The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Any written or oral statements made by or on behalf of FPIC may include forward-looking statements, which reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other factors include, but are not limited to:
• Uncertainties relating to government and regulatory policies (such as subjecting FPIC to insurance regulation or taxation in additional jurisdictions or amending, revoking or enacting any laws, regulations or treaties affecting our current operations);
• The occurrence of insured or reinsured events with a frequency or severity exceeding our estimates;
• Legal developments, including claims for extra-contractual obligations or in excess of policy limits in connection with the administration of insurance claims;
• Developments in global financial markets that could affect our investment portfolio and financing plans;
• Developments in reinsurance markets that could affect our reinsurance programs;
• The impact of mergers and acquisitions, including the ability to successfully integrate acquired businesses and achieve cost savings, competing demands for our capital and the risk of undisclosed liabilities;
• Risk factors associated with financing and refinancing, including the willingness of credit institutions to provide financing and the availability of credit generally;
• The loss of the services of any of our executive officers;
Our discussion and analysis of financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to income taxes, loss and loss adjustment expense (“LAE”) reserves, contingencies and litigation.
We believe the following critical accounting policies affect our more significant judgments and estimates used in preparation of the consolidated financial statements:
Goodwill and Intangible Assets. We have made acquisitions in the past that included significant amounts of goodwill and other intangible assets. Under GAAP in effect through December 31, 2001, we amortized these assets with charges to income over their estimated useful lives, and tested them periodically to determine if they were recoverable from operating earnings on the basis of an estimate of undiscounted cash flows over their useful lives.
Loss and Loss Adjustment Expenses. We estimate our liability for losses and LAE (“loss and LAE reserves”) using actuarial techniques and projections of the amounts of ultimate losses and LAE for each period. We also integrate other quantitative and qualitative analyses of conditions into our actuarial analysis that we expect to affect the future development of claims and related expenses. Our loss and LAE reserves comprise the largest liability and most significant estimate or compilation of estimates in our financial statements. Furthermore, our loss and LAE reserves are subject to significant inherent uncertainties and so there can be no assurance as to whether the actual results will be higher or lower than these estimates. Any adjustments or changes for such differences will almost certainly be material, especially to our operating results for a period. As our loss and LAE reserves are re-estimated, changes to those estimates and our carried reserves, if any, are recognized as a charge or credit to income, as the case may be, in the financial statements for the most recent period presented.
For the purposes of setting aside reserves on risks insured during the most recent year, including interim periods, for which very little experience is present, forecasted loss ratios were applied to earned premiums during the interim periods. The forecasted loss ratios were judgmentally determined taking into account the results of the most recent actuarial studies performed, current pricing and underwriting, expected loss and LAE trends and other pertinent considerations. In addition, we monitored and analyzed key loss and LAE indicators and trends throughout the year. These included paid losses, newly reported claims and incidents, closed claim activity and other metrics. These indicators were taken into account in assessing the reasonableness of our loss reserve estimates throughout the year and the forecasted loss and LAE ratios applied during each interim period.
Management fees of the reciprocal management segment, determined as a percentage of PRI’s premiums, are recognized as billed and earned under the contract, which generally corresponds with the reported premiums written of PRI, net of an estimate for premium refunds, for the calendar year. Such management fees are estimated, billed and earned for quarterly reporting purposes based upon semi-annual estimates of the reported premiums written of PRI rather than actual written premiums for a quarter, which may vary significantly from quarter to quarter. This convention is used so that management fees are recognized more ratably over the period in relation to the services provided by the reciprocal management segment to PRI.
FPIC Insurance Group, Inc. (“FPIC”) was formed in 1996 through a reorganization (the “Reorganization”) in which it became the parent company of Florida Physicians Insurance Company, Inc. (“Florida Physicians”) and McCreary Corporation (“McCreary”), a third party administrator. Under the Reorganization, Florida Physicians shareholders became the shareholders of FPIC and received five shares of FPIC common stock for each share of Florida Physicians common stock. In May 2001, we changed the name of Florida Physicians to First Professionals Insurance Company, Inc. (“First Professionals”). In January 2002, McCreary was merged into its subsidiary, Employers Mutual, Inc. (“EMI”), with EMI continuing as the surviving entity.
Overview: Twelve Months Ended December 31, 2002 Compared to Twelve Months Ended December 31, 2001
For the year ended December 31, 2002, we reported a net loss of ($14.7) million, or ($1.56) per diluted share, compared to net income of $2.9 million, or $0.31 per diluted share, for the year ended December 31, 2001. Our net loss for 2002 includes a $29.6 million after-tax charge for the cumulative effect of accounting change related to the adoption of FAS 142 on goodwill and other intangible assets ($48.4 million pre-tax). The transitional impairment charges, resulting from the adoption of FAS 142, were associated entirely with our non-insurance segments. Our income before the cumulative effect of accounting change was $14.9 million, or $1.58 per diluted share, for the year ended December 31, 2002.
Our total revenues for the year ended December 31, 2002 increased 12% to $220.9 million from $197.6 million for the year ended December 31, 2001. The increase in revenues is primarily the result of price improvements on our core MPL business and growth in the number of policyholders. Net premiums earned on our MPL business increased 23% to $148.6 million for the year ended December 31, 2002 from $120.5 million for the year ended December 31, 2001. Revenues earned by our reciprocal management segment increased $2.4 million primarily as the result of an increase in claims administration and management fees earned. In addition, brokerage commissions earned by FPIC Intermediaries, Inc. (“Intermediaries”) also increased when compared with the prior year.
Income before income taxes and cumulative effect of accounting change 23,710
Overview: Twelve Months Ended December 31, 2001 Compared to Twelve Months Ended December 31, 2000
Net income for the year ended December 31, 2001, totaled $2.9 million, or $0.31 per diluted share, compared with net income of $0.6 million, or $0.06 per diluted share, for the year ended December 31, 2000. The 2001 results include the after-tax effects of $5.4 million for an adjustment made to increase reserves on prior years’ business and $0.4 million in restructuring charges associated with our TPA operations. Improved pricing and growth in policyholders during 2001 generated significant top-line growth.
Total expenses for the year ended December 31, 2001 increased 6%, to $196.5 million, from $185.1 million for the year ended December 31, 2000. Net losses and LAE incurred for the year ended December 31, 2001 increased $5.6 million or 5%, over the prior year. Excluding the prior year portions of pre-tax reserve charges in 2001 and 2000 of $8.6 million and $6.5 million, respectively, net losses and LAE incurred increased $3.5 million, or 3% during the year 2001. The increase reflects growth and the continuation of our policy to maintain our reserves at a conservative level. Other underwriting expenses also contributed to the increase in total expenses, primarily as a result of enhancements made to our financial and reporting systems and an increase in operating expenses related to growth in business. Offsetting the increases in expenses was a reduction in the allowance for bad debts of $1.0 million.
Direct and assumed premiums written increased 24% to $245.4 million for the year ended December 31, 2001 from $197.3 million for the year ended December 31, 2000. Excluding the effects of the non-recurring portion of assumed premiums under the 100% quota share reinsurance agreement written in the first quarter of 2000 between our insurance subsidiaries and PRI and the effects of the decline in premiums written under A&H programs of $16.7 million, direct and assumed premiums written increased approximately $99 million or 71%. The increase in direct and assumed premiums written is due to the effect of rate increases and growth in new business in our core MPL lines, and growth in premiums written under fronting arrangements. The growth in direct premiums written was partially offset by declines in other MPL assumed premiums written. Under the 100% quota share reinsurance agreement with PRI, we assumed the death, disability and retirement (“DD&R”) risks under PRI’s claims-made insurance policies and recognized assumed premiums written, net of a deferred credit, of approximately $34 million.
Net premiums earned increased 9% to $131.1 million for the year ended December 31, 2001 from $120.5 million for the year ended December 31, 2000. The increase in net premiums earned is less than the increase in direct and assumed premiums written for the same period primarily due to the inherent lag between written and earned premiums. In addition, as noted above, direct premiums written include premiums written under fronting agreements for which a relatively small portion of business is retained and therefore only a small portion of premium is ultimately earned. The increase in net premiums earned is due to growth in the number of policyholders and the effects of rate increases instituted by our insurance subsidiaries during 2001. Partially offsetting this increase was a decline in A&H premiums earned of 70%, to $7.2 million for the year ended December 31, 2001, from $24.1 million for the year ended December 31, 2000.
Net investment income declined 14% to $19.7 million for the year ended December 31, 2002 from $22.9 million for the year ended December 31, 2001. The decline in net investment income is primarily due to lower prevailing interest rates and reduced yields on fixed income investments, beginning in the second half of 2001. We also continued to hold significant funds in short-term invested cash in anticipation of possible improvements in fixed income rates rather than committing those funds to longer-term investments at historically low yields. On a consolidated basis, our total cash and investments grew to $538.7 million in 2002, up $96.7 million or 22% from $442.0 million in 2001. Once again, the effects of historically low yields have been offset at least to some extent by growth in cash and invested assets.
Net investment income decreased 6% to $22.9 million for the year ended December 31, 2001 from $24.3 million for the year ended December 31, 2000. The decrease in net investment income is primarily due to lower prevailing interest rates in fixed income securities. The effects of lower yields were offset to some degree by growth in cash and invested assets resulting from growth in insurance premiums. On a consolidated basis, our total cash and investments grew to $ 442.0 million in 2001, up $18.0 million or 4%, from $424.0 million in 2000.
Net realized investment gains increased 420% to $1.4 million for the year ended December 31, 2001 from $0.3 million for the year ended December 31, 2000. We engaged new professional investment managers during 2001 as part of our overall investment strategy. While our investment strategy remains focused on high quality, fixed income securities, some changes have been made in our asset allocations among these types of securities to take advantage of changing market conditions. The increase in net realized investment gains coincides with the liquidation of investments associated with repositioning our investment portfolio.
Finance charges and other income increased 71% to $1.3 million for the year ended December 31, 2002 from $0.7 million for the year ended December 31, 2001. The increase in finance charges and other income is primarily the result of the sale of the renewal rights on Interlex’s legal professional liability business, whereby we realized income in the amount of $0.4 million.
Finance charges and other income decreased 52% to $0.7 million for the year ended December 31, 2001 from $1.5 million for the year ended December 31, 2000. The decline in finance charges and other income is due to our decision to include a provision for finance charges within our Florida MPL policy premiums, rather than assessing finance charges separately.
The loss and LAE reserves represent our best estimate of the ultimate cost of all losses incurred but unpaid and considers prior loss experience, loss trends, our loss retention levels and the expected frequency and severity of claims. The process of establishing reserves for property and casualty claims is a complex and uncertain process, requiring the use of informed estimates and judgments. Our estimates and judgments may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as the current legal environment affecting the settlement of our liability claims changes. Any such changes could result in future revisions in the estimates of losses or reinsurance recoverables, and would be reflected in our results of operations for the most recent period being reported coinciding with when the change occurs. We believe our reserves for losses and LAE are adequate; however, given the inherent uncertainty in reserve estimates, there can be no assurance that the ultimate amount of actual losses will not exceed the related amounts currently estimated. Furthermore, any such difference, either positive or negative, could have a material effect on our results of operations and financial position.
Other underwriting expenses decreased 26% to $19.2 million for the year ended December 31, 2002 from $25.9 million for the year ended December 31, 2001. The decline in other underwriting expenses is attributable to ceding commissions recognized under the terms of the finite quota share reinsurance agreement with Hannover Re in the amount of $13.2 million. In addition, First Professionals, our largest insurance subsidiary, performed a study of its 2001 expenses incurred in the administration of claims and based on the results of this study, decreased the amount of expenses allocated to LAE in 2002.
Claims administration and management fees increased 6% to $24.3 million for the year ended December 31, 2002, from $23.0 million for the year ended December 31, 2001. The claims administration and management fees earned by AFP are comprised entirely of management fees from PRI and the increase is due to the growth in premiums written by PRI.
Other income decreased 79% to $0.1 million for the year ended December 31, 2002 from $0.4 million for the year ended December 31, 2001. Effective January 1, 2002, AFP and PRI amended the management agreement, including the elimination of the sharing by AFP of 10% of PRI’s statutory net income or loss, which accounts for the decline in other income. The amendment was approved by the New York State Insurance Department.
Other income decreased 76% to $0.4 million for the year ended December 31, 2001 from $1.7 million for the year ended December 31, 2000. The decrease in other income is the result of lower statutory net income at PRI compared to the year 2000. The income received by AFP related to PRI’s statutory net income for the years ended December 31, 2001 and 2000 was $0.3 million and $1.6 million, respectively. In accordance with the management agreement between AFP and PRI, through 2001, AFP received or paid an amount equal to 10% of PRI’s statutory net income or loss.
Interest expense increased to $0.2 million for the year ended December 31, 2002. The increase in interest expense is the result of the 2002 amendment to the management agreement between AFP and PRI. In accordance with the amended agreement, AFP has agreed to pay 6% annual interest on the 10% profit share amounts already earned and collected under the original agreement for 1999, 2000 and 2001, while those years remain open for possible future re-determination and adjustment, if any.
Claims administration and management fees declined 3% to $12.5 million for the year ended December 31, 2001 from $13.0 million for the year ended December 31, 2000. The decline in claims administration and management fees is due to the termination of certain non-profitable contracts at our Albuquerque division. Excluding the effect of the terminated contracts, claims administration and management fees increased $1.1 million for the year ended December 31, 2001, as compared to the same period in 2000.
Claims administration and management expenses decreased 6% to $14.0 million for the year ended December 31, 2002 from $14.8 million for the year ended December 31, 2001. The decline in claims administration and management expenses is due to the disposition of our Albuquerque division. Excluding the effect of the Albuquerque TPA division, claims administration and management expenses increased $2.3 million for the year ended December 31, 2002, when compared with the year ended December 31, 2001. The increase in claims administration and management expenses is due to additional expenses incurred as the result of new business.
For the year ended December 31, 2001, other expenses decreased 28%, to $1.3 million from $1.8 million for the year ended December 31, 2000. Excluding the restructuring charges taken during the fourth quarter of 2001 and 2000 mentioned below, other expenses declined 46%, to $0.7 million for the year ended December 31, 2001, from $1.3 million for the year ended December 31, 2000. The decrease in other expenses represents savings from our disposition of non-core businesses during 2000.
During the fourth quarter 2001, we incurred a pre-tax charge of approximately $0.6 million in connection with the disposition of BSI. Under the plan, we sold the division’s assets and cancelled its service agreements with self-insured customers. Certain other contracts were retained and are serviced by our Jacksonville, Florida, division. The 2001 restructuring activity was a continuation of our consolidation of the TPA operations and concluded the restructuring activities of the Albuquerque division that began during 2000. We incurred a pre-tax charge of $0.5 million in 2000 related to this now disposed of division. Excluding the effects of the restructuring charges, the TPA segment incurred a net loss of approximately $0.2 million and $0.5 million for the years 2001 and 2000, respectively.
Management’s Discussion & Analysis of Financial Position: December 31, 2002 Compared to December 31, 2001
Premiums receivable increased 48% to $108.5 million as of December 30, 2002 from $73.4 million as of December 31, 2001. Approximately $28.3 million of the increase in premiums receivable is associated with growth in premiums written on our core MPL insurance business. Approximately $6.7 million of the increase in premiums receivable is associated with growth in premiums written under fronting arrangements for workers’ compensation business.
Due from reinsurers on unpaid losses and advance premiums increased 109% to $168.2 million as of December 31, 2002 from $80.4 million as of December 31, 2001. Approximately $38.8 million of the increase is associated with reserves ceded under the finite reinsurance agreement with Hannover Re. The remaining increase in due from reinsurers on unpaid losses and advance premiums is primarily the result of the increase in the underlying reserves ceded to other insurance carriers under reinsurance arrangements associated with growth in our core MPL insurance business.
Ceded unearned premiums increased 93% to $78.9 million as of December 31, 2002 from $40.8 million as of December 31, 2001. Approximately $37.4 million of the increase is associated with the unearned premiums ceded under the finite reinsurance agreement with Hannover Re.
On August 2, 2002, Gerling Global Reinsurance Corporation of America (“Gerling”), one of our reinsurers, had its financial strength rating lowered by A.M. Best from A- (Excellent) to B+ (Very Good). On December 20, 2002, Gerling’s A.M. Best rating was further downgraded to B- (Fair). These rating actions by A.M. Best followed an announcement by Gerling of its intention to exit the U.S. non-life reinsurance market. Since then, Gerling has essentially placed itself in voluntary run-off with respect to its U.S. non-life reinsurance business and A.M. Best has withdrawn Gerling’s financial strength rating and replaced it with the designation “NR-3,” which means that A.M. Best’s rating methodology no longer applies. Gerling has participated in our excess of loss reinsurance programs in 2000 at 15%, and in 2001 and 2002 at 20%. Gerling has also provided facultative reinsurance coverage for non-standard risks. We replaced Gerling’s participation in our reinsurance programs, effective with our renewal, as of January 1, 2003. As of December 31, 2002, the estimated amount of net reinsurance recoverables from Gerling was approximately $13 million, comprised of the gross recoverables from Gerling, less reinsurance payables to Gerling of approximately $4 million. Gerling is an authorized reinsurer in our markets; therefore, we do not hold collateral for these reinsurance recoverables.
The loss and LAE reserves represent our best estimate of the ultimate cost of all losses incurred but unpaid and considers prior loss experience, loss trends, our loss retention levels and the expected frequency and severity of claims. The process of establishing reserves for property and casualty claims is a complex and uncertain process, requiring the use of informed estimates and judgments. Our estimates and judgments may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as the current legal environment affecting the settlement of our liability claims changes. Any such changes could result in future revisions in the estimates of losses or reinsurance recoverables, and would be reflected in our results of operations for the most recent period being reported coinciding with when the change occurs. We believe our liability for losses and LAE is adequate; however, given the inherent uncertainty in reserve estimates, there can be no assurance that the ultimate amount of actual losses will not exceed the related amounts currently estimated. Furthermore, any such difference, either positive or negative, could have a material effect on our results of operations and financial position.
Reinsurance payable increased 261% to $96.5 million as of December 31, 2002 from $26.7 million as of December 31, 2001. Approximately $60.2 million of the increase is the result of funds withheld under the terms of the finite reinsurance agreement with Hannover Re. The remaining increase in reinsurance payable is primarily the result of an increase in MPL premiums written.
Paid in advance and unprocessed premiums increased 41% to $14.1 million as of December 31, 2002 from $9.9 million as of December 31, 2001. The increase in paid in advance and unprocessed premiums is primarily the result of growth in our core MPL book of business.
ii) Unexpected changes in the amounts needed to defend and settle claims;
iv) Failure of one or more of our reinsurers leading to uncollectible reinsurance recoverables;
Furthermore, liquidity and capital risks can come about as the result of the broader business and financial risks facing us including the uncertainties and factors disclosed in the Safe Harbor Disclosure. Many, if not most of these types of uncertainties, could have a corresponding and materially negative affect on our liquidity and capital resources, as well as our financial condition and results of operations. In order to compensate for such risk, we:
As of December 31, 2002, we had an outstanding principal balance of $47.2 million under a senior credit facility with five banks. The senior credit facility is comprised of (i) a $37.5 million revolving credit facility (with a $15 million letter of credit sub-facility), which matures on August 31, 2004, and (ii) a $10.2 million term loan facility, repayable in quarterly installments of approximately $1.5 million. We have also deposited $3.0 million (of which, $1.0 million was deposited in January 2003) as collateral under the terms of the credit facility, and are required to either pre-pay principal or make additional collateral deposits of $0.35 million quarterly in 2003. The credit facility also requires that we pre-pay principal or make additional collateral deposits of approximately $1.3 million each at March 31 and June 30, 2004. Amounts outstanding under the credit facility bear interest at a variable rate, primarily based upon LIBOR plus a current margin of 3.0 percentage points, which may be reduced to a minimum of 2.75 percentage points as we reduce our outstanding indebtedness. In connection with our credit facility, we also entered into two-interest rate swap agreements (the “swap agreements”). We use the swap agreements to minimize fluctuations in cash flows caused by interest rate volatility and to effectively convert all of our floating-rate debt to fixed-rate debt.
We are not required to maintain compensating balances in connection with our credit facility but we are charged a fee on the unused portion, which ranges from 30 to 40 basis points. Under the terms of the credit facility, we are required to meet certain financial and non-financial covenants. Significant covenants are as follows:
Should we fail to meet one or more of our loan covenants, such occurrence would be considered an event of default. If we were unable to provide an acceptable resolution for an event of default, our lenders would have the right to demand immediate repayment in full. Although we have consolidated cash and investments on hand and net cash flows from operating activities in excess of our outstanding debt, as explained further below, most of these funds are held and generated by our insurance subsidiaries, which are subject to regulatory requirements to maintain capital and surplus and dividend restrictions. Therefore, the majority of these funds are not available to the holding company. So, if repayment of our loans were accelerated, FPIC may not have sufficient liquidity from immediately available operating funds. In the case of a significant acceleration or demand for repayment in full, we may be required to secure replacement financing, raise additional capital, restructure our operations or sell assets, or a combination of these, in order to raise the funds necessary to repay our loans. Any such circumstances would likely have a material detrimental impact on our results of operations and financial condition.
On October 23, 2002, A.M. Best announced its decision to change our insurance group rating from A- (Excellent) with a negative outlook to B++ (Very Good) with a stable outlook. As a result of the rating change, we were temporarily in non-compliance with the credit facility. As a result of such non-compliance, we negotiated an amendment to the credit facility with our lenders. The terms and conditions of the credit facility described above reflect this amendment.
Shareholder dividends available from our insurance subsidiaries are subject to certain limitations imposed by Florida and Missouri laws. During 2003, these subsidiaries are permitted, within insurance regulatory guidelines, to pay dividends of approximately $12.5 million without prior regulatory approval.
In June 2002, the Financial Accounting Standards Board (“FASB”) issued FAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” FAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities. It requires that the cost associated with an exit or disposal activity be recognized when the liability is incurred, not necessarily at the date of an entity’s commitment to an exit plan. As a result, some costs relating to the disposition may be deferred until later periods when they are incurred. The provisions of FAS 146 are effective for exit or disposal activities initiated after December 31, 2002. Accordingly, we will adopt this statement for applicable transactions occurring on or after January 1, 2003.
In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 expands existing accounting guidance and disclosure requirements for certain guarantees and requires the recognition of a liability for the fair value of certain types of guarantees issued or modified after December 31, 2002. We do not believe that the adoption of FIN 45‘s guidance will have a material effect on our financial position.
In our opinion, the accompanying consolidated statements of financial position and the related consolidated statements of (loss) income and comprehensive (loss) income, changes in shareholders’ equity and cash flows, present fairly, in all material respects, the financial position of FPIC Insurance Group, Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the accompanying financial statement schedules present fairly, in all material respects, the information set forth therein, as of and for the years ended December 31, 2002 and 2001, when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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.
As discussed in Notes 2 and 10 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill following adoption of Statement of Financial Accounting Standard No. 142 “Goodwill and Other Intangible Assets.”
Cumulative effect of accounting change, net of deferred tax benefit 29,578
Purchase of property and equipment (1,876 ) (2,527 ) (1,931 )
Net cash (used in) provided by investing activities (81,362 ) 37,182
Net cash (used in) provided by financing activities (5,395 ) (14,171 )
• Specializes in professional liability insurance products and related risk management services for physicians, dentists, and other healthcare providers.
• Medical professional liability (“MPL”) and legal professional liability (“LPL”) insurance is primarily written in Florida and Missouri. FPIC is also licensed to write insurance in Alabama, Arizona, Arkansas, Delaware, Georgia, Illinois, Indiana, Kansas, Kentucky, Maine, Maryland, Michigan, Minnesota, Mississippi, Montana, Nevada, North Carolina, Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, Texas, Utah, Virginia, Washington and West Virginia.
(1) FPIC, the holding company, is also grouped within the insurance segment.
Reciprocal Management • Provides management, administrative and brokerage services to Physicians’ Reciprocal Insurers (“PRI”), a professional liability insurance reciprocal that conducts business in the state of New York. (PRI is not a subsidiary of FPIC.) Reciprocal Management also provides reinsurance brokerage and administrative services to FPIC.
• Professional Medical Administrators, LLC (“PMA”) (70% owned by FPIC as of December 31, 2002; Effective January 1, 2003, FPIC has an 80% ownership interest in PMA.)
Credit Risk is the risk that issuers of securities owned by FPIC will default, or other parties, primarily our insureds and reinsurers that owe FPIC money, will not pay. Financial instruments that potentially expose FPIC to concentrations of credit risk consist of fixed maturity investments, premiums receivable, deposits with reinsurers, and assets carried for reinsurance recoverable related to unpaid losses and LAE and unearned premiums. Reinsurers that are neither authorized nor accredited by applicable state insurance departments (“unauthorized reinsurers”) are required to provide collateral in the form of an irrevocable letter of credit or investment securities held in a trust account to collateralize their respective balances due to FPIC. We have not experienced significant credit-related losses.
Basis of Presentation. The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). These financial statements include the accounts of FPIC and all of our wholly owned and majority owned subsidiaries. Certain other entities in which FPIC has a significant investment are reported on the equity basis. Intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates. Management is responsible for making estimates in the preparation of FPIC’s financial statements. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The estimates most susceptible to change are those used in determining the liability for losses and loss adjustment expenses (“LAE”). Although these estimates can vary, we believe that the liability for losses and LAE is adequate. However, there can be no assurance that the estimated amounts will not differ from actual results.
Income on investments includes the amortization of premium and accretion of discount on the yield-to-maturity method relating to debt securities acquired at other than par value. Realized investment gains and losses are determined on the basis of specific identification. Declines in the fair value of securities considered to be other than temporary, if any, would be recorded as realized losses in the consolidated statements of income. As of December 31, 2002, we did not hold any investment securities that were deemed to be other than temporarily impaired.
Real estate investments consist of a building, condominium units and developed land. These investments are carried at cost less accumulated depreciation. Depreciation is computed over the estimated useful lives of the property (exclusive of land, which is non-depreciable), using the straight-line method. Estimated useful lives range from twenty-seven to thirty-nine years. Rental income and expenses are included in net investment income.
Reinsurance. We record our reinsurance contracts under the provisions of FAS 113, “Accounting and Reporting for Reinsurance on Short-Duration and Long-Duration Contracts.” Net premiums written, net premiums earned, losses and LAE and underwriting expenses are reported net of the amounts related to reinsurance ceded to other companies. Amounts recoverable from reinsurers related to the portions of the liability for losses and LAE and unearned premiums ceded to them are reported as assets. Reinsurance assumed from other companies including assumed premiums written and earned, losses and LAE and underwriting expenses (principally ceding commissions) is accounted for in the same manner as direct insurance written.
Reinsurance recoverables include balances due from reinsurance companies for paid and unpaid losses and LAE that will be recovered from reinsurers, based on contracts in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve FPIC from our primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to FPIC. We evaluate the financial condition of our reinsurers and monitor concentrations of credit risk with respect to the individual reinsurer that participates in our ceded programs to minimize our exposure to significant losses from reinsurer insolvencies. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the domiciliary Departments of Insurance.
See Notes 10 and 11 for a discussion of goodwill and intangible assets.
Losses and Loss Adjustment Expenses. The liability for losses and LAE is based upon our best estimate of the ultimate cost of settling the claims (including the effects of inflation and other societal and economic factors). The estimated costs of settling claims is generally based upon past experience adjusted for current trends, and any other factors that would modify past experience. These liabilities are not discounted.
We use various actuarial techniques to estimate the liability for losses and LAE, including losses that have been incurred but not reported to us (“IBNR”), where applicable. These techniques generally consist of statistical analysis of historical experience and are commonly referred to as loss reserve projections. Our estimation process is generally performed by line of business, grouping contracts with like characteristics and policy provisions. Our decisions to use particular projection methods and the results obtained from those methods are evaluated by considering the inherent assumptions underlying the methods and the appropriateness of those assumptions to the circumstances. No single projection method is inherently better than any other in all circumstances. We generally apply multiple methods in determining our actuarial estimates.
New Accounting Pronouncements. In June 2002, the Financial Accounting Standards Board (“FASB”) issued FAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” FAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities. It requires that the cost associated with an exit or disposal activity be recognized when the liability is incurred, not necessarily at the date of an entity’s commitment to an exit plan. As a result, some costs relating to the disposition may be deferred until later periods when they are incurred. The provisions of FAS 146 are effective for exit or disposal activities initiated after December 31, 2002. Accordingly, we will adopt this statement for applicable transactions occurring on or after January 1, 2003.
In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 expands existing accounting guidance and disclosure requirements for certain guarantees and requires the recognition of a liability for the fair value of certain types of guarantees issued or modified after December 31, 2002. We do not believe that the adoption of the FIN 45‘s guidance will have a material effect on our financial position.
In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities.” FIN 46 addresses whether certain types of entities, referred to as variable interest entities (“VIEs”), should be consolidated in a company’s financial statements. A VIE is an entity that either (1) has equity investors that lack certain essential characteristics of a controlling financial interest (including the ability to control the entity, the obligation to absorb the entity’s expected losses and the right to receive the entity’s expected residual returns), or (2) lacks sufficient equity to finance its own activities without financial support provided by other entities, which in turn would be expected to absorb at least some of the expected losses of the VIE. An entity should consolidate a VIE if it stands to absorb a majority of the VIE’s expected losses or to receive a majority of the VIE’s expected residual returns. The provisions of FIN 46 are effective immediately for all VIEs created after January 31, 2003. With respect to VIEs created before February 1, 2003, FIN 46 would become effective for public companies no later than the beginning of the first interim or annual period beginning after June 15, 2003 (i.e., third calendar quarter of 2003). FIN 46 also requires that if it is reasonably possible that an enterprise will consolidate or disclose information about a VIE when it does become effective, that the enterprise is required to disclose certain information about it in all financial statements initially issued after January 31, 2003. We have considered the guidance contained in FIN 46 and, to date, have not identified any interests or relationships that we believe would be a variable interest in a VIE, as defined.
Fair value estimates are made as of a specific point in time based on the characteristics of the financial instruments and relevant market information. Where available, quoted market prices are used. In other cases, fair values are based on estimates using valuation techniques, such as discounting estimated future cash flows using a rate commensurate with the risks involved or other acceptable methods. These techniques involve uncertainties and are significantly affected by the assumptions used and the judgments made regarding risk characteristics of various financial instruments, prepayments, discount rates, estimates of future cash flows, future anticipated loss experience and other factors. Changes in assumptions could significantly affect these estimates. Independent market data may not be available to validate those fair value estimates that are based on internal valuation techniques. Moreover, such fair value estimates may not be indicative of the amounts that could be realized in an immediate sale of the instrument. Also, because of differences in methodologies and assumptions used to estimate fair values, the fair values of FPIC’s financial instruments may not be comparable to those of other companies.
• Cash and cash equivalents - Carrying value approximates the fair value because of the short maturity of these instruments.
• Bonds and equity securities - Fair value was estimated based on bid prices published in financial newspapers.
• Other invested assets - Carrying value approximates the fair value.
• Interest rate swaps - Fair value was estimated using quotes from brokers and represents the cash requirement if the existing agreement had been settled at year-end.
The following table presents the carrying values and estimated fair values of FPIC’s financial instruments as of December 31, 2002 and 2001.
The amortized cost and estimated fair value of investments in debt and equity securities as of December 31, 2002 and 2001 were as follows:
The amortized cost and estimated fair value of debt securities at December 31, 2002 by contractual maturity are shown below. Expected maturities will differ from contractual maturities, because borrowers have the right to call or prepay these obligations with or without call or prepayment penalties.
Net investment income for the years ended December 31, 2002, 2001 and 2000 was as follows:
At December 31, 2002, FPIC’s other invested assets included investments in three limited partnerships and two private corporations. These assets were recorded at an aggregate value of $10,801 and $11,334 at December 31, 2002 and 2001, respectively. FPIC sold its investment in HCIF Management Company during November 2002 and received payment in the amount $174. In December 2002, FPIC sold its investment in Renaissance LLP and recorded a note receivable in the amount $2,037, all of which has been collected in 2003. In January 2001, FPIC’s investment in a joint venture, Bexar Credentials Inc., was redeemed for $70.
Changes in deferred policy acquisition costs for the years ended December 31, 2002, 2001 and 2000 were as follows:
During 2002, we recorded a charge related to our MPL business at Intermed, as it was estimated that not all of its deferred policy acquisition costs were recoverable. As a result, deferred policy acquisition costs were reduced by the amount $1,304.
Net deferred tax assets and Federal income tax expense in future years can be significantly affected by changes in enacted tax rates or by unexpected adverse events that would influence management’s conclusions as to the ultimate realizability of deferred tax assets.
The changes in the carrying amount of goodwill for the years ended December 31, 2002, 2001 and 2000 are as follows:
• Under the market multiple approach, the values of the reporting units were based on the market prices and performance fundamentals of similar public companies.
• Under the DCF approach, the values of the reporting units were based on the present value of the projected future cash flows to be generated.
Activity in the liability for loss and LAE for the years ended December 31, 2002, 2001, and 2000 was as follows:
In the year 2000, most of the prior years reserve increase occurred on claims reported to us in 1997 and 1998. We made this increase primarily because upon re-estimation we determined that severity (the average cost of a claim) had increased more than we expected. We also increased reserves on other lines of business at First Professionals in 2000, including its now discontinued accident and health line and its assumed reinsurance. The upward development on prior years’ reserves in 2001 included some increase in the initial estimate for 2000 MPL losses and LAE. In addition and while most claims and incidents reported are closed without a loss payment, we also raised our estimates relative to the ratio of claims closed with a loss payment to all claims and incidents closed in 2000 and 2001.
The effect of reinsurance on premiums written and earned for the years ended December 31, 2002, 2001 and 2000, was as follows:
First Professionals has the option to commute the agreement should the business perform such that the underlying protection proves to be unnecessary, in which case the reinsurance would cease, the underlying reinsurance assets and liabilities would unwind, and any net funds under the agreement, less a 4.2% risk charge to the reinsurers, would be retained by First Professionals. The decision of whether to commute the agreement and the timing of any such commutation will depend on the performance of the underlying business, the need for the agreement based on our capital position and other relevant considerations.
At December 31, 2002, three Hannover Re group companies and two other reinsurers accounted for approximately $138.7 million, or 63%, of our total reinsurance recoverables and ceded unearned premiums. The Hannover Re companies are authorized reinsurers, so we do not maintain collateral on their recoverable balances. At December 31, 2002, we withheld funds under the terms of the finite reinsurance agreement with Hannover Re in the amount of $60.9 million, and held collateral in the form of irrevocable letters of credit or assets held in trust for the reinsurance recoverables due from the other two reinsures in the aggregate amount of $52.0 million. At December 31, 2001, $48.9 million of our total reinsurance recoverables were due from three reinsurers, of which irrevocable letters of credit or assets held in trust collateralized $34.4 million.
The credit facility also contains minimum equity and risk-based capital requirements and requires our insurance subsidiary, First Professionals, to maintain at least a B++ (Very Good) group rating from A.M. Best.
Should FPIC fail to meet one or more of its loan covenants, such occurrence would be considered an event of default. In the event FPIC was unable to provide an acceptable resolution for such event of default, FPIC’s lenders would be entitled to certain remedies, including the right to demand immediate repayment, including payment in full. Were FPIC’s lenders to demand immediate payment in full, FPIC could not make such payment from existing funds and would have to seek replacement financing or take other steps to raise the required funds. Under such circumstances, FPIC’s ability to secure such replacement financing could not be assured, and if obtained, such financing would likely carry higher costs.
In connection with FPIC’s credit facility entered into on August 31, 2001, FPIC replaced its interest rate swaps (the “previous swaps”). In accordance with the accounting prescribed by FAS 133, “Accounting for Derivative Financial Instruments,” FPIC recorded an unrealized loss associated with the fair value of the previous swaps upon their replacement, which is included in accumulated other comprehensive income (loss) as a component of shareholders’ equity. The unrealized loss is being amortized into income over the term of the previous swaps, which would have expired January 2, 2004.
FPIC uses interest rate swap agreements (the “swap agreements”) to minimize fluctuations in cash flows caused by interest rate volatility and to effectively convert all of its floating-rate debt to fixed-rate debt. Such agreements involve the exchange of fixed and floating interest rate payments over the life of the agreement without the exchange of the underlying principal amounts. Accordingly, the impact of fluctuations in interest rates on these swap agreements is offset by the opposite impact on the related debt. Amounts to be paid or received under the swap agreements are recognized as increases or reductions in interest expense in the periods in which they accrue. We believe that the counterparties to the swap agreements are creditworthy.
The swap agreements in effect at December 31, 2002 are as follows:
At December 31, 2002, 2001 and 2000, FPIC’s deferred credit consisted of the following:
Effective January 1, 2000, FPIC’s insurance subsidiaries entered into a 100% quota share reinsurance agreement with PRI to assume the death, disability and retirement (“DD&R”) risks under PRI’s claims-made insurance policies in exchange for cash and investments. FPIC completed a GAAP valuation of the underlying liability during 2000 and a deferred credit in the amount of $13,205 was recognized. The deferred credit, which will be accreted into income over 20 years, represents the difference between the GAAP valuation of the underlying liabilities and the initial premium received. The liability was calculated using benefit assumptions and elements of pension actuarial models (i.e., mortality, morbidity, retirement, interest and inflation rate assumptions).
Total rental expense was $2,581, $2,410, and $2,190 for 2002, 2001 and 2000, respectively.
FPIC may also become involved in legal actions not involving claims under its insurance policies from time to time. FPIC has evaluated such exposures as of December 31, 2002, and in all cases, believes its position and defenses are meritorious. However, there can be no absolute assurance as to the outcome of such exposures.
In addition to standard assessments, the Florida and Missouri, Legislatures may also levy special assessments to settle claims caused by certain catastrophic losses. FPIC would be assessed on the basis of premiums written in the state. During 2001, a special assessment was levied on First Professionals and APAC that totaled $0.9 million. No special assessments were made in 2002 and 2000. In addition, FPIC could be subject to additional assessments in the future as a result of damages caused by catastrophic losses, such as a hurricane.
At December 31, 2002 and 2001, 558,641 and 483,250 shares of FPIC’s common stock were reserved for issuance in connection with the stock option plans, respectively. A summary of the status of FPIC’s stock options is presented below:
The fair value of options granted, which is amortized to expense over the option vesting period in determining the pro-forma impact, is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
In accordance with FAS 123, the weighted average fair value of stock options granted is required to be based on a theoretical statistical model using the preceding Black-Scholes assumptions. In actuality, because FPIC’s incentive stock options are not traded on any exchange, employees can receive no value nor derive any benefit from holding stock options under these plans without an increase in the market price of FPIC’s stock. Such an increase in stock price would benefit all stockholders commensurately.
FPIC currently sponsors eight post-retirement plans for its employees. The table below lists those plans and the subsidiary of FPIC whose employees are covered by that plan.
The FIG defined contribution profit sharing plan is available to all employees of FIG after meeting certain eligibility requirements. The plan is comprised of two parts. The first part of the plan is a defined contribution plan that allows employees to contribute up to 12.5% of their annual compensation, subject to IRS limits. FPIC contributes a matching amount equal to 2.5% of the employee’s annual compensation. The second part of the plan is a profit sharing plan, whereby FPIC may at its discretion make an additional contribution to the plan up to a maximum of 10% of the employee’s annual compensation. FPIC’s policy is to fully fund the liability for the matching portion at the end of each year. At December 31, 2002 and 2001, the fair market value of defined contribution profit sharing plan assets was $5,121 and $4,900, respectively. The expense for this plan amounted to $990, $1,138 and $896 in 2002, 2001 and 2000, respectively.
The FIG defined benefit plan is available to all eligible employees of FIG who have six months of service and whose ages are twenty and one half years of age or older. The amount of benefits is based on years of service and 0.75% of the employee’s average monthly salary not over the Social Security base plus 1.4% of the employee’s average monthly salary over the Social Security base. FPIC’s policy is to contribute the maximum amount towards funding benefits under the plan subject to IRS limits. At December 31, 2002 and 2001, the fair market value of defined benefit plan assets was $1,651 and $1,584, respectively. FPIC had a net periodic pension cost of $277, $217 and $197 for this plan in 2002, 2001 and 2000, respectively. The expense for this plan amounted to $183, $143 and $193 in 2002, 2001 and 2000, respectively.
The Tenere defined contribution profit sharing plan and trust is available to all employees of Tenere upon meeting certain eligibility requirements. The plan is comprised of two parts. The first part is a defined contribution plan that allows employees to contribute up to 10% of their annual compensation, subject to IRS limits. The second part is a profit sharing plan, whereby Tenere may at its discretion contribute an employer contribution to the plan. At December 31, 2002 and 2001, the fair market value of plan assets was $773 and $1,122, respectively. The expense for this plan amounted to $76, $66 and $59 in 2002, 2001 and 2000, respectively.
The EMI defined contribution profit sharing plan is available for all employees of EMI upon meeting certain eligibility requirements. Under the plan, employees can contribute up to 16% of their annual salary, subject to IRS limits, of which EMI may, at its discretion, contribute a matching amount of up to 100% of the employee contributions. Historically, EMI has contributed a matching amount equal to approximately 30% of the employee contribution. At December 31, 2002 and 2001, the fair market value of plan assets was $2,167 and $3,281. The expense for this plan amounted to $94, $147 and $125 for 2002, 2001 and 2000, respectively.
The actuarially computed net periodic pension cost for our two defined benefit plans combined at 2002, 2001 and 2000, included the following:
Prior service cost not yet recognized in net periodic pension cost
Assumptions used in the accounting for the net periodic pension cost and plan status for our two defined benefit plans combined at December 31, 2002, 2001 and 2000, were as follows (weighted-average of the combined plans based on the fair value of the plan assets at year-end):
Rate of increase in compensation levels 5.14 % 5.04 % 5.04 %
Investments in equity method investees (233,069 ) (241,309 ) (247,921 )
The restricted net assets for FPIC’s insurance subsidiaries at December 31, 2002, 2001 and 2000, are as follows:
The statutory capital and surplus for FPIC’s insurance subsidiaries at December 31, 2002, 2001 and 2000, is shown in the table below.
For the years ended December 31, 2002, 2001 and 2000, the statutory net income or loss for FPIC’s insurance subsidiaries was as follows:
On July 1, 1998, First Professionals and APAC also entered into a quota share reinsurance agreement with APAL whereby these two subsidiaries cede a 25% quota share portion of all business written by them related to anesthesiologists and certain related specialties to APAL. These agreements were entered into in connection with and at the time of FPIC’s acquisition of APAC. Premiums ceded and ceding commission earned by FPIC related to its agreement with APAL were as follows for the periods presented:
Effective in 2001, APAL formed a new subsidiary, APAL (SPC) Limited, which was established in accordance with Section 235(1) of the Company Law 2nd Revision of Caymanian Law as a segregated portfolio corporation. FPIC, through its subsidiaries, EMI and APAC, has developed alternative risk insurance programs for insureds, whereby segregated portfolio corporations have been formed for each to assume workers’ compensation risks. APAC receives a fee for the use of its policy forms and does not retain the underwriting risks or incur the administrative expenses under these programs. Like other reinsurance agreements, APAC does remain liable to the insureds under these programs as the primary insurer in the event APAL (SPC) Limited or other reinsurers under these programs were not to perform. Therefore, APAC maintains collateral in the form of assets in trust and an irrevocable letter of credit corresponding with applicable reinsurance recoverable balances. Premiums written and premiums ceded by FPIC related to its agreement with APAL (SPC) Limited were as follows for the periods presented:
Effective January 1, 2000, First Professionals entered into a 100% quota share reinsurance agreement with PRI to assume PRI’s death, disability and retirement risks under its claims-made insurance policies in exchange for cash and investments in the amount of $47.0 million. During 2000, a GAAP valuation of the underlying liability was completed and a deferred credit in the amount of $13.2 million was recognized. The deferred credit, which will be amortized into income over 20 years, represents the difference between the GAAP valuation of the liability and the initial premium received. The liability was calculated using benefit assumptions and elements of pension actuarial models (i.e., mortality, morbidity, retirement, interest and inflation rate assumptions). In connection with the agreement, First Professionals recognized a 5% ceding commission expense, which is being deferred and amortized as premiums are earned under the agreement.
Effective July 1, 2000, First Professionals entered into an agreement with PRI whereby, First Professionals, through FPIC’s 70% owned subsidiary, PMA, manages an MPL insurance program in Pennsylvania for PRI. Effective January 1, 2003, FPIC owns 80% of PMA. Under this program, whereby business is written on First Professionals’ policy forms and ceded to PRI under a 100% quota share reinsurance agreement. FPIC receives a fronting fee of 7% and PMA receives an administration fee of 20% of premiums written, in return for its services to PRI, which include underwriting, claims management and other administrative aspects of this program. PMA also pays all commissions and brokerage to outside agents and brokers for the placement of business under the program. Effective January 1, 2002, the terms of this agreement were amended to cede 100% of the premiums written to PRI. The amendment has been filed with the New York State Insurance Department. Direct premiums written, ceded premiums written and ceding commission earned by FPIC under this program were as follows for the periods presented:
During the fourth quarter of 2001, FPIC recorded a pre-tax charge of $632 in connection with the disposition of its unprofitable TPA division in Albuquerque, New Mexico. Under the plan, FPIC sold the division’s assets and cancelled its service agreements with self-insured customers. Certain other contracts were retained and are serviced by FPIC’s Jacksonville, Florida, TPA division. The 2001 restructuring activity was a continuation of FPIC’s consolidation of the TPA operations and brings to an end the restructuring activities of the Albuquerque division that began during the fourth quarter of 2000 when FPIC incurred a pre-tax charge of $500. As a result of the plan, fifty-two employees were terminated at December 31, 2001. This reduction represents 24% of the TPA workforce and 100% of the New Mexico office. Thirty employees were terminated at December 31, 2000. This reduction represented 12% of the TPA workforce and 35% of the New Mexico office. All employees terminated in 2001 and 2000 were located in the Albuquerque location. Restructuring activity for years 2002, 2001 and 2000 was as follows:
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2002, 2001 and 2000:
Summary of Investments Other Than Investments in Related Parties (in thousands)
Condensed Statements of Financial Position (in thousands, except common share data)