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.
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. As required by insurance regulatory authorities, we receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves.
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 reserves reflects an informed judgement 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. The variables considered include the effects of ultimate loss payments of internal factors such as claims handling practices and changes in the mix of our products, as well as external factors such as changes in loss severity trends, economic inflation, judicial trends and legislative and regulatory changes. Case reserves are periodically adjusted by the claims staff, as more information becomes available. The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process and does not represent an exact calculation of that liability. We maintain reserves for claims
As it often takes several years for medical professional liability claims to be resolved (three to six years on average from the time the loss is reported) the ultimate payment can be difficult to project due to typical delays in reporting claims to us, the often lengthy discovery process, and the time necessary to defend the claim. In addition, changes in our case reserving philosophy can introduce additional uncertainty into the actuarial estimation process. Further, claims with similar characteristics may result in very different ultimate losses depending on the state or region where the claim occurred. All of these factors contribute to the variability in estimating ultimate loss payments, especially since the effects of many of these variables cannot be directly quantified on a prospective basis.
Available-for-sale fixed income and equity securities are reported at their estimated fair value, with any unrealized gains and losses reported net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized appreciation or depreciation, net of any related tax effects, in other comprehensive income. Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method relating to investments acquired at other than par value.
The fair value of fixed maturity securities is based on market quotations provided to us by our third-party custodian who engages independent third party pricing sources that use valuation models. The valuation models used by the independent third party pricing sources use indicative information such as ratings, industry, coupon, and maturity along with publicly traded bond prices to determine security specific spreads, and the ultimate fair value of the non-publicly traded fixed maturity securities. Real estate is carried at the
lesser of historical cost, less accumulated depreciation or estimated fair value as determined by recent appraisals, offers from prospective independent third-party buyers, or the undiscounted future cash flows associated with the property. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
During the year ended December 31, 2005, there were no investment securities whose decline was deemed to be other than temporarily impaired.
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, 2005 and 2004, our recorded DDR reserves were $15.0 million and $14.0 million, respectively, which include a discount related to the present value calculation of approximately $5.7 million and $5.9 million, respectively.
We record any “windfall” 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.
Deferred policy acquisition costs, or DAC, are those costs that vary with and are primarily related to the production of new, or renewal, business and include such costs as commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Under GAAP, the premiums that will be earned in future periods, to which these deferred costs relate, must produce sufficient profits to offset the future expense that will be recognized from the amortization of the DAC, that is, the DAC must be recoverable. In evaluating the recoverability of DAC, we have made certain assumptions regarding the future amount and timing of costs associated with the business written, such as costs to maintain the policies and the ultimate projected loss and loss adjustment expense payments associated with these policies. In addition, we have considered future investment income, at an assumed 5.0% yield, in determining the recoverability of DAC. Based on our analysis as of December 31, 2005, the DAC carried on the Consolidated Balance Sheets, included elsewhere in this report, of $7.9 million, was deemed to be fully recoverable.
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 operating the insurance segments. 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, 2005, 2004 and 2003 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.
2005 Compared to 2004. The increase in net income for 2005 was the result of improved medical professional liability underwriting results,($13.2 million) our other insurance lines producing a small pre-tax profit in 2005 ($10.2 million) and the $28.0 million federal income tax benefit, which includes a $44.1 million benefit related to the reversal of the deferred tax asset valuation allowance. The underwriting results of our medical professional liability and other insurance lines segments are discussed in greater detail in the sections that follow.
The decrease in investment income for the year ended December 31, 2005 compared to the same period of 2004 was due to a variety of reasons. First, investment income in 2004 benefited from call premiums of approximately $1.5 million as a result of tender offers made by the issuer of bonds held in our portfolio. Also, we began to liquidate our high-yield bond portfolio late in the first quarter of 2004, and completed the disposition of all such bonds by the end of the third quarter of 2004. The proceeds from the liquidation of the high-yield bond portfolio were held in cash and cash equivalents, which was another factor contributing to the decrease in investment income from 2004 to 2005. We have maintained a large cash position in 2005 due to uncertainty regarding future changes in long-term interest rates. However, we anticipate that a substantial portion of our cash and cash equivalent resources will be redeployed into longer-term tax exempt securities sometime in 2006, which will reduce our future effective tax rate.
The change in fair value of certain investment securities that management has determined contain embedded derivative financial instruments is also included in investment income. As a result of fluctuations in interest rates, the estimated fair value of these securities decreased approximately $1.1 million during the year ended December 31, 2005 compared to decreases of $338,000 for the same period of 2004. These securities were sold in late 2005 and will have no impact on our reported investment income in future periods.
The net realized gain reported for the year ended December 31, 2005 was primarily the result of a one-time recovery of $2.7 million in cash related to securities that had been written-off in previous years. This amount was offset by approximately $700,000 of impairment charges and the subsequent realized loss related the sale of our last physician office building investment real estate property in 2005. We continue to own other development property located in East Lansing, Michigan. It is our intention to sell these properties over the next several years. We do not anticipate any losses related to the ultimate sales of the East Lansing properties.
In general, when evaluating or projecting our results of operations, management typically does not include realized gains or losses, as many of the factors that contribute to the generation of these gains and losses are beyond our control.
The decrease in general and administrative expenses from 2004 to 2005 was primarily the result of unusually high costs incurred in 2004 in connection with the Board of Directors’ exploration of strategic alternatives, as well as audit and other professional service fees incurred in connection with the initial assessment and opinions on the Company’s internal controls required under the Sarbanes-Oxley Act. We believe that general and administrative expenses incurred during 2005 are more representative of costs expected to be incurred in future periods.
Note 10 of the Notes to Condensed Consolidated Financial Statements, included elsewhere in this report, for further information regarding federal income taxes. Such cross-referenced information is incorporated herein by reference. We anticipate that our effective tax rate will be approximately 34% in future periods.
The decrease in investment expenses is primarily related to the liquidation of our high-yield portfolio during the first half of 2004 and the absence of depreciation for a portion of the 2004 year as a result of the sale of some of our physician office building investment real estate properties. The remaining office buildings were sold in 2005 and investment expenses for that year are more representative of what we anticipate incurring in future periods.
The increase in amortization expense during 2004 relates to an intangible asset arising from a two-year covenant not to compete with the Company’s former CEO and President upon his retirement effective December 31, 2003.
Other expenses for 2004 consist primarily of contract termination costs incurred in connection with the sub-lease of approximately 10,000 square feet of office space in Chicago, Illinois. Other expenses for 2003 were primarily related to employee separation costs as a result of terminations in connection with our exit from the workers’ compensation line of business.
We anticipate that medical professional liability direct premiums written will increase moderately in the future as the Company is granted additional rate increases by regulatory authorities. However, we do not expect that rate increases in 2006 will be as significant as those taken in recent years.
The decrease in loss and loss adjustment expenses and the loss ratio from 2004 to 2005 is primarily the result of our efforts over the last few years to re-underwrite risks in all markets combined with premium rate increases taken over the last several years. The re-underwriting efforts have resulted in a decrease in both the frequency and severity of reported and paid losses. As the trends of decreasing frequency and severity are now beginning to emerge in the loss data used to make actuarial projections of ultimate losses, we have adjusted downward our estimate of ultimate losses related to the 2004 and prior accident years by approximately $6.4 million. This favorable development was especially prevalent in our Ohio and Michigan markets. The adequacy of our reserves for unpaid loss and loss adjustment expenses is explained in greater depth under “- Financial Condition.”
2005 Compared to 2004. The direct premiums written for other insurance lines decreased during 2005 as we continued our exit from the workers’ compensation and health lines of business. As of June 30, 2005, all workers’ compensation and health policies had expired.
Incurred loss and loss adjustment expenses decreased primarily as a result of the decrease in exposure associated with the reduced number of covered lives in our health line, and the number of policies in-force for workers’ compensation. The decreases in prior year loss and loss adjustment expenses incurred were primarily the result of the stabilization of workers’ compensation reserves. Workers’ compensation is a long-tailed line of business, meaning that it may be several years from the date a claim is reported to us until the claim is ultimately settled. However, as claims age, the ultimate amount of exposure with regard to a claim often becomes more clear. As a result, volatility inherent in the actuarial projection of ultimate losses begins to stabilize, reducing the need to adjust loss reserves for previous accident years. There remain approximately 585 open workers’ compensation claims at December 31, 2005, down from 1,107 at December 31, 2004. We believe that the reserve for unpaid loss and loss adjustment expenses as of December 31, 2005 is adequate. However, due to the uncertainty inherent in such estimates, there can be no assurance that the ultimate cost of claims settlement will not exceed the reserves we have established, as future claims patterns may emerge differently than the assumptions utilized in our estimates.
2004 Compared to 2003. The direct premiums written for other insurance lines decreased during 2004 as we continued our exit from the workers’ compensation and health lines of business.
The decrease in underwriting expenses was primarily the result of reduced salary and employee benefit costs as a result of the departure of the other insurance management team in the last nine months of 2003, as well as a decrease in corporate and shared services salary, employee benefit and other costs allocated to the other insurance lines segment as a result of the decreased premium volume.
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets. We also enter into financing transactions from time to time to acquire additional capital. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, and the repurchase of APCapital stock.
In 2005, we repurchased 433,500 shares at a cost of $17.1 million, bringing the total number of shares purchased pursuant to these plans to 3,630,570, at a total cost of $77.4 million, or an average price per share of $21.33. In 2004, we did not repurchase any shares pursuant to this plan. Our repurchase of shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of December 31, 2005, there are approximately 410,000 shares of the November 2, 2005 stock repurchase program remaining to be purchased. We continually evaluate the benefits of repurchasing our shares.
Our net cash flow provided by operations was approximately $39.0 million for the year ended December 31, 2005, compared to $42.1 million provided by operations in 2004 and $9.5 million in 2003. Cash generated by operations principally consists of premiums received, net of reinsurance, in excess of net paid loss and loss adjustment expenses as shown in the table below.
Our statutory capital and surplus, which we refer to collectively as surplus, at December 31, 2005 was approximately $240.1 million. This results in a net premiums written to surplus ratio of .64:1 based on $153.7 million of net premiums written, which excludes PIC - FL surplus and net premiums written, as required by statutory reporting. Statutory surplus at December 31, 2004 was approximately $210.9 million, and our net premiums written to surplus ratio was .87:1. The Company’s Risk Based Capital and IRIS Ratios considered by regulators are more discussed under “Item 1. Business - Insurance Regulatory Matters.” Such cross referenced information is incorporated herein by reference.
The following table shows reported claim counts, open claim counts, the average net case reserve per open claim, and the average claim payment on claims that were closed with a payment for our medical professional liability segment at or for the years ended December 31, 2005, 2004 and 2003.
Activity in the liability for unpaid loss and loss adjustment expenses by insurance segment for the years ended December 31, 2004 and 2003 is included in Note 7 of the Notes to Consolidated Financial Statements included elsewhere in this report. Such cross-referenced information is incorporated herein by reference.
The following table shows the development of the net liability for unpaid loss and loss adjustment expenses from 1995 through 2004. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. The (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
During 2004, the Gerling Global Reinsurance Corporation (Gerling) commuted their reinsurance contracts with APCapital. The transaction produced a net loss of $4.4 million on prior years reserves as a result of APCapital reassuming Gerling’s obligation for loss and LAE in return for consideration which was discounted for the time value of money. For illustrative purposes, the following cumulative (deficiency)/redundancy amounts exclude the effect of prior year development due to the Gerling commutation:
In an effort to better explain the inherent uncertainty in our net loss and LAE reserves, we have developed a reasonable range of estimates around the net carried reserves. Our ranges in the table below were primarily established by reviewing the various actuarial methods, discussed under “- Critical Accounting Policies,” used to estimate net loss and LAE reserves.
The likelihood of reserves emerging differently than the carried reserves diminish as you approach the low and high end of the ranges. However it is meaningful to note the potential variability in the Company’s net income before the effect of income taxes if reserves develop to either the low or high end. The following table shows the effects on pre-tax net income if the carried reserves as of December 31, 2005 actually prove to be at the low or high end of the range:
Premiums receivable decreased $3.9 million, or 7.1%, to $50.7 million at December 31, 2005. This decrease is relatively consistent with the 9.6% decrease in medical professional liability direct premiums written.
Reinsurance recoverables increased $6.1 million, or 5.9%, to $109.4 million at December 31, 2005. Reinsurance recoverables, on a GAAP basis, represent reserves for unpaid losses and loss adjustment expenses ceded under the various reinsurance treaties we have in place, as well as receivables from reinsurers for loss payments we have made and are entitled to recover under the terms of the treaties. This increase is related to an increase in ceded IBNR as actuarial projections indicate an increase in the number and severity of losses above our retention levels under past and current reinsurance treaties.
Unearned premiums decreased $7.9 million, or 8.8%, to $82.1 million at December 31, 2005. The decrease is relatively consistent with the 9.6% decrease in medical professional liability direct premiums written from 2004 to 2005, as would be expected.
We are contractually obligated in accordance with various loan or borrowing agreements and operating leases. The following table shows the nature and the timing of our contractual obligations as of December 31, 2005:
The long-term debt is more fully described in Note 8 of the Notes to Consolidated Financial Statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Physicians Capital, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 3, 2006 expressed an unqualified opinion thereon.
In our opinion, the consolidated balance sheet as of December 31, 2004 and the related consolidated statements of income, statements of shareholders’ equity and comprehensive income and of cash flows for each of two years in the period ended December 31, 2004 (appearing in American Physicians Capital, Inc.’s 2005 Annual Report to Shareholders which has been incorporated by reference in this Form 10-K) present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and its subsidiaries at December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index under Item 15 (a)(1) and (2), present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. 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. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The most significant estimates that are susceptible to significant change in the near-term relate to the determination of the liability for unpaid losses and loss adjustment expenses, estimated fair value of investments, income taxes, reinsurance, the reserve for extended reporting period claims and the recoverability of deferred policy acquisition costs. Although considerable variability is inherent in these estimates, management believes that the current estimates are reasonable in all material respects. The estimates are reviewed regularly and adjusted as necessary. Adjustments related to changes in estimates are reflected in the Company’s results of operations in the period in which those estimates changed.
Medical professional liability coverage is written on both a claims-made and an occurrence basis. Claims-made policies cover claims reported during the year in which the policy is in effect. Occurrence-based policies cover claims arising out of events that have occurred during the year in which the policy was in effect, regardless of when they are reported. For each of the years in the three year period ended December 31, 2005, approximately 66.2%, 67.7% and 69.1% of the Company’s medical professional liability direct premiums written represented claims-made policies, with the remainder representing occurrence-based policies.
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 93.4%, 91.4% and 90.2% of the Company’s total medical professional liability direct premiums written during the years ended December 31, 2005, 2004 and 2003, respectively.
On a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. In 2005, the Company concluded that it had both the intent and ability to hold a significant portion of the Company’s fixed-income securities to maturity. Accordingly, the Company transferred fixed-income securities, with an estimated fair value of approximately $398.3 million at the date of transfer, from the available-for-sale category to the held-to-maturity category. The remainder of the Company’s fixed-income security portfolio, as well as its equity securities held for investment, remain in the available-for sale category.
Available-for-sale fixed income and equity securities are carried at their estimated fair value, with any unrealized gains and losses reported, net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized appreciation or depreciation, net of any related tax effects, in other comprehensive income.
Equity securities are carried at market values, determined by management and based on the securities’ estimated liquidation value. Fair values of fixed income securities are determined on the basis of dealer or market quotations, or comparable securities on which quotations are available.
The Company offers quarterly and monthly payment plans for policies with an annual term. Accordingly, premiums receivable include $47.7 million at December 31, 2005 and $50.5 million at December 31, 2004 of premium installments. Receivable balances consist principally of written premiums from physicians in the states of Michigan, Ohio, Illinois and New Mexico. Payment plans are designed so that credit risk associated with receivables is generally offset by the liability for unearned premiums. However, an allowance for doubtful accounts of approximately $75,000 and $205,000 at December 31, 2005 and 2004, respectively, has been established and is included in the premium receivable balance, primarily for receivable balances that may not be collectable and have no associated unearned premiums.
Insurance premium income is generally 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.
The Company assesses the likelihood that deferred tax assets will be realized based on the availability of future taxable income in the periods when the deferred tax assets are expected to be deducted in the Company’s tax return. If it is deemed that it is more likely than not that all, or a portion, of the Company’s deferred tax assets will not be realized, then a valuation allowance is established for the portion of the deferred tax assets that are deemed not likely to realized.
valuation allowance in the second quarter. The reversal of the entire valuation allowance was credited to federal income tax benefit, with the exception of the valuation allowance associated with certain deferred tax assets relating to stock-based compensation. The reversal of the valuation allowance pertaining to this “incremental tax benefit” of stock-based compensation was credited directly to additional paid-in-capital and did not affect net income for these periods.
As the Company was in a net loss position for the year ended December 31, 2003, no effect of options or other stock awards was calculated as the impact would be anti-dilutive.
See Note 16 for further information regarding the Company’s stock-based compensation plans and the methods and assumptions used to value employee stock-based awards.
Minority interests on the accompanying Consolidated Balance Sheets and Income Statements represents the 51% ownership interest of other investors in PIC-FL. PIC-FL is included in the Company’s Consolidated Financial Statements as it has been determined to be a variable interest entity and the Company’s subsidiary, American Physicians, has been determined to be the primary beneficiary in accordance with the guidance given in FASB Interpretation (“FIN”) No. 46R, “Consolidation of Variable Interest Entities.”
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 154, “Accounting Changes and Error Corrections, a replacement of Accounting Principles Board Opinion (APB) No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.” This Statement requires retrospective application to prior periods’ financial statements of a change in accounting principle. It applies both to voluntary changes and to changes required by an accounting pronouncement if the pronouncement does not include specific transition provisions. APB 20 previously required that most voluntary changes in accounting principles be recognized by recording the cumulative effect of a change in accounting principle. SFAS 154 is effective for fiscal years beginning after December 15, 2005. The adoption is not expected to have a material effect on the financial statements.
SFAS No. 130, “Reporting Comprehensive Income”, requires unrealized gains or losses on the Company’s available-for-sale investment securities arising during the period and the amortization of unrealized gains and losses on the Company’s held-to-maturity securities at the date of transfer to be included in other comprehensive income, net of tax. Adjustments must be made to other comprehensive income to avoid double counting in comprehensive income items that are included in net income that have also been included in other comprehensive income in that period or previous periods. Realized gains and losses, net of tax, related to the Company’s available-for-sale investment securities are included in net income of the period in which
The composition of the Company’s available-for-sale investment security portfolio, including unrealized gains and losses at December 31, 2005 and 2004 was:
At December 31, 2004, unrealized gains and losses for available-for-sale securities include $340,000 and ($246,000), respectively, of gains and losses related to securities that contain an embedded derivative instrument. These securities were sold during 2005.
In 2005, a portion of the Company’s fixed-income securities were transferred from the available-for-sale category to the held-to-maturity category. 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, 2005. The carrying value at December 31, 2005 includes approximately $4.9 million of unrealized gains, which are included in the accompanying Consolidated Balance Sheets as a component of accumulated other comprehensive income.
Those securities in the table above that are in an unrealized or unrecognized loss position at December 31, 2005 were determined to be in that position primarily as a result of changes in prevailing interest rates. Based on the Company’s ability and intent to hold these securities until their maturity, or for a sufficient period of time to allow for the recovery of the securities market value, their decline in market value is deemed to be temporary in nature.
Note that the table above excludes approximately ($246,000) of unrealized loss related to derivative securities. These losses have been excluded as any changes in the fair value of the related securities is already included in income. See Note 1 - “Derivative Financial Instruments.”
The components of pretax investment income and net realized gains for the years ended December 31, 2005, 2004 and 2003 were:
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. For the years ended December 31, 2005 and 2004, the Company received one-time call premiums of $283,000 and $1.5 million, respectively.
In 2004, the Company determined that the capitalized deferred acquisition costs associated with the other insurance lines segment were not recoverable and accordingly wrote-off $300,000 of capitalized costs. No additional costs associated with this segment were capitalized in 2005.
Depreciation expense associated with property and equipment for the years ended December 31, 2005, 2004 and 2003 was $1.7 million, $1.9 million, and $2.0 million, respectively.
The unfavorable development in 2003 was primarily related to the Company’s Ohio ($16.4 million), Florida ($16.0 million) and Kentucky ($15.0 million) markets, partially offset by positive development in the Michigan market. The Company announced its exit from the Florida market in 2002 and also discontinued writing occurrence-based policies in the Ohio and Kentucky markets in 2002.
Management believes that the estimate of the ultimate liability for unpaid losses and loss adjustment expenses at December 31, 2005 is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Company’s actual incurred loss and loss adjustment expenses will not conform to the assumptions inherent in the estimation of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying Consolidated Balance Sheets.
May 2008, the interest rate shall not exceed 12.50%. The weighted average interest rates of 7.43% (Trust I issuance) and 7.53% (Trust II issuance) resulted in interest expense of approximately $2.3 million and $1.7 million for the years ended December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, accrued interest payable to the trusts was approximately $298,000 and $224,000, 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.
Losses and loss adjustment expenses incurred are net of ceded losses of $20.5 million for 2005, $29.8 million for 2004, and $33.5 million for 2003.
In 2003, as a result of its assessment of the realizability of its deferred tax assets, the Company recorded a full valuation allowance against its net deferred tax asset. However, in 2005, after several consecutive quarters of pre-tax income, the Company concluded that deferred tax asset valuation allowance was no longer necessary. Accordingly, the Company reversed the entire valuation allowance balance in 2005. See Note 1 for further information regarding the accounting for the establishment, changes in, and reversal of the deferred tax valuation allowance.
At December 31, 2005, the Company had the following net operating loss carryforwards:
American Physicians merged with New Mexico Physicians Mutual Liability Company and State Mutual Insurance Company in 1997. As a result, the net operating losses acquired in these mergers are subject to certain change in control limitations.
There are no limitations on the annual use of net operating losses related to the tax year ended December 31,2003.
In addition, at December 31, 2005, the Company had approximately $8.8 million of minimum tax credits which can be carried forward indefinitely.
In September 2003, the Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. On November 2, 2005, the Board of Directors authorized the purchase of an additional five percent of the Company’s outstanding common shares, or 425,000 shares, bringing the total number of shares authorized to be repurchased under publicly announced plans to 4,040,439.
Activity in the liability for contract termination costs for the years ended December 31, 2005 and 2004 was as follows:
years. Commission expense incurred related to SCW approximated $4.8 million, $5.8 million, and $6.0 million in 2005, 2004 and 2003, respectively.
At December 31, 2003, the Company had a $286,000 non-interest bearing note receivable from SCW. At December 31, 2003, the Company had established an allowance in the full amount of the note, which resulted in a charge to income in 2003. As part of the new master agency agreement between American Physicians and SCW, which was effective January 1, 2004, this note was forgiven in exchange for certain more favorable contract terms.
The number of stock option awards outstanding and exercisable at December 31, 2005 by range exercise prices was as follows:
In 2005, 2004 and 2003, the Company recognized a tax benefit of $1,095,000, $1,775,000 and $261,000, respectively, related to the incremental tax benefit of restricted stock that vested during the year and stock options that were exercised during the year. This incremental tax benefit was credited to additional paid-in-capital.
Basic and diluted earnings (loss) per share are calculated in accordance with SFAS Statement No. 128, “Earnings per Share.”
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2005, 2004 and 2003:
As the Company was in a net loss position for the year ended December 31, 2003, the effect of options or other stock-based awards was not calculated as they would have been anti-dilutive.
The Company participates in various guaranty associations in the states in which it writes business, which protect policyholders and claimants against losses due to insolvency of insurers. When an insolvency occurs, the associations are authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar years. The Company accrues for its portion of assessments in accordance with American Institute of Certified Public Accountants’ Statement of Position 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments.” Assessments to date are not significant; however, the ultimate liability for future assessments is not known. Accordingly, the Company is unable to predict whether such future assessments will materially affect the financial condition or results of operations of the Company. At December 31, 2005 and 2004, the Company had a recorded liability of $100,000 and $392,000, respectively, for amounts assessed by state guarantee associations, as well as the Company’s estimate of its share of any insolvencies not yet assessed.
The Company was not subject to any litigation at December 31, 2005 other than routine litigation in the ordinary course of the Company’s business. Management does not expect these cases to have a material adverse effect on the Company’s financial condition or results of operations.
The following is statutory surplus at December 31, 2005, 2004, and 2003 and statutory net income (loss) for the years then ended.
Effective March 31, 2004, ownership of APSpecialty was transferred from the holding company, APCapital, to American Physicians as a surplus contibution. The amount of statutory surplus reflected at December 31, 2005 and 2004 does not include APSpecialty’s surplus as it is already recorded by American Physicians.
The accounting policies of the segments are consistent with those described in the basis of presentation. The premiums and loss and loss adjustment expenses of each segment are specific to the various insurance lines. Estimates for underwriting and other expenses are based primarily on the written or earned premium associated with the segment. Investment income, investment expenses and other items of income or expense are allocated to the segments based on that segment’s “ownership” percentage of the assets or liabilities underlying the income or expense. General and administrative expenses are all attributed to the holding company and are included in corporate and other. Restructuring expenses and exit costs are allocated to the segments based on the nature of the cost.
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:
American Physicians Capital Statutory Trust I - a trust formed in Connecticut for the purpose of issuing mandatorily redeemable trust preferred securities to institutional investors (Note 8).
Effective January 24, 2005, APCapital’s wholly-owned subsidiaries, APConsulting LLC and APDirectSales, LLC, were dissolved.