The Company is the owner of two office buildings, both located in Beverly Hills, California. One building contains approximately 25,000 square feet of office space and is used by the Company as a home office. The other office building contains approximately 24,000 square feet, of which the Company occupies approximately 17,000 square feet and the remaining 7,000 square feet of space in this office building is leased to unaffiliated persons. Both office buildings are currently unencumbered.
The Company is in the process of seeking leased space to replace its existing facilities. The Company has no commitments for such space to date.
(2) In the second quarter of 1996, the Company estimated an additional $9.0 million of policyholder dividends (offset by a $0.6 million credit for forfeited dividends declared in 1995) would be paid due to favorable loss experience related to policy years 1987 through 1992. This policyholder dividend was paid to members of the Exchange in the form of premium credits during 1997. The Company has ceased paying such dividends to its policyholders.
The following discussion should be read in conjunction with the financial statements and the related notes thereto appearing elsewhere in this Form 10-K. The financial statements for 1997 include the accounts and operations of SCPIE Holdings Inc. and its wholly-owned subsidiaries. The financial statements for 1996 and prior years include the accounts and operations of the Southern California Physicians Insurance Exchange (the Exchange) and its wholly-owned subsidiaries and certain affiliates.
For purposes of this Form 10-K, the terms "SCPIE" and the "Company" refer, at all times prior to January 29, 1997, to the Exchange and its subsidiaries, collectively, and at all times on or after such date, to SCPIE Holdings Inc. and its subsidiaries, collectively; and the term "SCPIE Holdings" refers at all times to SCPIE Holdings Inc., excluding its subsidiaries.
On January 29, 1997, SCPIE consummated its reorganization from a reciprocal insurance company to a stock insurance company by merging with and into SCPIE Indemnity Company (the Reorganization). In connection with the Reorganization, 9,994,652 shares of the Company's common stock were issued to members of the Exchange in exchange for their membership interests in SCPIE, and 500,000 shares of common stock were issued to SCPIE Indemnity.
In August 1995, the Company entered into a marketing arrangement with Sullivan, Kelly & Associates (SKA) to expand its business to other states. Under the agreement, SKA had the exclusive right to market the Company's malpractice coverage for
hospitals in all states, and the Company recognized SKA as the exclusive broker for medical group coverage in all states other than California. In December 1996, SKA filed for bankruptcy in the United States Bankruptcy Court, Central District of California, and its assets were acquired by another insurance company in September 1997 in a court-approved transaction. Effective October 1, 1997, the Company and SKA mutually agreed to terminate their exclusive marketing agreement. The Company now actively markets its hospital policies under a new program directly and through regional and local brokers, and must compete with SKA and a number of insurance companies in the underwriting of hospital malpractice policies.
American Healthcare Indemnity Company (AHI), a subsidiary of SCPIE Holdings, has formed a relationship with Poe & Brown, Inc. (Poe & Brown) one of the nation's top independent insurance agency organizations, to provide professional liability insurance to physicians commencing January 1, 1998. This coverage is offered to solo physicians and medical groups in eight states, the largest being Connecticut, Florida and Georgia. This replaces an existing program Poe & Brown had established with another insurance company. There is no assurance, however, that the Company will successfully retain or expand this business through Poe & Brown or that it will ultimately be profitable.
In addition, AHI has acquired the medical malpractice insurance business of Fremont Indemnity Company (Fremont) through a purchase agreement effective January 1, 1998. Simultaneously, a 100% quota-share reinsurance agreement went into effect, making SCPIE Indemnity the reinsurer for the Fremont policies pending regulatory approval of AHI to write this business directly. The Fremont policies are written through brokers in 10 states the vast majority in California and Arizona.
The Company has instituted no rate increases for 1998, which may offset the elimination of dividends to policyholders and somewhat improve its competitive position.
The Company believes that a combination of these and other factors have contributed to the recent redundancies in reserves established by SCPIE for prior years. The original reserves were established without full knowledge of the effect of these factors. Redundant reserves, which have been released in every year since 1985, have contributed significantly to reported earnings in recent years. The Company reduced reserves for prior years by $53.2 million, $59.7 million, and $57.8 million in the years ended December 31, 1997, 1996 and 1995, respectively. The Company cannot predict whether similar redundancies will be experienced in future years. The Company continues to establish its loss and LAE reserves at what it believes is the upper end of a reasonable range of reserve estimates, but there is no assurance that such reserves will ultimately prove to be redundant. The Company believes that some reduction in the amount of the redundancies recently experienced is reasonably likely. If such redundancies do not occur or loss and LAE experience does not improve, the Company's net income could be significantly reduced or a net loss could occur.
REALIZED INVESTMENT GAINS AND OTHER REVENUE Realized investment gains were approximately $6.6 million in 1997 compared to $11.7 million in 1996. Approximately $11.2 million of the gains from 1996 resulted from the sale of equity securities in connection with the Company's decision in the first quarter of 1996 to increase the focus of its investment portfolio on fixed-maturity securities. In 1997 sales were made in the fixed-maturity portion of the investment portfolio to reposition the portfolio by increasing the percentage of tax-exempt securities.
POLICYHOLDER DIVIDENDS The governing board of the Exchange declared a final dividend to members of the Exchange of record on November 5, 1996, who were also members of the Exchange during policy years 1987 through 1992. Such dividend was paid in the form of premium credits during 1997. This dividend of $9.0 million (offset by a $0.6 million credit for forfeited dividends declared in 1995) was reflected as an expense for the year ended December 31, 1996.
PREMIUMS EARNED Premiums earned increased approximately $4.1 million, or 3.5%, to $120.5 million in 1996 from $116.4 million in 1995. The increase was principally due to a $3.5 million increase in assumed reinsurance premiums. Medical malpractice premiums from physicians and medical groups were approximately $112.7 million in 1996 compared to $113.3 million in 1995. An average 4.4% increase in premium rates in effect during 1996 was offset by a 4.2% decrease in the average number of policies in force during 1996 as compared to 1995. Hospital medical malpractice premiums were approximately $2.3 million in 1996 compared to $1.3 million in 1995. Assumed reinsurance premiums were approximately $4.5 million in 1996 compared to less than $1.0 million in 1995.
NET INVESTMENT INCOME Net investment income, after a $0.4 million interest expense accrual for a federal income tax settlement, increased approximately $0.4 million, or 1.0%, to $40.8 million in 1996 from $40.4 million in 1995. Invested assets increased $22.9 million to $717.9 million in 1996 from $695.0 million at December 31, 1995. The average pretax yield on the investment portfolio increased to 6.1% in 1996 compared to 5.9% in 1995.
LOSSES AND LAE Losses and LAE decreased $9.2 million, or 7.8%, to $108.8 million in 1996 from $118.0 million in 1995. As a percentage of premiums earned, losses and LAE decreased to 90.3% in 1996 from 101.4% for the same period in 1995. For 1996, the Company reduced loss and LAE reserves incurred in prior policy years approximately $59.7 million as compared to a reserve reduction of $81.7 million for 1995 for claims incurred in prior policy years. This reserve reduction of $81.7 million was offset by a $23.9 million reserve increase for free tail coverage to be provided by the Company to currently insured physicians at the time of their death, disability or retirement. This increase was the result of a refinement in the actuarial methodology used to calculate this reserve.
OTHER OPERATING EXPENSES Other operating expenses increased $1.7 million, or 13.7%, to $14.3 million in 1996 from $12.6 million in 1995. This increase was principally attributable to increases in policy acquisition expenses and payroll/benefit expenses of $0.6 million and $1.3 million, respectively, offset partially by lower legal fees of $0.7 million. The expense ratio was 11.8% in 1996 and 10.8% in 1995.
The primary sources of the Company's liquidity are insurance premiums, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. Funds are used to pay losses, LAE, operating expenses, reinsurance premiums and taxes. The Company has also paid significant dividends, in the form of premium credits, to its members in each year since 1980. The Company paid $9.0 million and $9.9 million of such dividends during the years ended December 31, 1997 and 1996, respectively. The Company has now ceased paying such premium credit dividends to its policyholders.
SCPIE has consistently experienced positive cash flow from operations. Because of uncertainty related to the timing of the payment of claims, cash from operations for a property and casualty insurance company can vary substantially from year to year. Cash provided by operating activities for SCPIE, before the payment of dividends to policyholders, was $13.5 million in 1997 compared to $39.8 million in 1996. The higher amount of cash flow from operations in 1996 was due to a refund of federal income tax and interest of $25.9 million in settlement of a tax dispute for the 1985 through 1988 tax years.
Common stock dividends paid to stockholders were $0.20 per share in 1997. These dividends are funded through dividends from the Company's insurance subsidiaries. The Company expects to pay dividends in the future. However, payment of dividends is subject to Board approval, earnings and the financial condition of the Company.
The Company has received a commitment from a large lender for a bank facility in the amount of $50.0 million. The commitment is subject to certain terms and conditions as well as negotiation and completion of all documentation. The Company expects to use this facility for general corporate purposes.
The Company is in the process of seeking leased space for its operations. The Company has not entered into any commitments to date. The Company expects to use its cash flow from current operations to pay for any additional space and capital equipment.
The Company has initiated formal communications with its significant suppliers to determine the extent to which the Company's interface systems are vulnerable to those third parties' failure to remediate their own Year 2000 issues. However, there can be no assurance that the systems of other companies on which the Company's systems rely will be timely converted and would not have an adverse effect on the Company's systems.