The following discussion should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this Form 10-K. The consolidated financial statements include the accounts and operations of SCPIE Holdings Inc. and subsidiaries.
The Company’s insurance business is organized into two reportable business segments: direct healthcare liability insurance and assumed reinsurance operations. Primarily due to significant losses on medical malpractice insurance outside of the state of California and assumed reinsurance business losses arising out of the September 11, 2001, World Trade Center terrorist attack, the Company incurred significant losses in the three fiscal years 2001, 2002 and 2003. The resulting reductions in surplus and corresponding decrease in capital adequacy ratios under both the A.M. Best Company (A.M. Best) and National Association of Insurance Commissioners (NAIC) capital adequacy models has required the Company to take actions to improve its long-term capital adequacy position. The primary actions taken by the Company were to begin a withdrawal from all healthcare liability insurance markets outside of California and Delaware in 2002 and to enter into a 100% quota share reinsurance agreement in December 2002 to retrocede to another insurer the majority of reinsurance business written in 2002 and 2001.
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). Preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related notes. Management believes that the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. Actual results may differ from these estimates under different assumptions or conditions.
The Company had a growing volume of assumed reinsurance between 1999 and 2002. Assumed reinsurance is a line of business with inherent volatility. Ultimate loss experience for the assumed reinsurance operation is based primarily on reports received by the Company from the underlying ceding insurers. Many losses take several years to be reported through the system. The Company relies heavily on the ceding entity’s, especially Lloyd’s syndicates, estimates of ultimate incurred losses. Ceding entities, representing over 65% of the reinsurance assumed business for the 1999 to 2003 underwriting years (based on gross written premiums), submit reports to the Company containing ultimate incurred loss estimates reviewed by independent or internal actuaries of the ceding entities. These reported ultimate incurred losses are the primary basis for the Company’s reserving estimates. In other cases, the Company relies on its own internal estimates determined primarily by experience to date, individual knowledge of the specific reinsurance contract, industry experience and other actuarial techniques to determine reserve requirements.
Deferred policy acquisition costs include commissions, premium taxes and other variable costs incurred in connection with writing business. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed. Recoverability is analyzed based on the Company’s assumptions related to the underlying policies written, including the lives of the underlying policies, growth rate of the assets supporting the liabilities, and level of expenses necessary to maintain the policies over their entire lives. Deferred policy acquisition costs are amortized over the period in which the related premiums are earned.
the length of time for which the market value of the security has been less than its cost basis;
At December 31, 2003, the Company had $43.7 million of net deferred income tax assets. Net deferred income tax assets consist of the net temporary differences created as a result of amounts deductible or revenue recognized in periods different for tax return purposes than for accounting purposes. These deferred income tax assets include an asset of $13.9 million for a net operating loss carryforward that will expire in 2021. A net operating loss carryforward is a tax loss that may be carried forward into future years. It reduces taxable income in future years and the tax liability that would otherwise be incurred.
The Company’s estimate of future taxable income used the same assumptions and projections as in their internal financial projections. These projections are subject to uncertainties primarily related to future underwriting results. If the Company’s results are not as profitable as expected, the Company may be required in future periods to record a valuation allowance for all or a portion of the deferred income tax assets. That requirement would reduce the Company’s earnings.
The Company encountered intense price competition in its hospital expansion efforts. During 2000, the Company incurred unacceptable losses under its hospital policies. The Company experienced adverse loss development in its prior years loss reserves for hospitals and significant ongoing losses in this program, which is reflected in the results for the year ended December 31, 2000. The Company substantially reduced its hospital exposures during 2000 through policy nonrenewals and rate increases. At the beginning of 2001, it insured only 15 hospitals, and this was reduced to 10 hospitals at December 31, 2001, and the last hospital policy expired in December 2002.
The Company and Brown & Brown agreed in early 2002 to terminate both the physician and dental programs no later than March 6, 2003. During 2002, the Company continued to issue and renew those policies under the Brown & Brown programs that satisfied the stringent underwriting standards. The Company applied these same standards to the nonstandard physician policies renewed outside California. As of December 31, 2001, 2,997 policies were in force related to the Brown & Brown program. That number was reduced to 813 and 379 policies as of December 31, 2002 and 2003, respectively. The Company issued no new nonstandard physician policies outside of California in 2002 or 2003.
The Company rapidly expanded its assumed reinsurance operations after the formation of the division in late 1999. Written premiums were $18.5, $112.8, and $112.2 million, respectively for 2003, 2002 and 2001. Earned premiums, which lag behind written premiums, were $32.4, $122.5, and $79.5 million, respectively for 2003, 2002 and 2001. Assumed reinsurance represents the book of assumed worldwide reinsurance of professional, commercial and personal liability coverages, commercial and residential property risks, accident and health and workers’ compensation coverages and marine coverages.
Ultimate loss experience in this segment is based primarily on reports received by the Company from the underlying ceding insurers. Actual losses may take several years to be reported through the system. In 2001, the unprecedented September 11, 2001, terrorist attack materially impacted the results in this segment. The Company identified losses of $19.6 million, net of reinsurance benefit as of December 31, 2001, and a further $15.4 million and $7.2 million in losses has been recorded in 2002 and 2003, respectively.
The Company underwrites professional and related liability policy coverages for physicians (including oral and maxillofacial surgeons), physician medical groups and clinics, hospitals, dentists, managed care organizations and other providers in the healthcare industry. As a result of the Company’s withdrawal from certain segments of the healthcare industry, the premiums earned are allocated between core and non-core premium. Core premium represents California and Delaware business excluding the Brown & Brown dental program and hospital business. Non-core business
Premiums written for the core direct healthcare liability insurance business increased 5.4% and 4.8%, in 2003 and 2002, respectively, as average rate increases of 2.5% and 8.4% in 2003 and 2002, respectively, were partially offset by a decline in the number of insureds. Premiums earned in the core business increased 2.6% and 9.0% in 2003 and 2002, respectively, primarily due to rate increases. The Company has historically had a high renewal rate in its core business. The renewal rates of insureds who were offered renewal was 92% in both 2003 and 2002. The Company primarily loses insureds due to underwriting actions taken by the Company, insureds moving to competitors, leaving their practice, retiring or joining a health facility which provides for their insurance. These losses are offset by new sales activities. The core business policies inforce were 11,137 policies, 11,530 policies and 11,731 policies at year end 2003, 2002 and 2001, respectively.
The underwriting expense ratio increased from 19.6% in 2002 to 20.5% in 2003. The primary reason for the change was additional expenses connected with the rate approval hearing and regulatory triennial audit expenses in excess of amounts previously accrued. The expense ratio decreased in 2002 compared to 2001, primarily due to a smaller proportion of the core business being written through general agencies, thus decreasing commission expenses.
The loss ratio in 2003 of 223.4% compared to 193.3% in 2002 is the result of continued deterioration and additional upward development in loss reserves for prior years of $7.5 million in 2003. In addition, general increases in average claim costs continued to rise for the non-core business.
$32.4 million in 2003 from $122.5 million in 2002 and $79.5 million in 2001 because of reduction in treaty programs to one account and the cession of premiums written to GoshawK Re.
The retroactive accounting treatment required under FASB 113 requires that a charge to income be recorded to the extent premiums ceded under the contract are in excess of the estimated losses and expenses ceded under the contract. The charge related to the cession of the unearned premium as of July 1, 2002, and ceded premium written in the third quarter is included in operating expenses in the Assumed Reinsurance Segment. The charge and placement fees amounted to $15.4 million in 2003 and $18.4 million in 2002. The retroactive accounting treatment accounted for 9.4 and 6.4 percentage points of the expense ratio in 2003 and 2002, respectively.
The Company has had an ongoing relationship with GoshawK and its two business operations, Syndicate 102 at Lloyd’s of London (Syndicate 102) and GoshawK Re (a reinsurance company) in Bermuda. In 1999, the Company made a common stock investment in GoshawK of $12.9 million (representing 4.1% of the then outstanding shares of GoshawK). In addition, the Company participated through its assumed reinsurance segment in two treaties reinsuring Syndicate 102 for the 2000 and 2001 underwriting years. One treaty is a marine excess of loss reinsurance treaty and the other treaty was a quota share treaty covering Syndicate 102’s net retained business.
In late September 2003, GoshawK announced that Syndicate 102 had incurred significant losses in its 2000, 2001, 2002 and 2003 years of account. The losses stemmed primarily from two programs initiated in 1999. The losses were so significant GoshawK announced it would need to raise capital in Syndicate 102 and was reviewing its strategic options. GoshawK reported that GoshawK Re and its operations would not be materially affected by the financial problems of Syndicate 102. On October 31, 2003, Syndicate 102 was required to stop writing new business and was placed in run-off by regulators at Lloyd’s of London. GoshawK stated it would focus its further efforts on its GoshawK Re Bermuda operations.
The decrease in net investment income in 2003 from 2002 levels is primarily related to the decline in average invested assets resulting from lower premiums and loss payments related to the non-core healthcare liability and assumed reinsurance businesses. In addition, the net investment income was reduced in 2003 as the average rate of return before tax decreased due to the significant realized gains recognized in the latter half of 2002. The lower rate reflects the rates available for reinvestment at the time as the quality of the portfolio was maintained.
The decrease in net investment income in 2002 from 2001 levels is primarily related to changes in reinvestment rates available in the latter half of 2002 as the Company realized the investment gains.
The net realized gains of 2003 includes the $9.6 million write down of the Company’s GoshawK stock investment in the third quarter of the year offset by other gains recognized to increase statutory surplus.
The Company maintains a portion of its investment portfolio in high-quality, short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and LAE. Cash and cash equivalents investments totaled $62.1 million, or 9.6% of invested assets, at December 31, 2003. The Company believes that all of its short-term and fixed-maturity securities are readily marketable.
SCPIE Holdings is an insurance holding company whose assets primarily consist of all of the capital stock of its Insurance Subsidiaries. Its principal sources of funds are dividends from its subsidiaries and proceeds from the issuance of debt and equity securities. The Insurance Subsidiaries are restricted by state regulation in the amount of dividends they can pay in relation to earnings or surplus, without the consent of the applicable state regulatory authority, principally the California Department of Insurance. SCPIE Holdings’ principal insurance company subsidiary, SCPIE Indemnity, may pay dividends to SCPIE Holdings in any 12-month period, without regulatory approval, to the extent such dividends do not exceed the greater of (i) 10% of its statutory surplus at the end of the preceding year or (ii) its statutory net income for the preceding year. Applicable regulations further require that an insurer’s statutory surplus following a dividend or other distribution be reasonable in relation to its outstanding liabilities and adequate to meet its financial needs, and permit the payment of dividends only out of statutory earned (unassigned) surplus unless the payment out of other funds receives regulatory approval. The amount of dividends that SCPIE Indemnity is able to pay to SCPIE Holdings during 2004 without prior regulatory approval is approximately $14.0 million.
The Company’s capital adequacy position has been weakened by the continuing losses in the non-core business, particularly the $18.1 million loss incurred in September 2003 due to the unexpected losses attributable to GoshawK. On November 14, 2003, A.M. Best, after a review the third quarter results, reduced the rating of the Insurance Subsidiaries to B (Fair), with a negative outlook. A. M. Best assigns this rating to companies that have, in its opinion, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. The NAIC has developed a methodology for measuring the adequacy of an insurer’s surplus which includes a RBC formula designed to measure state statutory capital and surplus needs. The RBC rules provide for different levels of regulatory attention based on four thresholds determined under the formula. At December 31, 2003, the RBC level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2003, SCPIE Indemnity exceeded this threshold by $47.6 million.
The Company believes that it has the ability to fund its continuing operations at current and increased levels from its premiums written and investment income. The Company plans to focus on the efficient operation of its core business, while at the same time continuing to adjudicate and settle claims incurred in its discontinued non-core business. As the Company continues to “run-off” the non-core loss and LAE reserves, its capital position should improve. The Company believes it has, at best, only limited opportunities to raise capital, if that becomes necessary. The Company may improve its capital adequacy and RBC ratios through temporary reinsurance arrangements with highly rated insurers.
The Company has certain contractual obligations and commercial commitments principally for providing letters of credit in connection with its assumed reinsurance segment and for leasing office space for its headquarters and other regional offices. The table below presents the contractual payments due by period or expiration period for each obligation or commitment:
In November 2001, the Company arranged a letter of credit facility in the amount of $50 million with Barclays Bank PLC. Letters of credit issued under the facility fulfill the requirements of Lloyd’s and guarantee loss reserves under reinsurance contracts. As of December 31, 2003, letter of credit issuance under the facility was approximately $47.3 million. Securities of $52.1 million are pledged as collateral under the facility.