We also lease approximately 1,200 square feet of office space for our Insurance Services business at 5401 North Central Expressway, Suite 316, LB #B4, Dallas, Texas.
There have been significant changes in the type of information reported and the presentation format as a result of the acquisition of API effective April 1, 2007, since we effectively became an insurance company as a result of the transaction. With the acquisition of API, our consolidated revenue and earnings are predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on API’s earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of API’s earned premiums. In addition, any pre-tax profits of API were shared equally with us (profit sharing) so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, our management agreement with API was terminated and our consolidated results of operations are no longer affected by management fees from API; but, rather our results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
Fair Value Measurements. In April 2009, FASB ASC 820-10, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, was issued. It provides additional guidance to highlight and expand on the factors that should be considered in estimating fair value when there has been a significant decrease in market activity for a financial asset and identifying circumstances that indicate a transaction is not orderly. This FSP also requires new disclosures relating to fair value measurement inputs and valuation techniques (including changes in inputs and valuation techniques). FASB ASC 820-10 does not change the objective of fair value measurement. That is, even though there has been a significant decrease in market activity for a security, the fair value objective remains the same. Fair value is the price that would be received to sell a security in an orderly transaction (i.e. not a forced liquidation or distressed sale), between market participants at the measurement date under current market conditions (i.e., an exit price notion). We adopted FASB ASC 820-10 for the three months ended June 30, 2009.
Fair value is used on a recurring basis for our equity and fixed maturity, available-for-sale securities in which fair value is the primary basis of accounting. Fair value for these securities is the market value based on quoted market prices, when available (Level 1) or quoted prices for similar assets or liabilities in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Certain assets and liabilities are not actively traded in observable markets with listed prices or quotes and we must use alternative valuation techniques based on independent dealer quotes on the security, our own assumptions including internal pricing models and professional judgment to derive a fair value measurement (Level 3). In these instances when significant valuation assumptions are not readily observable in the market, instruments are valued based on the best available data to approximate fair value. This data would consider a risk premium that a market participant would require. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. Typically, during periods of market dislocation, the observability of prices and inputs may be reduced for the instruments we hold. This condition could cause an instrument to be reclassified to a lower level during any given period. For additional discussion regarding fair value measurement, see Note 9 to the financial statements included herein.
When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio, sale of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the expected future cash flows we anticipate to recover. The discount rate is the original yield or the effective yield if the fixed maturity security was previously impaired. If an OTTI exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Consolidated Statements of Operations. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Operations, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to OCI, as an unrealized OTTI loss on our Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.
For all fixed maturities securities evaluated for OTTI, we consider the timing and amount of the cash flows. When evaluating whether our non-agency collateralized mortgage obligations (“CMOs”), including our position in Alt-A’s, are other-than-temporarily impaired, we also examine the characteristics of the underlying collateral, such as delinquency, loss severities and default rates, the quality of the underlying borrower, the type of collateral in the pool, the vintage year of the collateral, subordination levels within the structure of the collateral pool, the quality of any credit guarantors, the susceptibility to variability of prepayments, our intent to sell the security and whether it is more likely than not we will be required to sell the security before the recovery of its amortized cost basis. In assessing corporate fixed maturities securities for OTTI, we evaluate the ability of the issuer to meet its debt obligations and the value of the company or specific collateral securing the debt position including the fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading; fundamentals of the industry in which the issuer operates; expectations regarding defaults and recovery rates; and changes to the rating of the security by a rating agency.
The estimate of reserves for losses and loss and loss adjustment expenses is reflective of the types of insurance policies written by us. We write our medical professional liability insurance policies predominantly on a claims-made basis. Claims-made insurance policies provide coverage for claims made and reported to the company during the period covered under the policy. We also write a small percentage of policies on an occurrence basis. Occurrence basis insurance policies provide coverage for losses that occur during the term of the policy, regardless of when the claim is reported. These occurrence policies also cover policyholders that purchase or earn, according to the terms of contract provisions, an extended reporting period, or tail endorsement, upon termination of coverage.
When a claim is reported to us, our claims adjusters establish a case reserve for the estimated amount of the ultimate payment including legal costs associated with defending the claim. The process of estimating case reserves reflects an informed judgment based upon the experience and knowledge of the claims adjuster regarding the nature and value of the specific claim, the severity of injury or damage, the judicial climate where the insured event occurred and the policy provisions relating to the type of loss. Lines of insurance like medical professional liability often have claims with complex and technical facts and circumstances that take many years to investigate and close. The lack of information available to the claims adjusters when a claim is first reported often makes establishing case reserves difficult. As the discovery phase of the claim proceeds, better information regarding the nature and severity of the claim becomes available enabling us to establish a more appropriate case reserve for the claim. Case reserves on severe claims are also reviewed for adequacy at least quarterly by our claims committee, which includes our Medical Director, physicians with specific expertise in the specialty of the claims being reviewed, and senior management. This process of periodically evaluating and adjusting case reserves is one of the factors we consider when establishing our ultimate loss and loss adjustment expenses. However, case reserves alone are insufficient in measuring our ultimate cost for losses and loss adjustment expenses.
The two components, case reserves and the reserve for IBNR claims, constitute the liability for unpaid losses and loss adjustment expenses, and together represent our best estimate of the ultimate cost of settling our claim obligations as of the reporting date. The combination of changing conditions including, but not limited to, historical settlement patterns, trends in loss severity and frequency, legal theories of liability and legislative changes and other factors such as the time required for claim resolution makes the estimation of reserves inherently difficult and requires actuarial skill and judgment. We perform an in-depth review of reserves for unpaid losses and loss adjustment expenses on a semi-annual basis with assistance from our outside consulting actuary.
The independent review of reserves by our outside consulting actuary plays an important role in the overall assessment of the adequacy of reserves. We establish reserves for unpaid loss and loss adjustment expenses taking into account the results of multiple actuarial techniques applied as well as other assumptions and factors regarding our business. The actuarial techniques used that are material to the evaluation of reserves for unpaid loss and loss adjustment expense include the following:
As part of its evaluation, our outside consulting actuary develops a central estimate and a range of reserves it believes is reasonable. In this analysis, a central estimate is first selected and the utilizing the different indications derived from the various actuarial projections, our outside consulting actuary selects a low and a high estimate. The central estimate approximates our actuaries' expected value over the range of reasonable possible outcomes and is selected from the multiple actuarial techniques as described above. The upper end of the range reflects their higher estimate of future loss and loss adjustment expenses while the lower end of the range reflects their lower estimate of future loss and loss adjustment expenses. In general, the width of a range reflects the level of variability in the underlying projections. These range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably possible outcomes.
The reconciliation between our net reserve for loss and loss adjustment expenses filed with state insurance departments prepared in accordance with statutory accounting principles and those reported in our consolidated financial statements prepared in accordance with GAAP is shown below:
We have established a net statutory reserve for loss and loss adjustment expenses at $80,339,000 as of December 31, 2009 or what we believe to be the upper end of the reserve estimates, as projected by actuarial review; however, there is no assurance that such reserves will ultimately prove adequate. We have established a position of conservatively reserving to the upper-end of the reserve estimate due to the inherent judgments and uncertainties in estimating ultimate claims losses and management’s philosophy that this is the appropriate approach to reserving at the current time.
Specifically, in establishing our best estimate as of December 31, 2009, we considered the following factors. First, as highlighted in the 10-year reserve development herein, API’s reserve estimates for the years 1999 through 2004 were significantly deficient. Not until recently, 2005 through 2008, have reserves trended favorably from the originally reported net liability. In addition, API has increased the number of policyholders it insures from 2,992 at January 1, 2004 to 6,363 at December 31, 2009 resulting in an approximately 113% increase in policyholder exposure over that time. Furthermore, we write approximately 70% of our premiums with physicians operating in group practices which could expose us to considerable losses resulting from one significant liability event or occurrence. Additionally, we insure predominantly surgical classes and higher risk specialties which are more susceptible to claim frequency and larger paid damages. We also recently began writing new medical liability policies in Oklahoma and Arkansas. The significant volatility in claim development patterns of API coupled with the uncertainty as to how our significant increase in policyholders and new business in Oklahoma and Arkansas will perform over time warrants a conservative position. Also, API began co-participating in the 2006, 2007, and 2008 reinsurance treaties on claims in excess of the retention of $250,000 on individual claims and $350,000 on multiple insured claims related to a single occurrence. The 2006, 2007, and 2008 reinsurance treaties provide for API retaining an additional 10% of the retention levels for 2006, 20% for 2007, and 40% for 2008. Furthermore, we increased our net retention under our 2009 reinsurance agreement from $250,000 to $1,000,000 with a $5,000,000 aggregate limit. Uncertainty in regards to how these increased participation levels and higher net retention will impact our recorded reserves were considered in determining our best estimate as of December 31, 2009.
In considering the potential sensitivity of the factors and assumptions underlying management’s best estimate of recorded loss and loss adjustment reserves, as previously mentioned, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a relatively large average cost per claim. For example, at December 31, 2009, we had 6,363 policyholders and during the calendar year ended 2009 we paid a total of $12,161,000 in gross paid damages on 86 claims. Even a small change in the number of claims expected to be paid (i.e. frequency) or a small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, our financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, API has closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the high average cost per claim, any change in the trends of key assumptions used in estimating the ultimate values could result in a significant change in the reserve estimate.
The following table shows net case, IBNR and total reserves and various claim statistics and reserve averages for the years ended December 31, 2009, 2008 and 2007.
Incurred-net of reinsurance depicts incurred loss and loss adjustment expense related to premium earned in that period, also referred to as accident year. Incurred-net of reinsurance for the prior years represents the net change in reserve estimates charged or credited to earnings in the current year with respect to liabilities that originated and were established in prior years.
Our incurred loss and loss adjustment expense for the most recent accident year of $44,827,000 in 2009 is reflective of the relative increases in the number of policyholders during the current year as compared to prior accident years of $39,134,000 in 2008 and $40,682,000 in 2007. In 2009 and 2008, we decreased our incurred loss and loss adjustment expense for prior year development by $19,849,000 in 2009 and $20,565,000 in 2008, which was primarily the result of loss severity for the 2002 through 2008 report years developing favorably compared to prior period estimates. During 2007, API recorded favorable prior year development of $16,023,000. We continue to see beneficial trends in claims frequency and relative stability in average paid loss severity as compared to pre-tort reform years.
The average number of claims reported and the average net claim paid with indemnity (net paid loss severity) over the last four years (2006-2009) since the passage of tort reform has averaged 425 and approximately $119,000 as compared to the four years (2000-2003) prior to tort reform in which claims reported averaged 779 and paid loss severity averaged $144,000. The effect of significant changes in claim frequency introduces a great deal of variability into our reserve estimation process. We are traditionally cautious with our assumptions concerning emerging trends in claims frequency and severity loss trends and consequently we do not immediately place much weight on the impact that any short-term declines in frequency and severity may have on our ultimate losses. However, actual frequency and severity loss trends have developed more favorably than originally anticipated. We utilize historical claims data to project future expected results. As a result, the impact of recent claims trends is moderated by historical data. We have recently experienced favorable trends of declining frequency and stable paid loss severity and the results of these trends are reflected in our reserve estimations. The impact of recent favorable trends is the main reason for the fairly stable prior years’ favorable development of $16,023,000 in 2007, $20,565,000 in 2008 and $19,849,000 in 2009.
To highlight the range of possible outcomes in our reserves, our outside consulting actuary models a probability distribution along various confidence levels to calculate the inherent variability in our loss reserves. This probability distribution does not contemplate factors that are not representative in our historical data base. These factors include items such as our significant increase in policyholders since 2004, our changes in the mix of business written or the impact of our increased retention due to changes in our reinsurance structure. These additional variables add to the potential variability of the results and increase the overall uncertainty of the estimate. Due to the correlation between reserving variables and how they inter-relate to one another, it is neither practical nor meaningful to isolate and demonstrate the impact of changes in a particular assumption such as claims frequency or severity or other specific parameters such as the effect of tort reform in calculating the reserve estimate. However, based on our historical development patterns, the probability distribution shows the impact if actual claims experience ultimately develops either favorably or unfavorably from our recorded reserves. Our recorded net reserves at December 31, 2009 of $80,339,000 (77% confidence level) are carried approximately 21% higher than the actuarial central estimate of $66,452,000 (51% confidence level). Should favorable development continue at post-tort reform levels, our expectation is that our carried reserves would trend downward toward the actuarial central estimate. Should adverse development occur such as either an erosion of the tort reform and/or one of the previously identified risks not inherent in the distribution, the outcome could be higher than the carried reserves. A result of $92,390,000 (15% higher than the recorded net reserves at December 31, 2009), represents a confidence level of 90%. These results show the wide dispersion of possible outcomes at reasonable levels of confidence given the inherent uncertainty of loss reserves in the medical professional liability line of insurance. This scenario is reasonably conceivable due to a significant liability event occurring, such as an unexpected adverse court decision that impacts our open claims or the occurrence of an unusually large number of liability losses in one reporting period or a single event involving multiple insureds. The following table shows the effects on pre-tax income if the recorded reserves as of December 31, 2009 develop under these scenarios:
Under API’s primary medical professional liability reinsurance contract or excess of loss treaty, certain premiums are ceded to other insurance companies under the terms of the reinsurance agreement. The 2009 reinsurance agreement is a fixed-rate treaty and provides 100% coverage in excess of our retention of $1,000,000 with a $5,000,000 aggregate limit. Prior to 2009, our insurance subsidiary, API entered into reinsurance contracts, which provided for losses in excess of API’s retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The 2006, 2007, and 2008 reinsurance treaties provide for these same terms with API retaining an additional 10%, 20% and 40% of the risk above the aforementioned retention levels for 2006, 2007 and 2008, respectively.
The reinsurance contracts for 2002 through 2008 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contracts are subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
Similar to the estimate for reserves, due to the long-tailed nature of the medical professional liability line of insurance, relatively small changes in the actuarial assumptions for trends, inflation, severity, frequency for projected ultimate loss and loss adjustment expense reserves can have a greater impact on the recorded balance for reinsurance recoverables than with most other property and casualty insurance lines. While we believe that API’s estimate for ultimate projected losses related to loss and loss adjustment expense is adequate based on reported and open claim counts, there can be no assurance that additional significant reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge. Reinsurance contracts do not relieve us from our obligations to policyholders.
We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer defaults. Any amount found to be uncollectible would be written off in the period in which the uncollectible amount is identified.
Death, Disability and Retirement Reserves. We have established a death, disability and retirement reserve for policyholders, which is intended to set aside a portion of the policy premium to account for the coverage provided for the extended reporting period or tail coverage offered by API upon the death and/or disability and/or retirement of a policyholder which is provided at no additional cost to the policyholder. The death, disability and retirement reserve is included in unearned premiums.
Stock-Based Compensation. We recognize compensation expense for all stock-based compensation awards made to employees and directors. We estimate the fair value of stock-based compensation awards on the date of grant using an option-pricing model. The portion of the value that is ultimately expected to vest is recognized as expense over the service period. Stock-based compensation expense recognized in our consolidated statements of income for fiscal years 2009, 2008 and 2007 is based on awards ultimately expected to vest and is reduced for estimated forfeitures. We recognize forfeitures based on an estimate at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In addition, we recognize the benefits of realized tax deductions in excess of tax benefits on compensation expense and report it as a component of cash flows from financing activities rather than as an operating cash flow.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believe it is more likely than not our deferred tax assets will be fully recovered We have developed and implemented a process to ensure that uncertain tax positions are identified, analyzed and properly reported in the Company’s financial statements. Based on all known facts and circumstances and current tax law, we believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2009, is not material to our results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2009, if recognized, would not have a material effect on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.
We are providing the following unaudited pro forma consolidated financial statements to present a picture of the results of operations of the combined company after giving effect to our acquisition of API, absent any operational or other changes, had API’s and our businesses been combined for the periods and at the dates indicated. The pro forma consolidated statement of operations for the year ended December 31, 2007 is presented as if the API acquisition occurred on January 1, 2007. The unaudited pro forma consolidated financial statements were prepared using the purchase method of accounting.
The pro forma adjustments are based upon available information and assumptions that each company’s management believes are reasonable. The unaudited pro forma consolidated financial statements are presented for illustrative purposes only and are based on the estimates and assumptions set forth in the notes accompanying these statements, which should be read in conjunction with these unaudited pro forma consolidated financial statements. The companies may have performed differently had they always been combined. You should not rely on this information as being indicative of the historical results that would have been achieved had the companies always been combined or the future results that the combined company will experience. The unaudited pro forma consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition. The unaudited pro forma consolidated financial statements and the related notes thereto should be read in conjunction with the consolidated financial statements of the Company for the year ended December 31, 2007, and the related notes thereto and other information in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the unaudited financial statements of API for the quarter ended March 31, 2007 filed in our Form S-1 dated June 19, 2007.
Records the elimination of the revenue component of management fee and sub-producer commissions by the Company, the management fee expense by API and the sub-producer expenses by the Company for the three months ended March 31, 2007.
With the acquisition of API on April 1, 2007, our consolidated revenue and earnings are predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on API’s earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of API’s earned premiums. In addition, any pre-tax profits of API were shared equally with us so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, the management agreement was terminated and our consolidated results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
Despite continued rate decreases of 4% in 2009 in our Insurance Services segment, improvements in the terms on our reinsurance contracts coupled with favorable reserve development allowed us to deliver strong results from our operations from this segment. As a result of favorable development in both claim counts and claim severity post-tort reform and increased competition, we lowered our rates on average approximately 4% in 2009. We continue to see increased competition by existing professional liability carriers. As a result of this increased competition, we continue to be faced with price pressure on both existing renewals and new business. Many of our competitors have been aggressive in seeking new business and are willing to compete on price. We will continue to monitor frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted. As a result of these market forces, we will face increased competition throughout 2010, but will continue to price insurance products at rates believed to be adequate for the risks assumed.
For comparative purposes, we have also included the results of operations for the year ended December 31, 2007 on a “pro forma basis” since we did not acquire API until April 1, 2007. This information is provided to highlight the results of operations prior to our acquisition of API and any reference in this Item 7 below to “pro forma” reflects the impact to us had we acquired API as of January 1, 2007.
Condensed income statement data for the years ended December 31, 2009 and 2008 are included in the following table:
Further explanation for the year-to-year variances are described below throughout the remainder of Item 7 of this Annual Report on Form 10-K.
Gross premiums written increased $1,313,000 (2%) to $65,430,000 for the year ended December 31, 2009 from $64,117,000 for the year ended December 31, 2008. The primary causes for this increase were a higher number of extended reporting period endorsements during the current year as compared to the prior year and new written business of $7,143,000 for the current year as compared to $6,297,000 for the prior year. We had smaller rate decreases on renewing business which averaged approximately 4% for the current year as compared to average rate decreases of approximately 6% for the prior year. Policyholder retention was approximately 90% for the year ended December 31, 2009 as compared to 92% for 2008, however, the number of policyholders increased to 6,363 at December 31, 2009 from 5,336 at December 31, 2008. We continue to experience competitive pricing pressures.
Premiums ceded decreased $766,000 (50%) to $2,309,000 for the year ended December 31, 2009 from $1,543,000 for the year ended December 31, 2008. Effective January 1, 2009, we changed our reinsurance treaty such that we now retain the first $1,000,000 of any loss occurrence. The 2009 reinsurance contract is a fixed-rated treaty and provides 100% coverage in excess of our retention of $1,000,000 with a $5,000,000 aggregate limit. We are retaining this additional risk in the reinsurance layer in order to lower our ceding costs based on decreases in claims. Due to the increased retention, the current year 2009 treaty year ceded premiums decreased $3,217,000 (61%) to $2,042,000 in 2009 treaty year ceded premiums as compared to $5,259,000 in 2008. The 2009 treaty, which significantly reduced ceded premiums in 2009, provides us with coverage against large losses and multiple claims arising from a single event, as well as excess policy limit coverage. While the 2009 treaty reduced our ceded premiums as a percentage of direct premiums written, thus resulting in a relative increase in net premiums written and earned, the overall impact on earnings is uncertain as the frequency and severity of losses in future periods is not yet known.
Investment income statement data for the years ended December 31, 2009 and 2008 are included in the following table:
Investment income, net of investment expenses, decreased by $1,890,000 (16%) to $10,109,000 for the year ended December 31, 2009 from $11,999,000 for the year ended December 31, 2008. As a result of the risk and uncertainty of the current economic crisis and the ultimate impact on the non-agency collateralized mortgage obligations (“CMOs”) market, we sold non-agency CMOs with a book value of $17,288,000 during the year ended December 31, 2009. As a result of these sales, the fair market value of our non-agency CMOs has been reduced from $25,438,000 as of December 31, 2008 to $4,801,000 as of December 31, 2009. The proceeds from these sales and additional cash generated from operations have been reinvested generally in high quality investment grade fixed maturities securities with short maturity dates and lower yields. In addition, interest rates on money market funds are substantially lower in 2009 as compared to 2008. This rebalancing of our fixed maturities investment portfolio resulted in a corresponding decrease in investment income for the year ended December 31, 2009 as compared to the same period in 2008.
Net realized capital losses and OTTI were $2,532,000 for the year ended December 31, 2009 as compared to $7,749,000 for the year ended December 31, 2008. Gross realized gains decreased by $536,000 (40%) to $818,000 in 2009 as compared to $1,354,000 in 2008 primarily due to recognizing a $558,000 realized gain on the sale of Financial Industries Corporation (“FIC”) stock in 2008. Gross realized losses decreased by $511,000 (34%) to $1,005,000 in 2009 as compared to $1,516,000 in 2008 primarily due to the sale of equity and fixed income securities during 2008 used to offset prior year capital gain carry forwards. As mentioned above, additionally, we sold a substantial percentage of our non-agency CMOs during 2009 resulting in a net realized loss of $152,000 on the sale of these securities.
The following table reflects the composition of our Alt-A securities as of December 31, 2009 after the OTTI (dollars in thousands):
Our financial services revenue increased $1,828,000 (30%) for the year ended December 31, 2009 compared to 2008. APS Financial, our broker/dealer, derives most of its revenue from transactions in the fixed income market, in both investment and non-investment grade securities. As the table above reflects, commission revenue at APS Financial was up $2,172,000 (42%) for the year ended December 31, 2009 compared to the same period in 2008. An improving trend in transaction activity of both high-yield securities and CMOs was the primary reason for the increase in broker/dealer commission revenues. Our bank debt/trade claim revenues were lower by $74,000 (10%) for the year ended December 31, 2009 compared to 2008. We would note though that bank debt and or trade claim revenues showed an $183,000 (69%) increase in the fourth quarter of 2009 as compared to the same period in 2008. These period-over-period variances are more related to timing issues than to a weakening or strengthening of opportunity as the revenue stream for this line of business is irregular with longer lead times to close a transaction than our traditional broker-dealer transactions. Our management fees and other revenue declined $270,000 (82%) primarily as the result of our decision during the first quarter of 2009 to no longer actively pursue investment banking business.
Loss and loss adjustment expenses for the year ended December 31, 2009 increased by $6,409,000 (35%) to $24,978,000 from $18,569,000 for the year ended December 31, 2008. The increase of $6,409,000 is primarily the result of higher current year development due to much higher retention levels in the 2009 reinsurance treaty and increased policyholder headcounts and lower favorable development of $716,000 on prior year losses for the year ended December 31, 2009 as compared to the same period in 2008. For the year ended December 31, 2009, current accident year loss and loss adjustment expenses totaled $44,827,000, an increase of $5,693,000 (15%) over the prior current year comparable period. We increased the 2009 current accident year estimated losses based on 380 new claims reported during the current year and the increased risk associated with the increase in policyholder headcount to 6,363 as well as the increased retention under the 2009 reinsurance treaty. Prior year losses developed favorably by $19,849,000 as a result of reductions in our estimates of claims severity, principally the 2002 through 2008 report years, driven by closure of 407 claims during the year. For the year ended December 31, 2008, current accident year loss and loss adjustment expenses were $39,134,000 based on 371 claims reported and a policyholder head count of 5,336 and there was $20,565,000 of favorable development on prior years’ claims. The positive effects of tort reform in Texas on average claim severity has resulted in continued favorable development of reserves and improved claim development patterns. During the current year we continued to favorably settle a significant number of post-tort reform claims at below the reserved amounts.
Our financial services expenses decreased $1,844,000 (19%) for the year ended December 31, 2009 compared to 2008. With the drop in trading activity associated with the U.S. economic downturn and the resultant investor uncertainty, we began making cost reductions in 2008 within this division, the full effect of which was not realized until 2009. As the table above shows, payroll and benefits decreased $1,171,000 (38%) and information services decreased $74,000 (13%) in 2009 compared to 2008 as a result of these cost reductions. In addition, legal and professional fees decreased $1,672,000 (87%) in 2009 as a result of non-recurring legal fees and accruals in 2008 as well as lower Sarbanes-Oxley, consulting and audit fees incurred in 2009. Other expenses includes fixed costs such as rent, dues, licenses, travel and insurance which were reduced in total by $169,000 (20%) in 2009 compared to 2008 as part of cost reduction measures aimed at returning this segment back to profitability. This segment’s primary variable cost, commission expenses, increased $1,242,000 (38%) in 2009 compared to 2008 as a result of the increase in trading activity and associated commission revenues mentioned above. In addition, a higher percentage of gross commissions were earned by brokers earning a higher commission rate either due to reaching pre-described rate thresholds or due to their being independent contractors whose rates are higher as they do not participate in any benefits that our employee brokers receive. These overall cost reduction measures, together with increase in our broker/dealer commission revenue, have for the time being returned this segment to profitability. However, there can be no assurance that we can sustain revenues necessary to remain profitable in the future.
General and administrative expenses for the years ended December 31, 2009 and 2008 are included in the following table:
General and administrative expenses decreased $550,000 (10%) for the year ended December 31, 2009 compared to 2008. The decrease in 2009 includes lower board compensation and fees of $390,000 (37%) resulting primarily from greater deferred stock awards expensed in 2008 versus fewer awards granted and expensed in 2009. In addition, deferred compensation to our two employee board members was expensed in board compensation and fees in 2008 but was recorded in options and other compensation in 2009. This accounts for the increase in 2009 options and other compensation. Interest and dividends represents interest paid on the outstanding balance of redeemable preferred stock. The $41,000 (11%) decline is a result of interest paid on a lower preferred stock balance resulting from redemptions made in 2008 and 2009. Legal and professional fees decreased $34,000 (8%) in 2009 due in part to lower audit and Sarbanes-Oxley compliance charges. The decrease in other expenses in 2009 was primarily due to a 2008 write-off of a note receivable in the amount of $323,000.
Condensed income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
Premium related income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
Gross premiums written increased $13,997,000 (28%) from $50,120,000 to $64,117,000 for year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
On a pro forma basis, gross premiums written decreased $1,469,000 (2%) from $65,586,000 for the year ended December 31, 2007 to $64,117,000 for the year ended December 31, 2008. While API increased in the number of policyholders to approximately 5,330 at December 31, 2008 from 4,930 at December 31, 2007, gross premiums written decreased due to rate decreases which averaged 6% for the year ended December 31, 2008 as compared to average rate decreases of 14% for 2007. We continue to experience growth in the number of policyholders; however, premium growth has decreased in 2008 as compared to 2007 as a result of pricing decreases.
Premiums ceded expenses increased $3,270,000 (68%) from $4,813,000 to $1,543,000 for the year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
Net premiums earned increased to $64,081,000 from $56,039,000 for the year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
On a pro forma basis, net premiums earned decreased by $8,269,000 (11%) to $64,081,000 from $72,350,000 for the year ended December 31, 2008 as compared to the same period in 2007. Written premiums were down $1,469,000 year over year primarily due to rate decreases and we recognized $4,086,000 less in favorable development for the prior years’ reinsurance treaties during 2008 as compared to 2007.
Net Realized capital gains (losses) and OTTI income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
Net realized capital losses and OTTI were $7,749,000 for the year ended December 31, 2008 as compared to a $5,256,000 for the year ended December 31, 2007 primarily as a result of “other than temporary” impairment losses incurred in our investment in Alt-A CMOs securities of $5,819,000 in 2008 as compared to $4,566,000 in 2007, resulting from fair market value declines. In addition, we incurred additional “other than temporary” charges in 2008 on two other non-agency CMO securities in the amount of $1,070,000 for CMO securities as noted above and realized losses due to the selective sale of equity and fixed maturities securities of $1,679,000 to offset prior year capital gain carry forwards.
Our financial services revenue decreased $14,863,000 (71%) for the year ended December 31, 2008 compared to 2007. APS Financial, our broker/dealer, derives most of its revenue from transactions in the fixed income market, in both investment and non-investment grade securities. As the table above shows, commission revenue at APS Financial was down 10,531,000 (67%) for the year ended December 31, 2008 compared to 2007 due to a continuing trend of very low transaction activity seen throughout the year. Among the factors affecting transaction activity include the well-publicized issues in the mortgage lending and financial markets with the anticipation of the continuation of these factors. This, along with widespread uncertainty as to the length and severity of the current economic recession, has led to the inclination of many of our investors to remain inactive. The same general market conditions affected the revenues derived from our investment banking and the bank debt/trade claims business. Decreases in investment banking revenues totaled $2,331,000 (93%) while bank debt-trade claim revenues were off $2,305,000 (76%) for the year ended December 31 2008 compared to 2007 due again to difficult credit market conditions. While our Financial Services business constitutes a much less significant portion of our consolidated results of operation since the acquisition of API, we are actively exploring avenues to return this segment to profitability. Cost cutting measures have been implemented which included reduction of personnel, compensation reductions and information services. However, a return to profitability for this segment will also depend, to a large extent, on improved market conditions and a corresponding increase in revenues. We cannot predict when this could occur.
Loss and loss adjustment expenses for the years ended December 31, 2008 and 2007 are included in the following table:
Loss and loss adjustment expenses increased $ 4,874,000 (36%) to $18,569,000 from $13,695,000 for the year ended December 31, 2008 compared to 2007 primarily as a result of the acquisition of API on April 1, 2007.
Other underwriting expenses and change in deferred acquisition costs for the years ended December 31, 2008 and 2007 are included in the following table:
Our financial services expenses decreased $9,281,000 (49%) for the year ended December 31, 2008 compared to 2007. The primary reason for the current year decrease is a reduction of commission expenses of $9,107,000 (73%) for the year ended December 31, 2008 compared to 2007 resulting from the decline in trading activity and associated commission revenues mentioned above. In addition, incentive compensation costs decreased $1,201,000 (95%) in 2008 as a result of the net loss incurred for the year in this operating segment. Partially offsetting these decreases was an increase in legal and professional expenses of $1,040,000 (117%) for the year ended December 31, 2008 compared to 2007 due primarily to costs incurred related to legal disputes. Lastly, payroll and employee benefits expense increased $99,000 (3%) due primarily to certain increases in staff at the investment banking and bank debt/trade claims businesses in early 2008. During the latter half of 2008, significant cost cutting measures were implemented in response to the sub-par performance of this segment in 2008 with cost reductions in personnel, compensation, consulting services, information services, rent and travel continuing throughout the remainder of the year.
General and administrative expenses for the years ended December 31, 2008 and 2007 are included in the following table:
Cash Flows. Our total cash and cash equivalents balance at December 31, 2009 was $18,277,000, a decrease of $3,783,000 (17%) in the current year as cash used in investing and financing activities surpassed cash provided by operating activities. Our cash flows provided from operating activities totaled $29,858,000 for 2009 on the strength of net income of $22,865,000 and from net reinsurance reimbursements for prior years’ swing-rated treaties totaling $3,463,000. Our Insurance Services segment generated the bulk of the cash received from operating activities, the result of increased premium receipts and decreased claims payouts. Our cash flows used in investing activities totaled $26,586,000 in 2009 primarily as a result of purchases of available-for-sale fixed maturities and equity securities in excess of proceeds from their sale. Cash used in financing activities totaled $7,055,000 for the year ended December 31, 2009 primarily as a result of repurchases of our common stock under share our repurchase program as well as from dividend payments to our common and preferred shareholders and preferred share redemptions. For details of the amounts described above, refer to the Consolidated Statements of Cash Flows of this Annual Report on Form 10-K.
Historically, we have maintained a strong working capital position and, as a result, we have been able to satisfy our operational and capital expenditure requirements with cash generated from our operating and investing activities. These same sources of funds have also allowed us to pursue investment and expansion opportunities consistent with our growth plans. Although there can be no assurance our operating activities will provide positive cash flow in the future, we are optimistic that our working capital requirements will be met for the foreseeable future because our current cash position is very strong, with a balance of approximately $18,277,000, and a large portion of our approximate $241,061,000 investment portfolio is in short-term, highly liquid bonds and other fixed income securities.
Restrictions on Dividends by API. In addition to restrictions on dividends and distributions applicable to all Texas stock insurance companies, for so long as any Series A redeemable preferred stock is outstanding, the Texas Department of Insurance prohibits API from paying dividends to us in any calendar year unless and until we have complied with our redemption and dividend payment obligations to the holders of our Series A redeemable preferred stock for that year. Our agreement with the Texas Department of Insurance also provides that, until all of the Series A redeemable preferred stock has been fully redeemed and all dividends have paid, API will not make aggregate annual dividends to us with respect to API’s capital stock in excess of the lesser of 10% of API’s prior year-end policyholder statutory surplus or API’s prior year statutory net income, and in no event may such distributions exceed API’s statutory earned surplus. Accordingly our subsidiaries may not be able to pay funds to us and, even if paid such funds may not be sufficient to enable us to meet our obligations. The dividend restriction for calendar year 2008 and 2009, based on 10% of API’s prior year ended statutory surplus, was $7,717,000 and $8,804,000, respectively, and for those respective years dividends paid to us were $7,377,000 and $8,804,000. For the calendar year 2010, the anticipated dividend restriction is $10,324,000 based on 10% of 2009 year-end statutory surplus and through March 1, 2010, no dividends have yet been paid to us.
The following is a summary of our contractual obligations as of December 31, 2009:
We extend credit to our customers, which is financed through our clearing organization, Southwest Securities, Inc. or Southwest, to help facilitate customer securities transactions. This credit, which earns interest income, is known as “margin lending.” In margin transactions, the client pays a portion of the purchase price of securities, and we make a loan (financed by our clearing organization) to the client for the balance, collateralized by the securities purchased or by other securities owned by the client.
In permitting clients to purchase on margin, we are subject to the risk of a market decline, which could reduce the value of our collateral below the client’s indebtedness. Agreements with margin account clients permit our clearing organization to liquidate our clients’ securities with or without prior notice in the event of an insufficient amount of margin collateral. Despite those agreements, our clearing organization may be unable to liquidate clients’ securities for various reasons including the fact that the pledged securities may not be actively traded, there is an undue concentration of certain securities pledged or a trading halt is issued with regard to pledged securities. If the value of the collateral were insufficient to repay the margin loan, a loss would occur, which we may be required to fund. As of December 31, 2009, the total of all customer securities pledges on balances held in margin accounts was approximately $105,000 while the total value of the securities within these margin accounts was approximately $454,000. We are also exposed to risks should Southwest be unable to fulfill its obligations for securities transactions.
We maintain a portion of our investment portfolio in short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and loss expenses. We also invest a substantial part of our cash flow from operations principally in bonds/fixed maturities securities. We plan to continue our emphasis on fixed maturities securities investments.
Cash and cash equivalents and invested assets totaled $259,338,000 and $231,769,000 at December 31, 2009 and December 31, 2008, respectively. Cash and cash equivalents and invested assets represent 87% and 82% of our total assets for the same respective periods. We believe that a majority of our short-term and fixed-maturity securities are readily marketable, and that our invested assets have scheduled maturities in line with our projected cash needs.
Reinsurance recoverables decreased by $4,899,000 (36%) to $8,897,000 at December 31, 2009 from $13,796,000 primarily as a result of the favorable development in the reinsurance layer of $4,351,000 as well as increased retention levels in our reinsurance contracts as discussed in Note 11 to the consolidated financial statements included herein.
Income tax receivable decreased $115,000 (16%) to $623,000 at December 31, 2009 from $738,000 at December 31, 2008 primarily due to a bad debt deduction recorded on our 2008 filed tax return related to credit impairments on certain non-agency collateralized mortgage obligations.
Deferred tax assets decreased $3,473,000 (37%) to $6,015,000 at December 31, 2009 from $9,488,000 at December 31, 2008 primarily due to a decrease in our realized losses on impairments of $1,782,000 and an increase in the tax effect of unrealized gains, net of losses in our investment portfolio of $2,722,000. The change in realized losses on impairments was the result of the recognition of realized losses on certain investments. The change in unrealized gains, net of losses was primarily due to improvements in market conditions. For a more complete listing of the components of deferred tax assets and liabilities see Note 13 to the financial statements included herein.
Effective July 1, 2009, the Financial Accounting Standards Board (“FASB”) established the FASB Accounting Standards Codification (the “Codification”), which superseded all previously existing non-Securities and Exchange Commission accounting and reporting standards for non-governmental entities and became the single source of authoritative U.S. GAAP. The FASB will no longer issue new standards in the form of SFASs, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the changes in the Codification.
The Codification does not change U.S. GAAP. Accordingly, its adoption did not have an impact on the Company’s financial position, results of operations or liquidity. However, previous references to applicable accounting literature, via disclosures, may have changed to reflect the new applicable Codification section reference.
In April 2009, FASB ASC 820-10 (Prior authoritative literature: FSP No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly), was issued. It provides additional guidance to highlight and expand on the factors that should be considered in estimating fair value when there has been a significant decrease in market activity for a financial asset and identifying circumstances that indicate a transaction is not orderly. It also requires new disclosures relating to fair value measurement inputs and valuation techniques (including changes in inputs and valuation techniques). FASB ASC 820-10 does not change the objective of fair value measurement. That is, even though there has been a significant decrease in market activity for a security, the fair value objective remains the same. Fair value is the price that would be received to sell a security in an orderly transaction (i.e. not a forced liquidation or distressed sale), between market participants at the measurement date under current market conditions (i.e., an exit price notion). We adopted FASB ASC 820-10 during the quarter ended June 30, 2009. The adoption of this pronouncement did not have a material impact on our results of operations, financial position or cash flows.
The financial statements and supplementary data of American Physicians Insurance Company required to be included in this Item 8 are set forth on the pages indicated in Item 15 of this report.