We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be five
to ten years in length. We currently lease and occupy a total of approximately 11,000 square feet of space in Louisville, Kentucky; Chicago, Illinois; and Albuquerque, New Mexico. Our Louisville, Kentucky lease, representing approximately 148 square feet, expires on March 31, 2008. We do not anticipate renewing this lease. We also own a parcel of investment property in East Lansing, Michigan as part of our investment portfolio.
Weighted average shares outstanding and the associated earnings per share amounts, both basic and diluted, have been retroactively adjusted to reflect a three-for-two stock split effective November 1, 2006.
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. The discussion that follows contains certain forward-looking statements relating to our anticipated future financial condition, operating results, cash flows and our current business plans. We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all of our forward-looking statements. When we use words such as “will,” “should,” “likely,” “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report and you should not place undue reliance on any such forward-looking statements. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to significant business, economic and competitive risks and uncertainties, many of which are beyond our control or are subject to change. These risks and uncertainties are detailed under “Item 1A - Risk Factors” and elsewhere in this report and from time to time in other reports we have filed with the Securities and Exchange Commission. The cross-referenced information is incorporated herein by reference.
Our Consolidated Financial Statements include estimated reserves for unpaid losses and loss adjustment expenses related to our various insurance lines of business. Our actuaries utilize standard actuarial techniques to project ultimate losses based on our paid and incurred loss information and claim count, as well as industry data. These projections are prepared using the Company’s data, including the number of claims reported and paid, and the average severity of reported and paid claims, as well as industry data. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Based on these quantitative as well as other qualitative factors, such as a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and the current reserving practices of the Company’s claims department, we select a “best estimate” of ultimate future losses, and then record this best estimate in the Company’s Consolidated Financial Statements. We receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves, as required by insurance regulatory authorities.
When a claim is reported to us, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The process of estimating the case reserves reflects an informed judgment based upon insurance reserving practices appropriate for the relevant line of business and on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. We also maintain reserves for claims incurred but not reported, commonly referred to as IBNR, to provide for future reporting of already incurred claims and development on reported claims. These two components, case reserves and the reserve for IBNR claims constitute the liability for unpaid losses and loss adjustment expenses, and together represent our best estimate of the ultimate cost of settling our claims obligations. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses is an inherently uncertain process and does not represent an exact calculation of that liability. Many internal and external factors can influence the estimation process, and even minor changes in assumptions regarding these factors can have a substantial impact on the projection of the ultimate liability.
Other external factors such as economic inflation, judicial trends and legislative and regulatory changes can also have a substantial impact on our reserve estimate assumptions. For example, when tort reform legislation is passed in a state, we estimate its impact on both the frequency and severity of losses. In addition, we evaluate whether or not the legislation will stand if it is legally challenged in the courts.
The paid development method estimates ultimate losses by reviewing paid loss patterns and applying them to accident years with further expected changes in paid loss. The incurred development method is similar to the paid development method, but it uses case incurred losses instead of paid losses. Case incurred losses are defined as paid losses plus the claims department’s provision for open claims (case reserves). The average loss method multiplies a projected number of ultimate claims by an estimated ultimate average loss for each accident year to produce ultimate loss estimates. The Bornhuetter-Ferguson method is a combination of the paid or incurred development method and the average loss method.
The assumptions and methodologies used in estimating and establishing the reserve for unpaid losses and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded 8% of our recorded net reserves as of the beginning of the period, but they can materially affect our results of operations when an adjustment is made. Due to the current volatility of losses in the medical professional liability industry, adjustments were necessary in each of the last several years. See Note 7 of Notes to Consolidated Financial Statements for a table showing changes in the loss reserve during each of the last three years, which table is incorporated herein by reference.
as a current period expense. Subsequent recoveries in the fair value of impaired securities are not reported in income, but rather as unrealized gains, net of tax, in comprehensive income. Inherent in our evaluation of a particular security are assumptions and estimates about the operations of the issuer, and its future liquidity and earnings potential. Some of the factors considered in evaluating whether a decline in market value is other than temporary are:
We recorded no expenses for OTTI charges during 2007. During the year ended December 31, 2006, we recorded expenses of $178,000 related to various equity securities whose decline in fair value was deemed to be other than temporary based on their anticipated liquidation. At December 31, 2007, we had eight, available-for-sale securities whose market value was less than amortized cost. Of these eight, only two had been in an unrealized loss position greater than 12 months. Our held-to-maturity portfolio had 70 securities whose market value was less than amortized cost at December 31, 2007, with 53 of those having been in that position for 12 months or more. For further information regarding the nature and amounts of these unrealized and unrecognized losses, see Note 3 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Our available-for-sale equity securities are reported in the “Other Investments” line of the Consolidated Balance Sheets included elsewhere in this report. Also included in Other Investments are the common stock of the statutory trusts used to issue manditorily redeemable trust preferred securities, as described in Note 8 of the Notes to Consolidated Financial Statements included elsewhere in this report, as well as investment real estate located in the East Lansing, Michigan area and membership interests in investment real estate LLCs that hold property adjacent to our investment real estate holdings. Investment real estate is carried at its historical cost as this is less than the market value of the land based on recent appraisals. The membership interests in the LLCs are accounted for following the equity method of accounting.
A portion of the coverage that physicians purchase under claims-made policies is for an additional death, disability and retirement, or DDR, insurance benefit. This DDR coverage provides coverage to the physician for any prior incidents occurring during the coverage period that are reported after their death, disability or retirement. The loss exposure associated with this product is known as extended reporting period claims. The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of expected future premiums associated with this DDR coverage. The reserves for these claims fluctuate based on the number of physicians who are eligible for this coverage and their age. Any changes in the DDR reserves are reflected as an expense in the period in which we become aware that an adjustment is necessary. At December 31, 2007 and 2006, our recorded DDR reserves were $15.0 million and $13.0 million, respectively, which include a discount related to the present value calculation of approximately $4.5 million and $5.5 million, respectively.
We annually review the financial stability of all of our reinsurers. This review includes a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2007, there are no known issues with the financial solvency of our reinsurers or their ultimate ability to pay amounts due to us. If we determine that the ultimate ability of a reinsurer is uncertain, we would be required to recognize a reserve and a corresponding expense in the period in which the determination is made. Our reinsurance arrangements are discussed in more detail in “Item 1. Business - Medical Professional Liability Operations” and in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - 2007 Compared to 2006” and in Note 9 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Changes in the valuation allowance during 2005 were allocated in the accompanying Consolidated Financial Statements to federal income taxes, a component of net income, other comprehensive income, or other components of shareholders’ equity, depending on the nature of the deferred item that gave rise to the change. See Notes 1 and 10 of the Notes to Consolidated Financial Statements for further discussion of the deferred tax valuation allowance and its impact on our financial condition and results of operations. Such information is incorporated herein by reference.
We are an insurance holding company whose financial performance is heavily dependent upon the results of operations of our insurance subsidiaries. Our insurance subsidiaries are property and casualty insurers that write almost exclusively medical professional liability insurance for physicians and other healthcare professionals throughout the United States, but principally in the Midwest and New Mexico. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
For further information regarding the operations of our medical professional liability insurance business is discussed in detail in “Item 1. Business - Medical Professional Liability Operations.”
We measure our performance using several different ratios and other key metrics. These ratios and other metrics are calculated on a GAAP basis and include:
Loss Ratio: This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The calendar year loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The accident year loss ratio uses only those loss and loss adjustment expenses that relate to the current accident year (i.e., excludes the effect of development on prior year loss reserves). The lower the percentage, the more profitable our insurance business is, all other things being equal.
Underwriting Expense Ratio: This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and managing our underwriting operations. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio, and overall profitability.
The following table sets forth our results of operations for the years ended December 31, 2007, 2006 and 2005 on a consolidated basis. The discussion that follows should be read in connection with the Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.
A positive percentage change represents an increase, while a negative percentage change represents a decrease.
Premiums are generally earned pro rata over the policy term, usually one-year, and as a result fluctuations in earned premiums typically lag fluctuations in written premium. Accordingly, net premiums earned during 2007 did not decline at the same rate as net premiums written as we continued to earn in 2007 some of the higher premium volume that was written in 2006.
The decrease in our incurred loss and loss adjustment expenses was primarily attributable to $34.2 million of favorable development on prior year loss reserves in 2007, compared with $12.9 million in 2006. In addition, the reduced exposure resulting from the decline in net premiums earned accounted for approximately $9.7 million of the overall $31.0 million decline in incurred loss and loss adjustment expenses. The unusually large amount of favorable prior year development in 2007 was the result of continued positive trends in claim frequency and relative
stability in average paid loss severity. The number of claims reported to us declined 18.5% to 952 in 2007 from 1,168 in 2006. Our average net paid loss and loss adjustment expenses per claim closed with payment, a measure of paid loss severity, has averaged $65,300 over the last five years, with a high of $78,800 in the first quarter of 2006 and a low of $56,600 in the first quarter of 2007. When comparing average paid loss statistics, we use a four quarter trailing average as this helps to minimize volatility that can result in certain quarters where the low volume of closed claims can distort average statistics.
As discussed in “- Critical Accounting Policies,” the effect of changes in claims frequency introduces a great deal of variability in our reserve estimation process. We have a practice of being cautious with the assumptions we make concerning emerging trends in claim frequency and severity and do not immediately reflect the impact that any short-term declines in frequency may have on our ultimate losses. However, actual frequency and severity loss trends have developed more favorably than we originally anticipated for several years. We use historical claims data to project future expected results. As a result, the impact of recent claims trends is often moderated by the substantial pool of historical data. However, we have now experienced the trends of declining claim frequency and stable paid loss severity for several years in a row, and as a result these trends need to be reflected in our reserve assumptions more fully now. This growing impact of the recent favorable trends is the primary reason for the increase in favorable development from $12.9 million in 2006 to $34.2 million in 2007. The following table shows the 2007 favorable development on prior years’ loss reserves by accident year.
As noted in the section “- Financial Condition, Reserves for Unpaid Loss and Loss Adjustment Expenses,” reserves are inherently uncertain and the ultimate cost to settle claims will likely be more or less than currently anticipated. Actual claim experience will dictate the magnitude and nature, whether favorable or unfavorable, of any future development. Our reserve estimate at December 31, 2007 reflects our best estimate of the future liability as of that date. However, if current trends continue, we believe that the actual claim experience is more likely to emerge favorably than unfavorably.
Our accident year loss ratio increased slightly to 74.6% in 2007, compared with the recast accident year loss ratio from 2006 of 71.9%. The recast 2006 accident year loss ratio is the accident year loss ratio reported in 2006, adjusted for any prior year development on the 2006 accident year recognized in 2007. All other things being equal, in a period of declining premium rates, as noted in the discussion of premiums above, we would expect that the loss ratio would increase as we have the same amount of exposure spread over a smaller premium base. While this expected relationship holds true with regard to our 2007 accident year loss ratio, the increase in the accident year loss ratio is less than what might be expected as we have begun to guardedly recognize the impact of the favorable claim trends discussed above in our estimates of current accident year losses.
Underwriting expenses decreased only $380,000, or 1.2%, in 2007, despite a 7.2% decrease in net premiums earned over the same period. As approximately half of our underwriting expenses are truly variable with regard to premium volume, we would have expected to see a decrease in underwriting expenses of approximately 3.6%, or
approximately $1.1 million. The difference is approximately $668,000 of additional underwriting expense in 2007 for costs incurred in connection with the development of our new policy and claims system. These cost primarily related to activities that could not be capitalized, such as data migration. If our premium volume in future periods continues to decline, underwriting expenses will also decrease. However, the decrease in underwriting expenses will not be as great as premium volume declines due to fixed costs associated with our underwriting process.
The net realized losses of $111,000 in 2007 were the result of a few individually insignificant security sales. The net realized gain of $3.3 million we reported for the year ended December 31, 2006 was the result of the sale of some of our investment real estate, which resulted in a realized gain of $1.4 million. In addition, the sale of ProAssurance common stock, received in exchange for our investment of Physicians Insurance Company of Wisconsin, or PICW, stock in connection with ProAssurance’s acquisition of PICW in 2006, resulted in a realized gain of $2.1 million. These realized gains were partially offset by approximately $178,000 of impairment charges in 2006.
2006 Compared to 2005. The increase in income before federal income taxes and minority interest for 2006 was primarily the result of improved underwriting results. Increases in investment income and realized gains, as well as a decrease in other expenses, also contributed to the increase in net income before taxes. The decrease in net income of $29.2 million in 2006 compared to 2005 is primarily attributable to the $28.0 million federal income tax benefit in 2005, which includes a $44.1 million benefit related to the reversal of the deferred tax asset valuation allowance.
The following table shows our direct premiums written by major geographical market for the years ended December 31, 2006 and 2005.
The decrease in our incurred loss and loss adjustment expenses in 2006 was partially attributable to a decrease in net premiums earned in 2006. We also continued to benefit from the enhancements we have made in our underwriting processes and claims processes in the preceding several years. The changes in our underwriting processes resulted in a more stable book of insured accounts, which resulted in a steady decline in the number of claims reported to us each quarter. Reported claims for 2006 totaled 1,168, compared to 1,513 in 2005. While we believe that the decrease in our claims frequency was largely attributable to underwriting measures we undertook, it now appears that there was an industry wide reduction in claims frequency, the cause of which remains uncertain.
The loss ratio for 2006 was 67.1% compared to 77.4% for 2005. The decrease in the loss ratio was primarily the result of changes in our claims handling practices and tighter underwriting standards. These changes resulted in a decrease in both the frequency (see above) and severity of paid losses. Favorable development on prior years’ loss reserves was $12.9 million and $4.4 million for 2006 and 2005, respectively. The favorable development on prior years’ loss reserves experienced in 2006 was primarily attributable to the emergence of lower frequency and severity trends than originally projected, especially related to accident years 2003 through 2005 in our Michigan and Ohio medical professional liability markets. These positive factors were partially offset by an increase in prior year reserves in our Florida market.
Investment income remained relatively unchanged from 2005 to 2006. However, the overall yield on our portfolio was down to 5.30% in 2006 compared with 5.43% in 2005. The decrease in the yield was the result of a higher allocation of the overall portfolio to tax-exempt securities. Offsetting the decrease in investment income in 2006 related to the lower yields produced by tax-exempt securities was the absence of any charges related to changes in the fair value of derivative securities. In 2005, the fair value of fixed-income securities that were determined to be derivatives decreased $1.1 million, resulting in a charge to investment income.
Net realized gains of $3.3 million were reported for the year ended December 31, 2006. During 2006, the Company sold investment real estate resulting in a realized gain of $1.4 million. In addition, the sale of ProAssurance common stock, received in exchange for our investment of Physicians Insurance Company of Wisconsin stock in connection with ProAssurance’s acquisition of PICW in 2006, resulted in a realized gain of $2.1 million. These realized gains were partially offset by approximately $178,000 of impairment charges.
Partially offsetting these decreases in other expenses was an increase in interest expense as a result of increases in short-term interest rates. Our long-term debt of $30.9 million bears interest at 4.15% plus the three-month London Inter Bank Offered Rate (“LIBOR”). The weighted average annual interest rate for this debt was 9.35% for 2006, compared to 7.58% for 2005.
We made net federal income tax payments of approximately $15.8 million in 2007. We anticipate that federal income tax payments will increase in future years as we have now utilized our minimum tax credits. Substantially all of our taxable income is generated by American Physicians. As such, it is primarily American Physicians responsibility to provide the cash resources to fund our tax obligations. APCapital generally has a net positive cash flow from income taxes as it is reimbursed by its subsidiaries for the tax benefit of the loss it generates in accordance with inter-company tax allocation agreements.
At December 31, 2007, the Company had $87.5 million of cash and cash equivalents and approximately $262.3 million of available-for-sale fixed-income securities to meet short-term cash flow needs. On a long-term basis, fixed-income securities are purchased on a basis intended to provide adequate cash flows from future maturities to meet future policyholder obligations and ongoing operational expenses. As of December 31, 2007, we had approximately $95.7 million, $177.7 million and $71.5 million of held-to-maturity fixed-income securities that mature in the next one to five years, five to ten years and more than ten years, respectively. We also have approximately $152.8 million of mortgage-backed securities that provide periodic principal repayments. See Note 3 of the Notes to Consolidated Financial Statements for further information regarding the anticipated maturities of our fixed-income securities.
We hold $30.9 million of long-term debt, which is described in greater detail in Note 8 of the Notes to Consolidated Financial Statements. In accordance with the terms of the original debenture agreements this debt may be paid down as early as May 2008. This debt pays a variable interest rate equal to 4.15% plus the three month LIBOR rate. It has been our intent to pay down this debt in 2008. However, with recent declines in short-term interest rates and the possibility of refinancing this debt at a lower fixed interest rate we are continuing to evaluate the various options with regard to this debt and its impact on our overall cost of capital.
Our statutory capital and surplus, which we refer to collectively as surplus, at December 31, 2007, was approximately $221.6 million. This results in a net premiums written to surplus ratio of 0.59:1 based on $130.8 million of net premiums written. Statutory surplus at December 31, 2006 was approximately $248.9 million, and our net premiums written to surplus ratio was also 0.59:1. The Company’s Risk Based Capital and IRIS Ratios considered by regulators are discussed under “Item 1. Business - Insurance Regulatory Matters.” Such cross referenced information is incorporated herein by reference. The $27.3 million decrease in statutory surplus in 2007 was due to $82.0 million of dividend payments made by the insurance subsidiaries to APCapital, as well a decrease in deferred income taxes and an increase in non-admitted assets totaling $9.3 million. Partially offsetting these decreases was an increase in statutory surplus related to $63.7 million of net income.
The following table shows various claim statistics and reserve averages for our medical professional liability line of business at or for the years ended December 31, 2007, 2006 and 2005. The 2005 data does not include PIC-Florida counts or reserves as this data was not available to us, and in 2006 and 2007 PIC-Florida was no longer a consolidated entity.
At December 31, 2007 and 2006, our available-for-sale and held-to-maturity fixed-income security portfolio consisted of the following:
In June 2007, we purchased approximately $61.5 million of tax-exempt municipal securities. We had sales and maturities of corporate securities totaling approximately $50.3 million throughout the year. In addition, throughout the year we received principal payments on mortgage-backed securities of approximately $11.0 million. Our fixed-income security portfolio had a weighted average Standard & Poors’ credit quality rating of AA+ at December 31, 2007. For additional information regarding the composition of and market risks associated with our fixed-income security portfolio, see “
We have audited the accompanying consolidated balance sheets of American Physicians Capital, Inc. and Subsidiaries (the “Company”) as of December 31, 2007 and 2006 and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and Subsidiaries at December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
Minority interest in the accompanying Statements of Income for the year ended December 31, 2005, represents the 51% ownership interest of other investors in Physicians Insurance Company, a Florida domiciled insurance company (“PIC-Florida”). PIC-Florida was included in the Company’s Consolidated Financial Statements during the year ended December 31, 2005, as it had been determined to be a variable interest entity and the Company’s subsidiary, American Physicians, had been determined to be the primary beneficiary in accordance with the guidance given in Financial Accounting Standards Board Interpretation (“FIN”) 46(R), “Consolidation of Variable Interest Entities.” In January 2006, the other owners of PIC-Florida began purchasing American Physicians’ interest in the company on an installment basis. As a result, American Physicians was no longer deemed to be the primary beneficiary and the investment reverted to being accounted for as an equity method investee in the first quarter of 2006. The sale of PIC-Florida was completed in the fourth quarter of 2007.
The Company writes business throughout the United States of America, with an emphasis on markets in the Midwest, specifically the states of Illinois, Kentucky, Michigan and Ohio, as well as the state of New Mexico. These five states accounted for approximately 98% of the Company’s total medical professional liability direct premiums written during the years ended December 31, 2007 and 2006. Due to the inclusion of PIC-Florida in the Company’s 2005 consolidated results, these five states accounted for approximately only 93% of total medical professional liability direct premiums written for the year ended December 31, 2005.
been less than the amortized cost, (d) the financial condition, near-term and long-term earnings and cash flow prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions, and (e) the specific reasons that a security is in a significant unrealized loss position, including market conditions that could affect access to liquidity. A decline in the market value of an available-for-sale or held-to-maturity security below its amortized cost that is deemed to be other than temporary, results in a write-down of the cost basis of that security to fair value.
Insurance premium income is typically recognized on a daily pro rata basis over the respective terms of the policies in-force, which is generally one year. Certain extended reporting endorsements, often referred to as tail coverage allow extended reporting of insured events after the termination of the original claims-made policy by modifying the exposure period of the underlying contract. Tail coverage can modify the exposure period for a definite or indefinite period. Premiums associated with tail policies that provide coverage for a definite period are earned over the period additional coverage is provided using the daily pro rata method. Premiums for tail policies that provide additional coverage for an indefinite period are fully earned at the date of issuance. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.
At December 31, 2007 and 2006, there were disputes with reinsurers regarding the recoverability of payment of amounts. See Note 9 for recoverable amounts from individually significant reinsurers.
The Company records any excess tax benefits related to employee share-based awards as a credit to additional paid in capital in the year that they are currently deductible in the Company’s consolidated tax return.
On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment” using the modified prospective transition method. Accordingly, the Company recorded share-based compensation expense of $160,000 and $571,000 for the years ended December 31, 2007 and 2006, respectively, for awards granted prior to, but not vested as of January 1, 2006, adjusted for estimated forfeitures, using the fair value method. Additional information regarding the Company’s share-based award plans can be found in Note 15.
Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements, which was issued in September 2006, defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. The Statement does not require any new fair value measurements and was initially effective for the Corporation beginning January 1, 2008. In February 2008, the FASB approved the issuance of FASB Staff Position (FSP) FAS 157-2. FSP FAS 157-2 defers the effective date of SFAS No. 157 until
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FAS 115, which permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this statement is to provide entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The provisions of SFAS No. 159 are effective for fiscal years beginning after November 15, 2007. The adoption of this statement is not expected to have a material impact on the Company’s consolidated results of operations, financial position or liquidity.
In June 2007, the FASB issued Emerging Issues Task Force Issues (“EITF”) No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards. EITF No. 06-11 requires that realized income tax benefits related to dividend payments that are charged to retained earnings and paid to employees holding equity shares, nonvested equity share units, and outstanding equity share options should be recognized as an increase in additional paid-in capital. EITF 06-11 shall be applied to share-based payment awards that are declared in fiscal years beginning after December 15, 2007. The Company does not expect the adoption of EITF 06-11 effective January 1, 2008 to have a material effect on its consolidated results of operations, financial position or liquidity.
The composition of the Company’s available-for-sale investment security portfolio, including unrealized gains and losses at December 31, 2007 and 2006, was:
The following table shows the carrying value, gross unrecognized holding gains and losses, as well as the estimated fair value of the Company’s held-to-maturity fixed-income security portfolio as of December 31, 2007 and 2006. The carrying value at December 31, 2007 and 2006, includes approximately $2.8 million and $3.8 million of unrealized gains, respectively, as a result of the transfer of certain securities from the available-for-sale to the held-to-maturity category in previous years. These unrealized gains continue to be reported as a component of accumulated other comprehensive income in the accompanying Consolidated Balance Sheets, and will be amortized over the remaining life of the security through comprehensive income.
Those securities in the tables above that are in an unrealized or unrecognized loss position at December 31, 2007 or 2006 were determined to be in that position primarily as a result of changes in prevailing interest rates. All securities in an unrealized or unrecognized loss position at December 31, 2007 or 2006 were considered investment grade. The Company defines investment grade securities as those that have a Standard & Poors’ credit rating of BBB and above. In addition, all mortgage-backed securities held by the Company were issued by U.S. government sponsored agencies. The Company has incurred no impairment losses related to sub-prime mortgage exposures. Based on the absence of significant negative factors regarding the issuer’s credit-worthiness, combined with the Company’s ability and intent to hold the securities above that are in an unrealized or unrecognized loss position until their maturity, or for a sufficient period of time to allow for the recovery of the securities market value, the decline in their market value is deemed to be temporary in nature.
The components of pre-tax investment income and net realized gains for the years ended December 31, 2007, 2006 and 2005 were:
The estimated fair value of fixed-income securities classified as available-for-sale and the carrying value and estimated fair value of fixed-income securities classified as held-to-maturity at December 31, 2007, by contractual maturity, were:
Proceeds on the sales of investments in bonds totaled $9.3 million in 2007, $11.9 million in 2006, and $33.0 million in 2005. Gross gains of $118,000, $0, and $358,000 were realized on the sales of investments in bonds for the years ended 2007, 2006 and 2005, respectively. Gross losses of $60,000, $133,000, and $329,000 were realized on the sales of investments in bonds for the years ended 2007, 2006 and 2005, respectively.
Depreciation expense associated with property and equipment for the years ended December 31, 2007, 2006, and 2005, was $1.0 million, $1.4 million and $1.7 million, respectively.
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2007, 2006, and 2005, was as follows:
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and three-month LIBOR plus 4.20% for the second trust issuance, payable quarterly. The interest rate is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 12.50%. The average interest rates of 9.59% (Trust I issuance) and 9.69% (Trust II issuance) resulted in interest expense of approximately $2.9 million for the year ended December 31, 2007. Interest expense for the years ended December 31, 2006 and 2005 was $2.8 million and $2.3 million, respectively. At December 31, 2007 and 2006, accrued interest payable to the trusts was approximately $320,000 and $333,000, respectively. The Debentures are callable by APCapital at par beginning in May 2008. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS. As the amounts that could potentially be payable under the guarantees are recorded as liabilities by the Company, no additional liability related to these guarantees has been accrued.
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation. A reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2007, 2006 and 2005, is as follows:
The Company had reinsurance recoverables from the following reinsurers at December 31, 2007 and 2006:
The Company’s income tax reconciliation for the years ended December 31, 2007, 2006 and 2005, is as follows:
valuation allowance on federal income tax benefit included in net income, other comprehensive income and shareholders’ equity for the year ended December 31, 2005.
At December 31, 2007, the Company had approximately $1.4 million and $1.2 million of net operating loss carryforwards that expire in 2011 and 2010, and are limited to $340,000 and $575,000 annually, respectively. The Company fully utilized its alternative minimum tax credits during 2007.
In April 2006 the Company announced that its Board of Directors had authorized the repurchase of shares of its common stock pursuant to a plan adopted under Rule 10b5-1 of the Securities Exchange Act of 1934. Shares may be repurchased under a Rule 10b5-1 plan at times when the Company otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. A broker selected by the Company has the authority under the terms and limitations specified in the plan to repurchase shares on the Company’s behalf pursuant to a pre-determined formula. A total of $30 million was authorized for share repurchases under the Rule 10b5-1 plan during 2006.
Effective April 1, 2007, the Company completed the last of its employee separations related to the exit from the workers’ compensation line of business. The activity in the liability for termination benefits for the years ended December 31, 2007, 2006 and 2005 was as follows:
Activity in the liability for contract termination costs for the years ended December 31, 2007, 2006 and 2005, was as follows:
The Company offers benefits under certain defined contribution plans. In 2007, 2006 and 2005 the defined contribution plans provide for Company contributions of 5% of employee compensation, as defined in the plan, and a 100% match of employee contributions on the first 3% of contributions and 50% match on the next 2% of contributions. Employer contributions to the plans were approximately $855,000, $831,000, and $937,000 for 2007, 2006 and 2005, respectively.
The Board of Directors and shareholders have authorized the American Physicians Capital, Inc. Stock Compensation Plan (the “Plan”). The Plan provides for the award of stock options and other share-based awards for officers, directors and employees of the Company. These awards must be approved by the compensation committee of the board of directors. The total number of shares of the Company’s common stock authorized for issuance under the Plan is 1,800,000 shares, of which only 9,585 remain available at December 31, 2007 for future grants.
In addition to the stock options above, the remaining 11,472 shares of non-vested stock that were outstanding at December 31, 2006, vested in January 2007. These non-vested shares were originally granted in January 2004, with a fair value at the date of grant of $11.47 per share
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted market price (adjusted for the effect of the stock split described in Note 1) of the Company’s common stock for the options that were in-the-money at December 31, 2007. For the years ended December 31, 2007, 2006 and 2005, the total intrinsic value of options exercised was $2.5 million, $5.9 million, and $2.1 million, respectively, determined as of the date of option exercise.
The Company determines its pool of “windfall” tax benefits accumulated in additional-paid-in-capital following the ’short-cut” method as permitted by FASB Staff Position No. FAS 123(R)-3: Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. During the years ended December 31, 2007, 2006 and 2005, the excess tax benefit realized from the exercise of options and vesting of other share-based awards resulted in increases in additional-paid-in-capital of $1.0 million, $2.1 million, and $1.1 million respectively.
Employee share-based compensation expense recognized under SFAS No. 123(R) was not reflected in our results of operations for the year ended December 31, 2005 for employee stock option awards as all options were granted with an exercise price equal to the market value of the underlying common stock on the date of grant. However, the Company has historically provided the required pro forma disclosures under SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosures.” The originally disclosed pro forma effects of share-based compensation expense have been included here for purposes of comparison to the results of operations for the years ended December 31, 2006. In accordance with adoption pursuant to the modified-prospective method, previously reported amounts in the income statement have not been changed.
The pro forma information for the year ended December 31, 2005, was as follows:
There were no stock options or other share-based awards granted during the years ended December 31, 2007 or 2006. The grant date fair value of stock options for award grants made in 2005 was estimated using a binomial lattice model. The following table indicates the assumptions used, or the range of assumptions, in estimating the grant date fair value for options granted during the year ended December 31, 2005.
The reserve associated with DDR coverage benefits is included as a component of unpaid loss and loss adjustment expense reserves for GAAP. Any change in the estimate of the liability associated with such coverage is charged or credited to the incurred loss and loss adjustment expenses in the GAAP Statement of Income. Statutory accounting principles require that the reserve for DDR benefits be included as a component of unearned premium reserves, with any change in the estimated reserve treated as an adjustment to earned premium in the period of change.
The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period without prior regulatory approval is limited to the greater of statutory net income for the preceding year, excluding net realized gains (losses) on the sale of investments, or 10% of statutory surplus as of the preceding year end on an individual company basis. During 2007, APCapital’s insurance subsidiaries paid it dividends totaling $82.0 million, of which $42.3 million required prior regulatory approval as they exceeded the aforementioned limits. Such approval was granted in August 2007 by the State of Michigan Office of Financial and Insurance Regulation. Dividend payments totaling $64.2 million can be made in 2008, without prior regulatory approval. However, due to the timing of dividend payments in 2007, no dividend payments can be made in 2008 until late in the second quarter, when approximately $11.0 million could be paid. The remaining $53.2 million in dividend payments can not be made until various dates in the third quarter of 2008.
The unaudited operating results by quarter for 2007 and 2006 are summarized below:
American Physicians Capital, Inc. (APCapital) is an insurance holding company incorporated under Michigan law on July 6, 2000. APCapital owns all of the issued and outstanding common stock of the following entities either directly or indirectly through one of the entities listed below:
APSpecialty Insurance Corporation - a stock insurance company incorporated under Michigan law (APSpecialty). APSpecialty is a wholly-owned subsidiary of American Physicians.
APCapital received the following dividends payment from it American Physicians insurance subsidiary during 2007: $13 million in March, $13 million in May, $6 million in July and $46.2 million in August. In addition, APCapital received a $3.8 million dividend payment from ICA in August 2007. Of the $46.2 million and $3.8 million paid by American Physicians and ICA, respectively, in August 2007, $40 million and $2.3 million, respectively, required prior regulatory approval as they exceeded ordinary dividend limits imposed by the State of Michigan.