regional offices where it rented office space in Indianapolis (5,000 square feet) and Dallas (5,000 square feet).
Basic and diluted loss per share of Common Stock for the year ended December 31, 2001 is computed using the weighted average number of common shares outstanding during the year of 13,524,959. Basic and diluted loss per share of Common Stock for the year ended December 31, 2000 is computed using the weighted average number of common shares outstanding during the year of 14,100,043. Basic earnings per share of common stock for the year ended December 31, 1999 is computed using the weighted average number of common shares outstanding during the year of 13,497,110. Diluted earnings per share of common stock for the year ended December 31, 1999 is computed using the weighted average number of common shares outstanding during the year of 13,534,052. Basic and diluted earnings per share for the years ended December 31, 1998 and prior gives effect to the issuance of approximately 12,025,000 shares of Common Stock to Distributees in the Company's reorganization consummated on August 4, 1999.
The Company's determination of loss and LAE reserves involved the projection of ultimate loss and ALAE through the following actuarial techniques:
For a brief description of each of these techniques, refer to "Business - Loss and LAE Reserves."
The Company has no securities classified as "trading" or "held-to-maturity." Investments are recorded at the trade date.
A significant estimation inherent in the valuation of investments is the evaluation of other-than-temporary impairments. The Company regularly evaluates the carrying value of its investments based on current economic conditions, past credit loss experience, the length of time and the extent to which the fair value has been less than book value, and other circumstances. Additionally, for certain securitized financial assets with contractual cash flows, Emerging Issues Task Force ("EITF") 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interest in Securitized Financial Assets," require the Company to periodically update its best estimate of cash flows over the life of the security. If the Company estimates that the fair value of its securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, then an other-than-temporary impairment charge is recognized.
A decline in fair value that is other-than-temporary is recognized by an adjustment to carrying value treated as a realized investment loss and a reduction in the cost basis of the investment in the period when such a determination is made. Temporary changes in fair values of available-for-sale securities, after adjustment of deferred income taxes, are reported as unrealized appreciation or depreciation directly in equity as a component of other comprehensive income.
Premiums and discounts on investments (other than loan-backed and asset-backed bonds) are amortized/accreted to investment income using the interest method over the contractual lives of the investments. Realized investment gains and losses are included as a component of revenues based on a specific identification of the investment sold.
The New Jersey Insurance Commissioner Currently Has the Authority to Place MIIX in Supervision, Rehabilitation or Liquidation.
If the Company Establishes Inadequate Loss and LAE Reserves, MIIX and LP&C May Face Further Regulatory Action, Including Supervision, Rehabilitation or Liquidation of MIIX.
enact meaningful tort reform. During 2000, for example, the Company paid two claims of at least $2.0 million in New Jersey. During 2001, the Company paid five claims of at least $2.0 million in New Jersey. During 2002, the Company paid eight claims of at least $2.0 million in New Jersey. These payments indicate a worsening in severity of the New Jersey physician book of business.
The Volatility of the Capital Markets May Further Erode the Value of the Company's Investment Portfolio.
The Company has entered into a number of aggregate reinsurance contracts. The contracts in effect provide reinsurance for policies written during 1995 through September 1, 2002 and contain certain provisions related to funds held balances or surplus level that obligate the Company to accept additional reinsurance coverage if the stipulated levels are not maintained. Continued operating losses could result in the Company falling below the stipulated levels and require the Company to accept additional reinsurance coverage. Additional loss and loss reserve adjustments could exceed maximum losses that can be ceded under the terms of the contract in a particular calendar year. The Company would be liable for the full amount of losses and ALAE above the maximum covered by the aggregate reinsurance contracts.
The MIIX Group Common Stock May be Delisted From the New York Stock Exchange.
The Company May Not Be Able to Retain the Key Employees Necessary to Operate the Company.
It is essential that the Company retain qualified key employees to manage the runoff of its insurance subsidiaries, if allowed to continue to do so, and to service MIIX
The Company May Not Be Able to Maintain Adequate Cash Flow and Liquidity.
The following is an overview of the Company's insurance business, which is now in runoff. The Company believes it will assist stockholders in understanding the Company's results of operations, liquidity and capital resources.
The determination of loss and LAE reserves involves the projection of ultimate losses through quarterly actuarial analyses of the claims history of the Company and other professional liability insurers, subject to adjustments deemed appropriate by the Company due to changing circumstances. Management relies primarily on such historical experience in determining reserve levels on the assumption that historical loss experience provides a good indication of future loss experience despite the uncertainties in loss trends and the delays in reporting and settling claims. As additional information becomes available, the estimates reflected in earlier loss reserves have been and may continue to be revised. The Company increased prior year gross reserves by $161.2 million and $117.9 million in 2002 and 2001, respectively. If prior trends continue, the Company may have to increase gross reserves again in 2003, which could materially adversely impact the Company's financial position and result in the rehabilitation or liquidation of MIIX.
The Company offered traditional occurrence coverage from 1977 through 1986 and offered a form of occurrence-like coverage, "modified claims made," from 1987 to August 31, 2002. Occurrence and modified claims made coverages constituted the majority of the Company's business throughout its history. In recent years, however, the Company increased its
claims made business. Development of losses and LAE is longer and slower for occurrence business than claims made business.
Reserves for incurred but not reported claims ("IBNR reserves") have consistently represented the majority of total loss and LAE reserves held by the Company. At December 31, 2002 and 2001, gross IBNR reserves composed 60.5% and 60.1%, respectively, of total gross loss and LAE reserves. The increase in the proportion of IBNR in 2002 is the result of many factors; most notable among them was increased loss severities during 2002. Gross loss and LAE reserves on claims made medical malpractice policies amounted to $395.8 million, or 34.4% of total gross loss and LAE reserves at December 31, 2002, compared to gross loss and LAE reserves on claims made policies of $357.5 million, or 29.9% of total gross loss and LAE reserves at December 31, 2001.
The Company's aggregate reinsurance contracts are maintained on a funds withheld basis, whereby the Company holds the ceded premiums in a funds withheld account for the purpose of paying losses and related ALAE. Interest charges are credited on funds withheld at predetermined contractual rates. Each of the aggregate excess reinsurance contracts also contains a provision requiring that the funds withheld be placed in trust should the A.M. Best rating assigned to MIIX or its predecessor, Medical Inter-Insurance Exchange of New Jersey, fall below B+. On March 22, 2002, A.M. Best lowered the rating of MIIX, to C+ and MIIX withdrew from the interactive rating process with A.M. Best. As a result of the downgrade, reinsurers requested that assets supporting the funds withheld account be placed in a trust. The Company has established the required trust accounts in accordance with these contract provisions. Each of the aggregate excess reinsurance contracts also contains a provision allowing reinsurers to offer additional reinsurance coverage that MIIX or its predecessor, Medical Inter-Insurance Exchange of New Jersey is obligated to accept. For contract years beginning November 1, 1999 and forward, the contracts require that the funds withheld balance on a particular contract year be below $500,000 before reinsurers may offer the additional coverage. For contract years prior to November 1, 1999, the contracts provide no funds withheld threshold amount, although the reinsurance intermediary has confirmed in writing that the intention of the parties was that the additional coverage would be offered only if and when the funds withheld balance was in a loss position. As of December 31, 2002, 2001 and 2000, no funds withheld balances were below $500,000 or in a loss position.
NET PREMIUMS EARNED. Net premiums earned were $100.2 million in 2002 compared to $146.9 million in 2001, a decrease of approximately $46.7 million or 31.8%. This net decrease is composed of decreased direct, assumed and ceded premiums earned. Direct premiums earned decreased $54.4 million or 25.4% to $159.5 million in 2002 from $213.9 million in 2001 primarily due to ceasing insurance operations, commutations and cancellation activity during the last nine months of 2002. Direct earned premiums were impacted by the return of
Average invested assets at amortized cost decreased to approximately $1.15 billion in 2002 from $1.26 billion in 2001. The average pre-tax yield on the investment portfolio decreased to 5.31% in 2002 from 6.38% in 2001 primarily as the result of lower market yields and an increase in short-term investments held during 2002 for the reasons set forth above.
REALIZED INVESTMENT GAINS AND LOSSES. Net realized investment losses increased $1.3 million, or 61.2%, to net realized investment losses of $3.5 million in 2002 compared to net realized investment losses of $2.2 million in 2001. In 2002,net realized gains of approximately $13.4 million were recognized primarily due to sales of fixed maturity investments as a result of investment portfolio modifications and recognized approximately $16.9 million of losses related to other-than-temporary declines in investment values, of which $8.9 million was attributable to collateralized bond obligations and $4.8 million was associated with United Airlines corporate bonds. In 2001, $19.7 million of net realized gains were taken primarily from continued repositioning of the portfolio, offset by $21.8 million of losses related to other-than-temporary declines in investment values, including $8.1 million ($5.3 million net of tax) resulting from activity following adoption of EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" effective April 1, 2001. EITF 99-20 established new guidelines for recognition of income and other-than-temporary declines for interests in securitized assets.
LOSS AND LOSS ADJUSTMENT EXPENSES (LAE). Losses and LAE decreased $54.3 million, or 21.6%, to $196.5 million in 2002 from $250.8 million in 2001. Losses and LAE were net of ceded losses and LAE of $115.3 million in 2002 and $97.5 million in 2001. The ratio of net losses and LAE to net premiums earned increased to 196.1% in 2002 from 170.8% in 2001.
As a result of a reserve study conducted by the Company and the annual external actuarial review, the Company recorded a $20.5 million net adjustment to loss and LAE reserves
As a result of reserve studies conducted by the Company, the Company's outside actuary and a second actuarial firm specializing in medical malpractice reserving, the Company recorded a $64.5 million net adjustment to loss and LAE reserves as of December 31, 2001. During 2001, the Company increased direct and assumed prior year loss and LAE reserves of $113.1 million and $4.8 million, respectively. During 2001, ceded reserves associated with the Company's aggregate reinsurance contracts increased by $61.7 million. The increase in prior year loss and LAE reserves resulted from three primary factors: increased loss severity, particularly in the Pennsylvania institutions and New Jersey physicians book; adverse development in the form of additional frequency and severity relating to physicians business in certain states, primarily in Pennsylvania, Texas and Ohio; and adverse development associated with reserves held on an assumed excess of loss reinsurance contract which was non-renewed January 1, 2001. The increase in current year loss and LAE reserves resulted primarily from increased severity levels and reduced profitability indications from prior accident years.
UNDERWRITING EXPENSES. Underwriting expenses decreased $14.0 million, or 29.7%, to $33.1 million in 2002 from $47.1 million in 2001. This decrease is primarily due to the effects of discontinued insurance operations, with reduced commissions, premium taxes and a reduction in compensation and benefits resulting from downsizing actions taken during 2002. The ratio of underwriting expenses to net premiums earned increased to 33.1% in 2002 from 32.1% in 2001. The increase resulted primarily from lower net earned premiums which was impacted by additional ceded premiums associated with additional losses ceded under the Company's aggregate reinsurance contracts.
FUNDS HELD CHARGES. Funds held charges increased $11.7 million, or 27.6%, to $54.2 million in 2002 from $42.5 million in 2001. Funds held charges relate to the Company's ceded aggregate reinsurance contracts, and represent balances due to reinsurers which are withheld as collateral for losses and ALAE ceded under the contracts. Funds held charges increased $30.0 million resulting from adjustments made to ceded loss and ALAE reserves and ceded premiums recorded during the first, third and fourth quarters of 2002. In 2001 funds held charges increased $19.8 million resulting from changes to loss reserves, ceded losses and ceded premiums during 2001.
OTHER EXPENSES. Other expenses increased $0.1 million, or 1.5%, to $3.5 million in 2002 from $3.4 million in 2001. This net increase is primarily due to increased costs resulting from management services provided to MIIX Advantage, which commenced operations on September 1, 2002, offset by the sale of substantially all the assets of the Company's leasing subsidiary, HNL, effective April 30, 2002.
RESTRUCTURING CHARGE. The Company announced in March, 2002 that LP&C's operations would be placed into runoff and recorded a restructuring charge of $2.6 million during the first quarter of 2002 relating to the reduction of regional and home office staff and the closing of regional offices in Dallas and Indianapolis. No such event occurred during 2001.
INCOME TAXES. An income tax expense of $41.9 million was recorded in 2001, as compared to an income tax benefit of $22.1 million in 2000. The increase of $64.0 million in income tax expense in 2001 is primarily the result of a $95.1 million valuation allowance recorded against the net deferred tax asset in accordance with Statement of Financial Accounting Standards 109, "Accounting for Income Taxes," offset by an increase in pre-tax loss of $52.0 million resulting in an increased tax benefit of $18.2 million at a 35% tax rate, a tax contingency reserve release of $10.2 million, and a net increase in taxes of $2.9 million in other items including $1.0 million due to lower tax exempt interest. The release of the tax contingency reserve resulted from the establishment of the valuation allowance, at approximately full value.
Insurance regulations permit the Insurance Commissioner to allow an insurer, like MIIX, that is writing no new insurance policies and which is running off its existing insurance policies to continue its runoff under the supervision of the Commissioner. However, no assurance can be given that the Commissioner will allow MIIX to continue to runoff its business. The Company's other insurance subsidiaries are organized and subject to similar provisions and restrictions. No significant amounts are currently available for payment of dividends by the Company's other insurance subsidiaries without prior approval of the applicable insurance department. During the first quarter of 2002, the New Jersey Department of Banking and Insurance approved a $2.1 million dividend payment from MIIX to the MIIX Group. The MIIX Group does not expect that MIIX will have the ability to declare and pay dividends to the MIIX Group to meet its operating needs, except to the extent that the New Jersey Department of Banking and Insurance specifically approves dividend payments in the future. The Company cannot provide assurance that the Department will approve further dividend payments. If it does not, the Company may not be able to continue in business.
The primary sources of the Company's liquidity are net investment income, proceeds from the maturity or sale of invested assets, recoveries from reinsurance, revenues from non-insurance operations and unearned premium. Funds are used to pay losses and LAE, operating expenses, reinsurance premiums and taxes. The Company's net cash flow (used in)/provided by operating activities were approximately ($180.6) million, ($23.6) million and $59.3 million for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in cash flow during 2002 was primarily the result of increased loss payments, reflecting both the maturation of the Company's expansion book of business and the settlement of several higher severity cases, lower investment income and a decrease in premium collection reflecting the decrease in written premium offset, in part, by a federal income tax refund and proceeds from the sale of substantially all of the assets of HNL. Because of the inherent unpredictability related to the timing of the payment of claims, it is not unusual for cash flow from operations for a medical malpractice insurance company to vary, perhaps substantially, from year to year. Because the Company ceased writing insurance policies, cash flow is expected to decrease substantially. The Company's cash flow could be further impacted adversely as a result of MIIX being subject to mandatory control. The Company cannot determine the impact on cash flow of further regulatory actions by the New Jersey Department of Banking and Insurance. See "Business - Recent Developments" and ""Management's Discussion and Analysis of Financial Condition and Results of Operation - Risks and Uncertainties."
The Company, through the normal course of operations, entered into contractual obligations relating to leases for premises and equipment. The following table details the Company obligations for the years presented.
The Company's cash flow could be further impacted by actions taken by the insurance department regulators of New Jersey and Virginia. See "Recent Developments" and "Management's Discussion and Analysis of Financial Condition and Results of Operation - Risks and Uncertainties." See "Business - Business Strategy" and "Business - Regulation - Risk-Based Capital."
The Company investments consist primarily of fixed-maturity securities. The Company's current investment strategy seeks to maximize after-tax income through holding an investment grade, intermediate term, diversified, taxable bond portfolio, while maintaining an adequate level of liquidity. The Company currently plans to continue this strategy. Approximately $263.0 million has been set aside in short-term investments to provide for acceleration of claims. If claim payments continue at current levels these funds will be inadequate and the investment portfolio will be diminished faster than anticipated. Any diminution of the investment portfolio will reduce net investment income. At December 31, 2002, the portfolio had an average credit quality of "AA," an average duration of 3.5 years, and an annualized yield of 5.3%.
At December 31, 2002 and 2001, the Company held collateral of $332.7 million and $374.2 million, respectively, in the form of funds held, and $161.2 million and $166.5 million, respectively, in the form of letters of credit, for recoverable amounts on ceded unpaid losses and LAE under certain reinsurance contracts. Under the contracts, reinsurers may require that a trust fund be established to hold the collateral should one or more triggering events occur, such as a downgrade in the Company's A.M. Best rating below B+, a reduction in statutory capital and surplus to less than $60 million, or a change in control. Under the contracts, and as a result of the downgrade of the Company's A.M. Best rating to below B+ during the first quarter of 2002, reinsurers requested that assets supporting the funds withheld account be placed in trust. The Company has established the required trust accounts in accordance with contract provisions. The Company does not anticipate a material impact on the Company's financial condition or results of operations from placing the funds withheld in trust. In accordance with the provisions of the reinsurance contracts, the funds held are credited with interest at contractual rates ranging from 6.0% to 8.6%, which is recorded as an expense in the year incurred.
During 2001, The MIIX Group repurchased 84,178 shares at a value of approximately $0.7 million related to the resignation of a former executive officer of the Company. During 2002, certain current and former officers tendered 110,061 shares in the aggregate of The MIIX Group Common Stock and exercised 101,591 stock appreciation rights, which were designated as phantom stock options in the respective agreements. These tenders and additional loan repayments reduced the stock purchase and loan balances of the officers by approximately $1.8 million in the aggregate. All transactions were recorded at the fair market value of the MIIX Group Common Stock on the effective date of the respective transactions.
Interest rate risk is considered by management to be the most significant market risk element currently facing the Company. Interest rate risk is the price sensitivity of a fixed maturity security to changes in interest rates. The Company views these potential changes in price within the overall context of assets and liability management. To reduce the Company's interest rate risk, duration targets are set for the fixed income portfolio after consideration of the duration of associated liabilities, primarily losses and LAE reserves and other factors.
At December 31, 2002, the Company had net after-tax unrealized gains on its fixed maturity investment portfolio of $17.3 million. The net after-tax unrealized gains of $17.3 million on the fixed maturity portfolio represented 73.7% of total shareholders' equity gross of net after-tax unrealized losses on investments. The net unrealized gains were the result of the decline in market interest rates during 2002, 2001 and 2000.
Approximately 49% of the investment portfolio is concentrated in mortgage-backed and asset-backed securities. Mortgage-backed and asset-backed securities involve similar risks associated with fixed maturity investments: interest rate risk, reinvestment rate risk and default or credit risk. In addition, mortgage-backed and asset-backed securities also possess prepayment risk, which is the risk that a security's originally scheduled interest