance) resulted in interest expense of approximately $1.7 million and $1.0 million for the years ended December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, accrued interest payable to the trusts was approximately $224,000 and $182,000, respectively. The Debentures are callable by APCapital at par beginning in May 2008. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS. As the amounts that could potentially be payable under the guarantees are recorded as liabilities by the Company, no additional liability related to these guarantees has been accrued.
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation.
Losses and loss adjustment expenses incurred are net of ceded losses of $29,832,000 for 2004, $33,497,000 for 2003, and $31,725,000 for 2002.
The Company had reinsurance recoverables from the following reinsurers at December 31, 2004 and 2003:
The provision for income taxes for the years ended December 31, 2004, 2003 and 2002 consists of:
Income taxes incurred do not bear the usual relationship to income before income taxes for the years ended December 31, 2004, 2003, and 2002 due to the following:
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. The Company has reviewed its deferred federal income tax assets for recoverability based on the availability of future taxable income when the deductible temporary differences are
At December 31, 2004 and 2003, the components of the net deferred federal income tax asset were as follows:
The following table shows the intraperiod allocation of the change in the deferred tax valuation allowance for the years ended December 31, 2004 and 2003.
At December 31, 2004, the Company had the following net operating loss carryforwards:
In addition, the Company had approximately $8.4 million of minimum tax credits which can be carried forward indefinitely.
In September 2003, the Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439.
The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of December 31, 2004, the Company has 418,369 shares of its September 11, 2003 stock repurchase program remaining to be purchased.
In addition to the shares above, which were repurchased in connection with publicly announced plans, the Company repurchased 166,017 that were tendered in lieu of cash in connection with the exercise of stock options awards.
In 2001, the Company reduced personnel in its Information Systems department and its management team and completed its phase out of the personal and commercial lines. At December 31, 2002, substantially all activities related to the restructuring initiatives were substantially complete; however, structured severance packages were not completely paid out until 2003.
related to these individuals will be recognized prospectively over the future service period. At December 31, 2004, total future employee separation costs are estimated to be approximately $89,000.
In the fourth quarter of 2004, the Company subleased approximately 10,000 square feet of office space in Chicago, Illinois. The difference in the cash flows between the Company’s obligation for the subleased space in accordance with the original lease terms, and the rent the Company will receive from the sublessor over the next ten years, has been discounted, using an interest rate of approximately six-percent, to approximate the fair value of the liability incurred in connection with the contract termination. Other costs incurred in connection with the subleased space, such as broker commissions, were also included in the calculation of the liability.
The following table shows the costs incurred, payments made, and ending liability incurred in connection with this contract termination:
The costs above have been included in the Other Expenses line in the income statement and are allocated to the Company’s various segments based on the estimated square footage of the subleased space that segment intended to use. No additional costs are expected to be incurred in future periods in connection with this sublease; however, changes in the estimate of the liability may be recognized as certain costs under the original lease terms were not fixed.
On January 2, 2004, the $6.0 million obligation to the Company’s former President and Chief Executive Officer (“CEO”) was repaid in its entirety in connection with his retirement.
SCW leased approximately 10,000 square feet of office space from the Company for a portion of 2004, approximately 10,000 square feet in 2003 and approximately 13,000 square feet in 2002. The Company received $80,000, $214,000 and $283,000 in rental income in 2004, 2003, and 2002, respectively, from the agency related to the leased office space.
During the fourth quarter of 2004, the Company sold its 25% ownership interest in another of its real estate partnerships, Chandler Homes LLC, to the partnership’s other investors. These other investors also own the other 50% of the Chandler Office Park, LLC mentioned above. A gain of $650,000 was recognized on the sale of the Company’s interest in Chandler Homes LLC. The consideration received by the Company consisted of $65,000 in cash and a note receivable in the amount of $585,000. The note bears interest at a rate of prime plus 1%, beginning on January 1, 2005, and is due in quarterly installments beginning on April 1, 2005, with any outstanding interest and principal due and payable in full on December 31, 2005.
The number of stock option awards outstanding and exercisable at December 31, 2004 was as follows:
The following table shows the number of unvested shares outstanding, the number of shares granted, vested and forfeited, as well as the compensation cost recognized in the Consolidated Income Statements related to these awards for each of the three years ended December 31, 2004, 2003 and 2002.
In 2004 and 2003, the Company recognized a tax benefit of $1,775,000 and $261,000, respectively, 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 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. At December 31, 2004 and 2003, the Company had a recorded liability of $392,000 and $300,000,
respectively, for amounts assessed by state guarantee associations, as well as the Company’s estimate of it’s share of any insolvencies not yet assessed.
APCapital has issued guarantees in connection with the formation of non-consolidated subsidiary trusts that were formed during 2003 for the purpose of issuing mandatorily redeemable TPS. In accordance with the structure and nature of the transactions, APCapital has guaranteed that amounts paid to the trusts, related to the debentures issued by APCapital that the trusts hold, will be distributed to the holders of the TPS. The amounts payable to the holders of the TPS are recorded as liabilities on the Company’s Consolidated Balance Sheets. See Note 9 for further information on the trusts, the TPS, and the debentures issued by APCapital.
The Company is obligated under operating leases, which have various expiration dates through December 2014. Minimum future lease payments are as follows: 2005 - $1,068,000; 2006 - $984,000; 2007 - $737,000, 2008 - $625,000 and 2009 and thereafter - $2,999,000. Rental expense was $1,321,000 in 2004, $1,615,000 in 2003, and $1,900,000 in 2002.
As of September 17, 2004, American Physicians entered into a stock purchase agreement with various shareholders of Physicians Insurance Company of Wisconsin, Inc. (“PICW”) to acquire a substantial minority interest in PICW. The stock purchase agreement, as amended in November 2004, states that American Physicians will purchase 4,782 shares of PICW common stock at a purchase price of $3,800 per share in cash, or approximately $18.1 million. The closing of the purchase is subject to various conditions, including the receipt of approval from Wisconsin’s Office of the Commissioner of Insurance. If the transaction is completed, American Physicians will own approximately 24% of PICW’s outstanding shares.
Unpaid losses and loss adjustment expenses and unearned premiums are reported net of the impact of reinsurance for statutory accounting purposes.
The following is statutory surplus at December 31, 2004, 2003, and 2002 and net income (loss) for the years then ended.
Prior to 2004, the Company had five reportable segments - medical professional liability, workers’ compensation, health, personal and commercial insurance lines, as well as the corporate and other segment. As the Company has implemented its exit from the workers’ compensation and health insurance lines, and exited the personal and commercial lines in 2001, management’s emphasis on these lines, as well as their financial significance has decreased. Accordingly, these three previously separately reported segments have been aggregated into the other insurance lines segment reported in 2004. Reported 2003 and 2002 amounts have been reclassified to conform to the current year presentation.
These condensed financial statements should be read in conjunction with the accompanying consolidated
APCapital owns all of the issued and outstanding common stock of the following entities either directly, or indirectly through one of the entities listed below:
American Physicians Assurance Corporation - a stock insurance company incorporated under Michigan law (American Physicians), formerly Mutual Insurance Corporation Of America
Insurance Corporation of America - a stock insurance company incorporated under Michigan law (ICA).
Net investment income is allocated to each of the segments based on that segment’s “ownership” of the underlying income producing assets.