Basic earnings (loss) per share of common stock at December 31, 2004, 2003, 2002, 2001 and 2000 are computed using the weighted average number of common shares outstanding during the year of 9,387,556, 9,352,070, 9,322,249, 9,333,425, and 9,375,735, respectively. Diluted earnings per share of common stock at December 31, 2004, 2003, 2002, 2001 and 2000 are computed using the weighted average number of common shares outstanding during the year of 9,387,556, 9,352,070, 9,322,249, 9,333,425, and 9,382,494, respectively. For further discussion of basic earnings per share and diluted earnings per share, see the “Note 10 to Consolidated Financial Statements.”
SCPIE Holdings is a holding company owning subsidiaries engaged in providing insurance and reinsurance products. The Company is primarily a provider of medical malpractice insurance and related liability insurance products to physicians, healthcare facilities and others engaged in the healthcare industry in California and Delaware. Previously, the Company had also been actively engaged in the medical malpractice insurance business and related products in other states and the assumed reinsurance business. During 2002 and 2003, the Company largely completed its withdrawal from the assumed reinsurance market and medical malpractice insurance outside of California and Delaware.
The actions taken by the Company have significantly reduced capital requirements related to the premium written to surplus ratio in both the A.M. Best and NAIC capital adequacy models. The capital requirements associated with the reserve to surplus ratio continue to decline as the Company settles the claims in its non-core businesses.
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 estimates of ultimate incurred losses, especially those of Lloyd’s syndicates. 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.
Because the reserve establishment process is by definition an estimate, actual results will vary from amounts established in earlier periods. The Company recognizes such differences in the periods they are determined. Since reserves accumulate on the balance sheet over several years until all claims are settled, a determination of inadequacy or redundancy could easily have a significant impact on earnings and therefore stockholders’ equity. The Company has established net reserves of $442.4 million as of December 31, 2004, after considering both prospective and retrospective reinsurance. The net reserves (including retrospective reserves ceded) attributable to the operating segments of the Company are as follows:
A 1% difference in the ultimate value of total loss and LAE reserves at December 31, 2004, net of reinsurance recoverable, would decrease or increase future pretax earnings by $4.4 million.
At December 31, 2004, the Company had $48.5 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 $24.3 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 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. 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.
In 2002, 2003 and 2004, the Company derived approximately 27%, 9% and .3% of its healthcare liability earned premium volume, respectively, from policies issued outside the state of California, principally under the Brown & Brown and nonstandard physician programs. In 2001, the Company recognized that these programs were seriously underpriced and implemented significant premium increases, averaging approximately 40% and 30% in 2001 and 2002, respectively, in its principal non-California markets. The Company also instituted more stringent underwriting and pricing guidelines in these states. Despite the significant price increases and more stringent underwriting guidelines, the non-California programs produced significant underwriting losses in 2002, 2003 and 2004.
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, 2002, 813 policies were in force related to the Brown & Brown program. That number was reduced to 379 policies as of December 31, 2003. The Company has no active claims-made policies in force for the non-core healthcare liability insureds as of December 31, 2004. The Company remains exposed under extended reporting policies required to be issued upon cancellation or non-renewal of the non-core insureds. This exposure is currently reserved and declines over time.
The Company rapidly expanded its assumed reinsurance operations after the formation of the division in late 1999. Written premiums were $2.4, $18.5 and $112.8 million, respectively for 2004, 2003 and 2002. Earned premiums, which lag behind written premiums, were $14.6, $32.4 and $122.5 million, respectively for 2004, 2003 and 2002. 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.
During 2002, the Company pursued various financial alternatives to improve its capital position, including a complete or partial divestiture of its assumed reinsurance operations. In December 2002, the Company entered into a quota share reinsurance transaction with Rosemont Reinsurance Ltd. (Rosemont Re) (formerly known as GoshawK Reinsurance Limited), a Bermuda reinsurance subsidiary of GoshawK Insurance Holdings plc, a publicly held London-based Lloyd’s underwriter (GoshawK), under which the Company ceded to Rosemont Re almost all of its unearned assumed reinsurance premiums as of June 30, 2002, together with written reinsurance premiums after that date, in each case related to the assumed reinsurance business for the 2001 and 2002 underwriting years. The effect of this transaction was to retrocede to Rosemont Re $129.3 million of premiums written in 2002, $38.0 million of premiums written in 2003, and ($0.1) in 2004. The Company retains certain losses related to the assumed reinsurance business, including those related to the World Trade Center, and the Company continued to participate in one Lloyd’s syndicate for the 2003 underwriting year. The Rosemont Re treaty relieved the Company of underwriting leverage and improved the Company’s risk-based capital adequacy ratios under both the A.M. Best and NAIC models. Other than net premiums written of $18.3 million and $1.2 million from the Lloyd’s syndicate in 2003 and 2004, respectively, the Company had no significant premiums written from prior year contracts.
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 represents business related to physician and dental programs formerly conducted for the Company primarily in states outside California and Delaware by a national independent insurance agency, other state non-standard physician programs and hospital programs including those in California. The following tables summarize by core and non-core businesses the underwriting results of the direct healthcare liability insurance segment for the periods indicated:
Premiums written for the core direct healthcare liability insurance business increased 4.4%, 5.4% and 4.8%, in 2004, 2003 and 2002, respectively, as average rate increases of 7.4%, 2.5% and 8.4% in 2004, 2003 and 2002, respectively, were partially offset by a decline in the number of insureds. Premiums earned in the core business increased 3.4%, 2.6% and 9.0% in 2004, 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 has remained at 92% for 2004, 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 that provides for their insurance. These losses are offset by new sales activities. New policies written in 2004, 2003, and 2002 were 1,124, 1,225, and 1,463, respectively. The core business policies inforce were 10,684 policies, 11,137 policies and 11,530 policies at year end 2004, 2003 and 2002, respectively.
The loss ratio (losses and LAE related to premiums earned) for 2004 was 80.6% compared to a loss ratio of 88.6% and 91.2% for 2003 and 2002, respectively. The change in loss ratio primarily reflected increases in average claim costs offset by a decline in the frequency of claims, favorable development on prior year reserves and the effect of the average rate increases on earned premiums.
The underwriting expense ratio (expenses related to premiums earned) remained relatively unchanged at 20.9% in 2004 compared to 20.5% in 2003. The expense ratio increased in 2003 compared to 2002, primarily due to additional expenses connected with the rate approval hearing and regulatory triennial audit expenses in excess of amounts previously accrued.
The negative premiums written and earned in 2004 represent reinsurance premiums paid by the Company in connection with the reinstatement of excess of loss layers for older years. Premiums written decreased in 2003 to $5.3 million from $21.9 million in 2002. This resulted from the significant decline in the number of insureds from 2,997 at December 31, 2001, to 813 and 379 insureds at December 31, 2002 and 2003, respectively. The decline in insureds resulted from the Company’s actions taken to withdraw from this business. After March 6, 2003, no new or renewal business was written in the non-core programs. Premium earned in the non-core direct healthcare liability insurance business decreased as the Company withdrew from states other than California and Delaware and its hospital program wound down.
The underwriting loss incurred in 2004 is primarily due to two adverse litigation decisions, reserve increases attributable to older years on dentists coverage and a general reserve increase of $3.0 million in the fourth quarter 2004.
The following table summarizes the underwriting results of the assumed reinsurance segment for the periods indicated:
The earned premium in 2004 is a result of one ongoing assumed reinsurance program for the 2003 underwriting year.
The underwriting loss was slightly higher for 2004 ($13.8 million) versus 2003 ($13.5 million).
The underwriting loss in 2004 was principally attributable to unexpected adverse loss development during 2004 principally in connection with the Lloyd’s syndicates, additional losses incurred under a single excess of loss directors and officers liability insurance treaty, and losses involving issuers of bail and immigration bonds. The fall in the U.S. dollar compared to the British pound also contributed to the loss.
The underwriting loss in 2003 was principally attributable to the failure of Goshawk Syndicate 102 and upward development on World Trade Center losses.
The net realized gains of 2003 includes a $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 GoshawK stock was sold in early 2004.
The Company had a minor income tax expense in 2004 compared to a benefit of $7.4 million and $22.6 million in 2003 and 2002, respectively. During the third quarter, the Company settled with the California Franchise Tax Board (FTB) for $4.0 million, an assessment received in 2002. Legislation enacted in California during the third quarter of 2004 restored 80% of a deduction provision under which insurance holding companies had for many years deducted all dividends received from their insurance company subsidiaries. The $4.0 million settlement is included in income taxes and offsets a federal tax benefit for the year of $3.9 million.
The Company maintains a significant 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 $94.4 million, or 16.4% of invested assets, at December 31, 2004. The Company believes that all of its short-term and fixed-maturity securities are readily marketable and have scheduled maturities in line with projected cash needs.
The Company invests its cash flow from operations principally in taxable fixed maturity securities. The Company’s current policy is to limit its investment in unaffiliated equity securities and mortgage loans to no more than 8.0% of the total market value of its investments. The market value of the Company’s portfolio of unaffiliated equity securities was $16.2 million at December 31, 2004 compared to $20.5 million at December 31, 2003. The Company plans to continue its emphasis on fixed maturity securities investments for the indefinite future.
and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions. As of December 31, 2004, SCPIE Holdings held cash and short-terms securities of $8.0 million of which approximately $4.0 million was utilized to satisfy the California franchise tax liability in January 2005. Based on historical trends, market conditions and its business plans, the Company believes that its sources of funds (including dividends from the Insurance Subsidiaries) will be sufficient to meet the liquidity needs of SCPIE Holdings over the next 18 months.
The Company’s capital adequacy position has been weakened by the losses in the non-core business. The Company’s current rating from A.M. Best is 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 risk-based capital (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, 2004, the RBC level of each Insurance Subsidiary exceeded the threshold requiring the least regulatory attention. At December 31, 2004, SCPIE Indemnity exceeded this threshold by $38.0 million.