The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements appearing elsewhere in this report. The consolidated financial statements include the results of all of FPIC Insurance Group, Inc.’s (“FPIC”) wholly owned and majority owned subsidiaries.
Legal developments, including claims for extra-contractual obligations or in excess of policy limits in connection with the administration of insurance claims;
The loss of the services of any of our executive officers;
Our liability for losses and LAE (also referred to as our loss and LAE reserves) is the largest liability of FPIC and represents the financial statement item most sensitive to estimation and judgment. Medical professional liability (“MPL”) insurance, including business written directly and reinsurance assumed, is our primary line of business and accounted for $610.6 million and $549.8 million, or 96%, of our total consolidated liability for losses and LAE as of December 31, 2004 and 2003, respectively.
Deferred tax assets and liabilities are estimated and recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.
A valuation allowance against deferred tax assets is estimated and recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. Valuation allowances are based on estimates of taxable income and the period over which deferred tax assets will be recoverable. We believe it is more likely than not that our deferred tax assets will be fully realized. In the event that actual results differ from our estimates or those estimates are adjusted in future periods, we may need to establish a valuation allowance, which would impact our financial position and results of operations.
During the first quarter of 2002, we performed transitional impairment testing required under the new standard and took a charge in the form of a cumulative effect of accounting change for $29.6 million, net of an income tax benefit, as of January 1, 2002.
Our invested assets comprise our largest single asset class and consist mostly of investment securities with fixed maturities, including bonds and notes. Our fixed maturity investment securities are carried at their market values and accounted for $548.5 million and $528.6 million or 99% and 98% of our total investments, and 43% and 45% of our total assets, respectively as of December 31, 2004 and 2003. Unrealized gains or losses in their market values are recorded directly in shareholders’ equity, net of tax effects, as a component of accumulated other comprehensive income.
Our insurance subsidiaries are also subject to assessment by the financial guaranty associations in the states in which they conduct business for the provision of funds necessary for the settlement of covered claims under certain policies of insolvent insurers. Generally, these associations can assess member insurers on the basis of written premiums in their particular states. In addition to standard assessments, the Florida and Missouri legislatures may also levy special assessments to settle claims caused by certain catastrophic losses. No special assessments were made in 2002, 2003 or 2004. In addition, we could become subject to additional assessments in the future as a result of damages caused by catastrophic losses, such as hurricanes.
During 2003, we completed the integration of Anesthesiologists Professional Assurance Company (“APAC”) operations and transitioned the management of APAC and Intermed Insurance Company (“Intermed”) into First Professionals Insurance Company, Inc. (“First Professionals”). During the fourth quarter 2003, we negotiated and completed the commutation of our reinsurance with Gerling Global Reinsurance Corporation of America (“Gerling”). We also negotiated our primary excess of loss reinsurance program renewal for 2004 at a reduced cost for the first time in several years. Finally, we played an active part in tort reform on behalf of our policyholders, as well as the healthcare economy and the citizens of the State of Florida.
Financial and selected other data of our insurance segment for the years ended December 31, 2004, 2003 and 2002 is summarized in the table below. Dollar amounts are in thousands.
DIRECT and ASSUMED PREMIUMS WRITTEN decreased 8% to $312.7 million for the year ended December 31, 2004 from $340.7 million for the year ended December 31, 2003. The decrease in direct and assumed premiums written is primarily attributable to our planned exits from fronting programs and non-core states. We began exiting our fronting programs in 2002 to free up capacity for our core MPL business and all of our previous programs are now in run-off. Also contributing to the decrease was the non-renewal of the excess of loss reinsurance treaty under which First Professionals assumed reinsurance from PRI. Direct premiums written for the year ended December 31, 2004 excluding premiums under fronting programs increased 2% to $273.3 million for the year ended December 31, 2004 from $268.5 million for the year ended December 31, 2003. The increase in direct premiums written excluding premiums under fronting programs reflects a combination of factors including increased insurance rates offset by an overall shift in the mix of policies written and renewed, primarily by First Professionals, towards lower limits of coverage. The total number of MPL insurance policyholders increased 1% to 14,047 at December 31, 2004 from 13,919 at December 31, 2003. The 1% net increase in the number of policyholders was comprised of an increase in First Professionals policyholders in Florida of 1,272, or 13%, offset by reductions in policyholders at Intermed and in non-core states totaling 1,144 during 2004.
Net premiums earned decreased 13% to $131.7 million for the year ended December 31, 2003 from $151.7 million for the year ended December 31, 2002. The decline in net premiums earned for 2003 is the result of ceded premiums earned under the Hannover Re net account quota share reinsurance agreement. Excluding the effect of ceded premiums earned under the Hannover Re net account quota share reinsurance agreement, net premiums earned increased $19.1 million primarily due to the effects of price increases. The positive effects of price increases were, in turn, offset by an 18% reduction in the total number of professional liability insurance policyholders from 16,915 at December 31, 2002 to 13,919 at December 31, 2003. Of this decline, the sale of the renewal rights to the Interlex legal professional liability book of business in 2002 accounted for approximately 1,800 fewer policies. The remaining decline occurred in non-core states and in Missouri as capacity was freed up with a view towards using it for First Professionals’ core MPL business in Florida. The declines in Missouri were expected as we implemented a very large rate increase in 2003.
Other underwriting expenses decreased 44% to $9.4 million for the year ended December 31, 2003 from $16.9 million for the year ended December 31, 2002. The decrease in other underwriting expenses is primarily due to the ceding commissions under the Hannover Re net account quota share reinsurance agreement, which is a credit to other underwriting expenses. The ceding commission increased $9.9 million to $23.1 million for the year ended December 31, 2003 from $13.2 million for the year ended December 31, 2002.
Interest expense on debt increased 24% to $5.9 million for the year ended December 31, 2003 from $4.8 million for the year ended December 31, 2002. The increase in interest expense on debt is primarily due to charges of $2.5 million in 2003 to unwind swap agreements associated with the pay down and retirement of our former bank credit facility. This was offset by the lower total borrowing costs, as compared with the former bank credit facility, of FPIC’s newly issued junior subordinated debentures and unsecured senior notes and the recapture of the amortization of unrealized losses of previous interest rate swap agreements.
INCOME TAXES increased 246% to $8.3 million for the year ended December 31, 2004 from $2.4 million for the year ended December 31, 2003. Income tax expense was relatively higher for 2004 compared to 2003 primarily due to higher taxable income. Income tax expense for 2004 also includes a $0.8 million provision for income tax contingencies identified in a current IRS examination. We also incurred additional state income taxes in 2004 from the amendment of certain prior year state income tax returns.
The results of our insurance segment include the effects of a significant net account quota share reinsurance agreement with the Hannover Re companies. Amounts ceded under the Hannover Re net account quota share reinsurance agreement for the years ended December 31, 2004, 2003 and 2002 are summarized in the table below. Dollar amounts are in thousands.
INSURANCE MANAGEMENT NET INCOME increased 23% to $10.9 million for the year ended December 31, 2004 from $8.8 million for the year ended December 31, 2003. The increase is primarily due to higher management fees. The growth in management fees was the result of growth in premiums written at PRI, a significant portion of which was due to the acquisition of two new institutional clients, and higher insurance premiums placed by Professional Medical Administrators (“PMA”) under a PRI professional liability insurance program. The new institutional clients were acquired in the first and third quarters of 2004. Partially offsetting the positive effect of higher revenues on net income were higher claims administration and management expenses.
The insurance management segment recorded a transitional impairment charge of $24.4 million, after income taxes, during the first quarter of 2002, as a result of the adoption of FAS 142. This transitional impairment charge is accounted for as a cumulative effect of accounting change. The non-cash transitional impairment charge primarily reflects certain intangibles and synergies, which, in our opinion, are opportunistic in nature and carry a significant degree of uncertainty; therefore, we treated these intangibles conservatively in the valuation required by FAS 142.
CLAIMS ADMINISTRATION AND MANAGEMENT FEES earned by the insurance management segment are mainly comprised of management fees from PRI. In accordance with the management agreement between AFP and PRI, AFP receives a management fee equal to 13% of PRI’s direct premiums written. As such, increases in the direct premiums written by PRI result in a corresponding increase in management fees earned by AFP.
Claims administration and management fees increased 47% to $39.1 million for the year ended December 31, 2004 from $26.6 million for the year ended December 31, 2003. The increase in claims administration and management fees is due to a corresponding increase in direct written premiums by PRI. Two new institutional clients have added approximately $56 million to PRI’s 2004 annual written premiums. The addition of these new accounts had the effect of increasing AFP’s management fee revenue by $7.3 million for the year ended December 31, 2004. Subsequent to entering into the agreement with PRI, certain physicians of one of the institutional clients decided to self insure. The effect of these cancellations is reflected in the fourth quarter. Also, PRM commenced operations effective July 1, 2004 and had management fee revenues of $0.9 million for the year ended December 31, 2004.
Claims administration and management fees increased 9% to $26.6 million for the year ended December 31, 2003 from $24.3 million for the year ended December 31, 2002. The increase in claims administration and management fees is due to a corresponding increase in direct written premiums by PRI.
Commission income increased 47% to $5.5 million for the year ended December 31, 2003 from $3.7 million for the year ended December 31, 2002. The increase in commission income in 2003 is primarily due to increases in brokerage commissions earned by FPIC Intermediaries from third party reinsurers for the placement of reinsurance and by PMA based on growth in the insurance program it manages for PRI in Pennsylvania. FPIC Intermediaries’ brokerage commissions are determined as a percentage of reinsurance premiums ceded and have increased significantly as the underlying ceded premiums have grown at both our insurance subsidiaries and PRI, for which FPIC Intermediaries participates in the placement of reinsurance. In addition, commission income of approximately $0.5 million was recognized in 2002 as a result of a brokerage fee earned from Hannover Re related to the placement of our net account quota share reinsurance agreement.
CLAIMS ADMINISTRATION AND MANAGEMENT EXPENSES increased 37% to $29.2 million for the year ended December 31, 2004 from $21.2 million for the year ended December 31, 2003. The increase in claims administration and management expenses is due to the increase in operating expenses at AFP and commission expenses at PMA. The increase in operating expenses at AFP is primarily the result of the growth of PRI’s business. The increase in commission expenses at PMA was associated with an increase in premiums written and placed under a PRI professional liability insurance program. Also contributing to the increase in claims administration and management expenses for the year ended December 31, 2004 were direct costs associated with compliance with the Sarbanes-Oxley Act of 2002 of approximately $1.0 million.
The TPA segment recorded a transitional impairment charge of $5.2 million, after income taxes, during the first quarter of 2002, as a result of the adoption of FAS 142. This transitional impairment charge is accounted for as a cumulative effect of accounting change. The non-cash transitional impairment charge primarily reflects changes in market conditions and an increase in competition in recent years in the markets served by the TPA segment.
Our reinsurance assets, REINSURANCE RECOVERABLE ON PAID LOSSES and DUE FROM REINSURERS ON UNPAID LOSSES, increased in 2004 primarily as the result of the continuing effects of growth in our insurance premiums. Approximately $34.9 million of the increase in due from reinsurers on unpaid losses is attributable to the net account quota share reinsurance agreement with Hannover Re under which loss and LAE reserves are ceded. CEDED UNEARNED PREMIUMS decreased in 2004. Approximately $25.3 million of the reduction is due to a decrease in ceded unearned premiums under the Hannover Re net account quota share reinsurance agreement. As discussed under Results of Operations, we terminated future cessions under this agreement effective July 1, 2004.
In keeping with our growth management strategy, we terminated all of our fronting programs as of June 30, 2004. Therefore, we expect the insurance assets and liabilities associated with former fronting programs to decline in the future as the underlying business runs off.
OTHER ASSETS increased $9.7 million as of December 31, 2004. The increase is primarily the result of growth in management fees receivable corresponding with the growth in business at PRI and deposits paid in the course of the implementation of a new policy administration system. Other assets also increased as a result of sale transactions involving investment securities, which were entered into prior to December 31, 2004, but for which settlements occurred in January 2005.
A loss and LAE reserve study as of December 31, 2004, was performed by an independent actuarial firm. The independent actuarial firm calculated aggregate point estimates and estimated ranges of reasonable values around the point estimates for FPIC's aggregate loss and LAE reserves, gross and net of reinsurance. As discussed more fully below, management has utilized the calculations made by the independent actuarial firm along with other relevant considerations in forming its best estimate of FPIC's reserves. The estimated range of values as determined by the independent actuarial firm around our carried reserves, net of reinsurance, was $259.9 million to $310.4 million. Our carried reserves, net of reinsurance, of $301.7 million ($635.1 million gross, less related reinsurance recoverables of $333.4 million), as of December 31, 2004, were approximately 6% higher than our independent actuarial firm’s respective point estimate and within the upper end of the range.
The following table sets forth (in thousands) the development of our liability for losses and LAE, net and gross of reinsurance, for the 10-year period preceding the year ended December 31, 2004(1):
In 2003, we increased our net reserves for the years 1999 through 2001 primarily in recognition of higher severity than initially assumed, particularly in Missouri. As of December 31, 2004, we increased our net allocated loss adjustment expense (“ALAE”) reserves for calendar years 1999 through 2003, which resulted in additional upward development in reserves for years 1999 through 2001. The higher ALAE reserves are the result of our harder claims philosophy, under which we began taking more cases to trial in 2001. We also experienced some upward development in loss experience on corporate policy endorsements and on business in non-core states and increased our 2000 and 2001 reserves.
Despite higher ALAE and other upward development for years 1999, 2000 and 2001, our loss experience and outlook overall has improved significantly in the most recent years. Improvements in our loss experience resulting from claims and underwriting initiatives we’ve implemented since 2001 have essentially met or exceeded our estimates for years since 2002. Accordingly, the upward development in 1999 through 2001 net reserves has been substantially offset by downward development in reserves for years 2002 and 2003 resulting in relatively immaterial net development for all years prior to 2004 combined.
Given the proximity and status of the years 2000 through 2002, in particular, relative to the timing of the initiation of our harder claims payment philosophy and the implementation of initiatives to control increasing ALAE expenditures attendant to executing that philosophy, it is still reasonably possible that the remaining reserves for these years, in particular, may experience upward or downward development in the future.
As a result of the commutation of our ceded reinsurance to Gerling Global Reinsurance Corporation of America (“Gerling”) during 2003, we now retain the corresponding insured risks and losses and LAE we formerly ceded. We received $23.2 million in exchange for the release of Gerling from its reinsurance obligations to us, which we added to our net reserves. No gain or loss was recognized on the transaction.
REINSURANCE PAYABLE decreased $3.1 million since year end 2003 primarily as a result of a reduction in premiums due under FPIC’s excess of loss reinsurance program and the exit from our fronting programs. These decreases were partially offset by business ceded under the Hannover Re net account quota share reinsurance agreement. Reinsurance premiums payable under the Hannover Re net account quota share reinsurance agreement increased approximately $14.5 million for the year ended December 31, 2004.
FPIC guarantees the floating rate interest and principal obligations under the trust preferred securities issued by its separately created, unconsolidated trusts, which have been established solely for the purpose of issuing the securities. The total principal balance of these trust preferred securities was $35.0 million as of December 31, 2004. FPIC also carries corresponding junior subordinated debentures on its balance sheet, which debentures were issued to these trusts in exchange for the proceeds raised by the trusts upon their respective issuances of the trust preferred securities. The junior subordinated debentures of FPIC are comprised of the same maturities, floating interest rates and other applicable terms and are the instruments by which FPIC funds the related interest and principal obligations of the unconsolidated trusts. See Note 9, Long Term Debt, to the consolidated financial statements for additional disclosures about FPIC’s trusts and junior subordinated debentures.
(1) The liability for losses and LAE represents our best estimate of the unpaid cost of settling claims, including claims that have been incurred but not yet reported. The estimated costs of settling claims are generally based upon past experience adjusted for current trends, and any other factors that would modify past experience. 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 estimated and such differences could be material. The liability for losses and LAE are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable are reported separately in the consolidated statements of financial position. As of December 31, 2004, our reinsurance balances recoverable related to the liability for losses and LAE were $333.4 million in aggregate.
The payment of losses and LAE, insurance operating expenses (including reinsurance costs), claims administration and management expenses, non-insurance operating expenses, interest expense and income taxes in the ordinary course of business are the principal needs for our liquid funds. The principal sources of cash from our operations to meet our on-going liquidity requirements are the premiums collected for the insurance sold by our insurance subsidiaries, income on the investment of those funds, and claims administration and management fees and reinsurance brokerage and other commission income earned by our non-insurance subsidiaries.
As reported in the consolidated statement of cash flows, net cash provided by operating activities was $64.9 million for the year ended December 31, 2004 compared with net cash provided by operating activities of $89.9 million for the year ended December 31, 2003. The majority of the decrease in cash provided by operating activities for the year ended December 31, 2004 can be attributed to the commutation of our ceded reinsurance to Gerling in 2003, pursuant to which we received $23.2 million in exchange for the release of Gerling from its reinsurance obligations to us.
As of December 31, 2004, we had cash and invested assets of $684.0 million and held fixed maturity debt securities with a fair value of approximately $12.0 million with scheduled maturities during the next twelve months. We believe that our cash and invested assets as of December 31, 2004, combined with expected cash flows from operating activities and the scheduled maturities of investments, will be sufficient to meet our cash needs for operating purposes for at least the next twelve months.
A number of factors could cause unexpected changes in liquidity and capital resources available, including but not limited to, the following:
Furthermore, liquidity and capital risks can come about as the result of the broader business and financial risks facing us, including the uncertainties and factors disclosed in the Safe Harbor Disclosure. Many, if not most, of these types of uncertainties could have a corresponding and materially negative effect on our liquidity and capital resources, as well as our financial condition and results of operations. In order to compensate for such risks, we:
We established three wholly owned, but not consolidated, trusts for the sole purpose of issuing the trust preferred securities: FPIC Capital Trust I, FPIC Capital Statutory Trust II and FPIC Capital Statutory Trust III. The proceeds received by the three trusts were used to purchase junior subordinated debentures from FPIC of the same amounts, maturities and other applicable terms and features. The debentures issued by FPIC, which are reported as long term debt in the consolidated statements of financial position, to the three trusts are subordinated to all senior indebtedness, including the senior notes, and are equal in standing with one another.
Shareholder dividends available from our insurance subsidiaries are subject to certain limitations imposed by Florida and Missouri laws. As of December 31, 2004, the insurance subsidiaries are permitted, within insurance regulatory guidelines, to pay FPIC dividends of approximately $16.0 million during 2005 without prior regulatory approval.
The financial statements and supplementary data required to be included in this Item 8 are set forth in Item 15 of this report.