The following Selected Consolidated Financial Data is derived from the audited consolidated financial statements of the Company. The Company acquired MDA on June 26, 1995, and the accompanying data which pertains to preacquisition periods have been prepared as if the companies were combined throughout those periods. This data should be read in conjunction with the Consolidated Financial Statements and accompanying notes and management discussion and analysis included elsewhere herein.
(1) For 1995 earnings per common share are reflected for earnings subsequent to June 26, 1995, which is the date that Medical Defense Holding Co. completed its acquisition of Medical Defense Associates and its subsidiaries. For years prior to 1995 no earnings per share data is presented since all earnings are related to Medical Defense Associates preacquisition activities and, therefore, are not considered earnings per common share of Medical Defense Holding Co.'s stockholders. See Note 12 of Notes to Consolidated Financial Statements. (2) Anti-dilutive.
Management's discussion and analysis of financial condition and results of operations is intended to provide a review of significant factors affecting the financial condition and results of operations of Medical Defense Holding Co. (the "Company") and its subsidiaries as of December 31, 1997 and 1996 and for each of the three years presented elsewhere herein. These financial statements give retroactive effect to the acquisition of MDA and its subsidiaries by the Company on June 26, 1995. The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto of the Company which appear elsewhere herein.
The Company is a Missouri general business corporation formed for the purpose of facilitating the conversion of MDA from a mutual association to a stock insurance company. On June 26, 1995, the conversion was completed with the exchange of the policyholders' rights in MDA, the mutual insurance association, for shares of convertible Preferred Stock in the Company, the parent holding company. The Company owns one hundred percent (100%) of the outstanding shares of MDA.
The professional medical liability market in Missouri continues to be one of intense competition. There are several major competitors and with the "soft" portion of the insurance cycle continuing, the market is abundant with price cutting and discounting. The Company has refused to respond in kind but rather has chosen to maintain its actuarially based pricing structure. Due to changes in the health care industry, the recent trend has been for physicians, surgeons and dentists, who have been the company's primary clients, to become employees of hospitals or other health care networks and cease to obtain their own medical professional liability insurance. Due to this change, the Company's market share has continued to decline during the past three years. During 1995 the policyholder count declined from 1,751 to 1,609, while in 1996 the count declined to 1,459, and in 1997 the policyholder count further declined to 1,165. However, the Company continues to intensify its services to policyholders in an attempt to maintain or increase market share.
The Company recorded a 7% or $1,401,058 decrease in total revenues during 1997 as compared to 1996. This decrease was primarily the result of a reduction in premium income of approximately $1,100,000, a decline in investment income of approximately $305,000 and, an increase in realized investment gains of $12,316. The decline in premium income was primarily the result of an approximate 20% decline in MDA's total policyholders and occurred despite a 15% rate increase which was effective January 1, 1997 on all of MDA's new and renewal business. The decrease in the Company's investment income was primarily the result of a decline in fixed maturity investments during 1997 as compared to 1996. These fixed maturity investments normally generate a higher rate of return than short- term investments. In addition, interest rate yields in 1997 were slightly lower then the previous year. Realized investment gains increased $12,316, when compared to 1996, as fixed-income investment prices were somewhat higher in 1997 and therefore the opportunity to realize investment gains was more prevalent than in 1996.
For the year ended December 31, 1997, the Company had net income (before provision for income taxes) of $1,365,030, compared to a net loss (before provision for income taxes) of $4,705,629 in 1996. Although the Company's net income increased approximately $6 million from the prior year's net loss the total tax provision was virtually unchanged at approximately $790,000. This was primarily due to a decrease in the deferred tax provision of approximately $2 million, when compared to the prior year. This decrease in the deferred tax provision was due to the change in the deferred tax asset valuation allowance and the deferred tax asset. The deferred tax asset valuation allowance relates entirely to loss reserve discounting and represents the difference between the total deferred tax asset related to loss reserve discounting required by the Internal Revenue Service and the amount that is more likely than not to be realized by the Company. Due to a change in the tax law effective January 1, 1998, the Company may only carry back net operating losses two years and as no taxes were paid in 1997 or 1996 the Company does not have any tax benefit to recover from prior years taxes. Furthermore, the Company does not believe it can reasonably determine the amount of loss reserve deferred tax benefit which can be recovered from future taxable income using a more likely than not standard. Therefore, as of December 31, 1997, the Company's total deferred tax asset was included in the deferred tax asset valuation allowance. As a result, the Company's net income for 1997 was $582,319 compared to a net loss of $5,501,042 for 1996.
Stockholders' equity as of December 31, 1997, increased $519,318 or 2.4% from December 31, 1996. This increase was due to the net income in 1997 of $582,319, the purchase of the Company's preferred stock for $706,377, and the net increase in the unrealized gains and losses on fixed maturity investments of $643,376.
Future cash flow for the Company will be primarily dependent on the ability of its subsidiary, MDA, to pay cash dividends. MDA's cash flow is generated from its insurance operations and investment portfolio. MDA is subject to annual statutory dividend limitations as to the amount of any dividend which may be paid without prior approval of the Director of the Missouri Department of Insurance. For 1997 the maximum dividend payable to the Company from MDA, without prior approval of the Missouri Department of Insurance, is $1,979,766.
The Company's consolidated net cash flow used by operating activities for the year ended December 31, 1997 was $2,997,262 which was an increase in net cash provided by operation of $4,113,584 when compared to the previous year. This increase was primarily the result of an increase in net income for 1997 compared to the net loss in 1996 of $6,083,361, coupled with an increase in paid loss and loss adjustment expenses over incurred loss and loss adjustment expenses of $1,949,676 in 1997 compared to 1996. For the year ended December 31, 1996, compared to the previous year, the Company's consolidated net cash flow provided by operating activities decreased by $12,750,632. This decrease was primarily the result of several factors including a decrease in net income for 1996 compared to 1995 of $7,317,420, a decrease in unpaid loss and loss adjustment expenses during 1996 compared to 1995 of $2,455,000, and the collection in 1995 of amounts recorded as receivable from reinsurers which accounted for $2,307,494 million of the variation from 1995.
The Company's cash flow from operations and its investment portfolio are utilized to meet its obligations related to payment of losses and loss adjustment expenses, payment of operating expenses, and other needs as deemed necessary from time to time. Under employment agreements with certain officers and directors, payments totaling approximately $500,000 are to be made if the number of insureds fall below 913. Such payments are forfeited in whole or in part if the individual does not remain employed for a period of 36 months following the payment date.
We have audited the accompanying consolidated balance sheets of Medical Defense Holding Co. and Subsidiaries (the "Company") as of December 31, 1997 and 1996, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Medical Defense Holding Co. and Subsidiaries as of December 31, 1997 and 1996 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
Consolidated Statements of Cash Flow for the years ended December 31, 1997, 1996 and 1995
Medical Defense Holding Co. (the "Company") is a Missouri general business corporation formed on November 28, 1994, for the purpose of facilitating the consummation of a series of transactions whereby Medical Defense Associates ("MDA") converted from a mutual assessment insurance organization under Chapter 383 RSMo to a wholly-owned stock insurance company subsidiary of the Company. MDA's conversion was completed on June 26, 1995 in accordance with an agreement and plan of conversion dated November 29, 1994. The agreement and plan of conversion was approved by eligible policyholders at a special meeting on April 3, 1995.
The following is a description of the significant accounting policies under generally accepted accounting principles followed by the Company in the preparation of the accompanying consolidated financial statements:
C. MDA Statutory Net Income and Surplus: The accompanying financial statements have been prepared in conformity with generally accepted accounting principles which vary in certain respects from accounting practices prescribed or permitted by the Missouri Department of Insurance statutory accounting practices.
C. MDA Statutory Net Income and Surplus, continued: A reconciliation of net income for the years 1997, 1996 and 1995 and surplus as regards policyholders at December 31, 1997, 1996 and 1995 reported by MDA on a generally accepted accounting principles (GAAP) basis which includes its wholly-owned subsidiaries MDS and MDIC, to the amounts reported by MDA on a statutory basis which includes equity in MDS and MDIC is as follows:
The maximum amount of dividends which can be paid by Missouri insurance companies without prior approval of the Insurance Commissioner is subject to statutory provisions. Dividends paid by MDA to the Company during 1997 and 1996 were $2,100,000 and $0, respectively. The maximum dividend payout which may be made in 1998, without prior approval of the Missouri Department of Insurance, is $1,979,766.
E. Unpaid Losses and Loss Adjustment Expenses: As more fully described in Note 10, the reserves for losses and loss adjustment expenses include amounts determined on the basis of individual claims and actuarially determined estimates of future losses. The methods of making such estimates and for establishing the resulting liabilities are continually reviewed and updated based upon current circumstances and any adjustments resulting therefrom are reflected in current operations.
F. Investments: Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities ("SFAS"), requires companies to classify securities into three categories. Held-to-maturity debt securities that the Company has the positive intent and ability to hold to maturity, are to be reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are to be reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified in the other two categories are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings, and reported as a separate component of surplus as regards policyholders.
I. Cash Equivalents: Cash equivalents represent bank repurchase agreements or certificates of deposit with original maturity dates within 90 days.
On August 8, 1997, MDHC initiated a tender offer for up to 5,000,000 shares of the Company's $1.00 par value redeemable preferred stock at a price ranging from $0.30 to $0.40 per share, utilizing a method commonly referred to as a Dutch auction. This offer closed on October 3, 1997, with the Company accepting 1,721,445 tendered shares at a price of $0.40 per share. The tender offer was completed on October 16, 1997, with the Company's payment of $688,578 for all preferred shares accepted for purchase. In addition, during December 1997, the Company purchased 44,498 shares of its convertible preferred stock, at a total purchase price of $17,799, from a small number of shareholders, at their request, at a price of $0.40 per share. The difference between the payment and the par value of the stock has been credited to additional paid-in capital.
The change in net unrealized holding gain or loss on available for sale securities, net of deferred taxes, for the years ended December 31, 1997, 1996 and 1995 are as follows:
The amortized cost and estimated market value of debt securities by estimated and contractual maturity are shown as follows:
Securities on Deposit With Statutory Authorities: MDA had a U.S. Treasury Note with a par value of $1,400,000 at December 31, 1997, on deposit with the state of Missouri. In addition, MDA had on deposit U.S. Treasury Notes with a par value totaling $5,000,000 at December 31, 1997, on deposit with the state of Missouri in compliance with a joint custody agreement with the Missouri Department of Insurance. This joint custody agreement relates to the release of MDA's former members' assessment liabilities relative to assessable insurance policies issued by MDA prior to the conversion date (Note 1).
MDA and MDIC entered into contracts in 1983 with MDS whereby MDS performs management and administrative services on behalf of the insurance companies.
MDS has a noncontributory defined contribution pension plan covering substantially all employees of the affiliated group. As a matter of policy, pension costs are funded as they accrue. Pension expense was $210,602, $175,968 and $203,710 in 1997, 1996 and 1995, respectively. MDS also has a 401(k) savings plan covering substantially all employees of the affiliated group which the Company provides a 100% matching contribution up to 6% of compensation subject to current IRS limitations. The 401(k) savings plan expense for 1997, 1996 and 1995 totaled $82,323, $85,042 and $79,985, respectively.
MDA reinsured all occurrence basis policies issued after October 31, 1980 and all claims-made policies issued before November 1, 1987. MDA ceased reinsuring claims-made policies as of November 1, 1987. All claims related to occurrence policies issued after October 31, 1980 and claims-made policies before November 1, 1987 are still reinsured. The Company is liable for reinsured amounts in the event a reinsurer is unable to pay its portion of the losses. The recoverable related to the policies is an asset on the balance sheet.
The Company files a consolidated federal income tax return. The following table accounts for the differences between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate to income before income taxes:
The components of the net deferred tax asset at December 31, 1997 and 1996 are as follows:
In February of 1997, the Financial Accounting Standards Board published Statement of Financial Accounting Standard No. 128, Earnings Per Share ("SFAS 128"), which requires certain changes in the reporting of earnings per share. The Company was required to adopt SFAS 128 at December 31, 1997. Additionally, the Company was required to restate 1996 and 1995 earnings per share data as previously presented.
On June 26, 1995, MDA was converted to a stock insurance company and became a wholly owned subsidiary of MDHC. Therefore the net income of $617,713 recorded by MDA as of June 30, 1995, is virtually entirely attributable to preconversion results and, therefore, is excluded for 1995 earnings per share presentation purposes.