We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be five to ten years in length. We currently lease and occupy a total of approximately 26,000 square feet of space in Louisville, Kentucky; Chicago, Illinois; Boca Raton, Florida; and Albuquerque, New Mexico. Our Boca Raton, Florida and Louisville, Kentucky leases, representing approximately 16,000 square feet, expire April 30, 2007, and March 31, 2007, respectively. We do not anticipate renewing these leases. We also own a parcel of investment property in East Lansing, Michigan as part of our investment portfolio.
Debt issue cost amortization of $181,000, $181,000 and $128,000 in 2005, 2004 and 2003, respectively, has been reclassified from amortization expense to interest expense to conform to the current year presentation.
As a property and casualty insurer, our results of operations are primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
Our medical professional liability insurance business is discussed in detail in “Item 1. Business - Medical Professional Liability Operations.”
of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process and does not represent an exact calculation of that liability. We maintain reserves for claims incurred but not reported, commonly referred to as IBNR, to provide for future reporting of already incurred claims and developments on reported claims. The reserve for IBNR claims is determined based on historical loss trends.
The Company classifies all investment securities as either held-to-maturity or available-for-sale at the date of purchase based on the Company’s ability and intent to hold individual securities until they mature. In addition, on a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. In 2005, the Company concluded that it had both the intent and ability to hold a significant portion of the Company’s fixed-income securities to maturity. Accordingly, the Company transferred fixed-income securities, with an estimated fair value of approximately $398.3 million at the date of transfer, from the available-for-sale category to the held-to-maturity category. The remainder of the Company’s fixed-income security portfolio, as well as its equity securities held for investment, remained in the available-for-sale category.
Available-for-sale fixed-income and equity securities are reported at their estimated fair value, with any unrealized gains and losses reported net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized appreciation or depreciation, net of any related tax effects, in other comprehensive income. Held-to-maturity securities, other than those transferred to the held-to-maturity category as described above, are carried at amortized cost. Investment income includes amortization of premium and accrual of discount for both held-to-maturity and available for sale securities on the yield-to-maturity method if investments are acquired at other than par value.
The fair value of fixed-income securities is based on market quotations provided to us by our third-party custodian who engages independent third party pricing sources that use valuation models. The valuation models used by the independent third party pricing sources use indicative information such as ratings, industry, coupon, and maturity along with publicly traded bond prices to determine security specific spreads, and the ultimate fair value of the non-publicly traded fixed maturity securities. Investment real estate is carried at the lesser of historical cost or at estimated fair value based on recent sales or offers for similar properties. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
During the year ended December 31, 2006, we recorded losses of $178,000 related to various equity securities whose decline in fair value was deemed to be other than temporary based on their anticipated liquidation.
We annually review the financial stability of all of our reinsurers. This review includes a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2006, there are no known issues with the financial solvency of our reinsurers or their ultimate ability to pay amounts due to us. Our reinsurance arrangements are discussed in more detail in “Item 1. Business - Medical Professional Liability Operations” and in Note 9 of the Notes to Consolidated Financial Statements included elsewhere in this report.
A determination must be made for deferred tax assets regarding whether it is more likely than not that sufficient taxable income will exist in future periods when deductible temporary differences are expected to reverse to enable the Company to realize the benefit of its deferred tax assets. If it is determined that it is more likely than not that sufficient taxable income will not exist, a valuation allowance should be recorded for the portion of deferred tax assets the Company likely will not realize.
Changes in the valuation allowance during 2005 and 2004 were allocated in the accompanying Consolidated Financial Statements to federal income taxes, a component of net income, other comprehensive income, or other components of shareholders’ equity, depending on the nature of the deferred item that gave rise to the change. See Notes 1 and 10 of the Notes to Consolidated Financial Statements for further discussion of the deferred tax valuation allowance and its impact on our financial condition and results of operations. Such information is incorporated herein by reference.
Deferred policy acquisition costs, or DAC, are those costs that vary with and are primarily related to the production of new, or renewal, business and include such costs as commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Under GAAP, the premiums that will be earned in future periods, to which these deferred costs relate, must produce sufficient profits to offset the future expense that will be recognized from the amortization of the DAC; that is, the DAC must be recoverable. In evaluating the recoverability of DAC, we have made certain assumptions regarding the future amount and timing of costs associated with the business written, such as costs to maintain the policies and the ultimate projected loss and loss adjustment expense payments associated with these policies. In addition, we have considered future investment income, at an assumed 4.5% yield, in determining the recoverability of DAC. Based on our analysis as of December 31, 2006, the DAC carried on the Consolidated Balance Sheets, included elsewhere in this report, of $7.6 million, was deemed to be fully recoverable.
On January 1, 2006, we began accounting for stock options and non-vested stock awards under the provisions of Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment”, or SFAS No. 123(R), which requires the recognition of share-based compensation expense based on the fair value of the awards granted. Prior to the adoption of SFAS No. 123(R), we had accounted for stock options using the intrinsic value method, which resulted in no compensation expense for stock option awards as the option exercise prices were equal to the market price of the Company’s stock at the respective dates of grant. Under both the intrinsic value and fair value models, compensation expense for non-vested share awards is based on the market price of the Company’s stock at the date of grant.
This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income.
The following table sets forth our results of operations for the years ended December 31, 2006, 2005 and 2004 on a consolidated basis. The discussion that follows should be read in connection with the Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.
2006 Compared to 2005. The increase in income before federal income taxes and minority interest for 2006 is primarily the result of improved underwriting results. Increases in investment income and realized gains, as well
A portion of the decrease in direct premiums written is related to the deconsolidation of PIC-Florida and the exit from our other lines of business. These items are described more fully in Note 1 to the Consolidated Financial Statements. The remaining decrease is attributable to price competition in our core professional liability markets, primarily in our Illinois, Kentucky and Ohio markets. As a result of the continued soft medical professional liability insurance market, we anticipate that competitive pressures in our core markets will remain strong. However, we remain committed to our strategy of adequate pricing and strict underwriting. This strategy may result in the loss of additional policyholders and further decreases in direct premiums written. Our insured physician count at December 31, 2006 was 9,454, a decrease of 1.1% compared to December 31, 2005. Our retention ratio, the ratio of previously insured physicians compared to the number of physicians that we renew, was 82% in 2006 and 2005.
The loss ratio for 2006 was 67.1% compared to 77.4% for 2005. The decrease in the loss ratio is primarily the result of changes in our claims handling practices and tighter underwriting standards. These changes have resulted in a decrease in both the frequency (see above) and severity of reported and paid losses. Favorable development on prior years’ loss reserves was $12.9 million and $4.4 million for 2006 and 2005, respectively. The favorable development on prior years’ loss reserves experienced in 2006 was primarily attributable to the emergence of lower frequency and severity trends than originally projected, especially related to accident years 2003 through 2005 in our Michigan and Ohio medical professional liability markets. These positive factors were partially offset by an increase in prior year reserves in our Florida market.
The decrease in underwriting expenses from 2005 to 2006 is primarily the result of the decrease in net premiums earned. However, the underwriting ratio increased moderately to 20.4% for 2006 compared with 20.1% for 2005 as fixed costs increased in relation to total underwriting expenses.
assets were fully amortized as of December 31, 2005, reduced audit and other professional service fees relating to the initial year of furnishing a report on our internal control over financial reporting as required by the Sarbanes-Oxley Act of 2002 and related compliance matters (general and administrative expenses) and reduced exit cost activities (“other” expenses).
Partially offsetting these decreases in other expenses was an increase in interest expense as a result of increases in short-term interest rates. Our long-term debt of $30.9 million bears interest at 4.15% plus the three-month London Inter Bank Offered Rate (“LIBOR”). The weighted average annual interest rate for this debt was 9.35% for 2006, compared to 7.58% for 2005. If the three-month LIBOR continues to increase, our interest expense will also increase. However, the annual rate of interest on this debt is capped at 12.5%. We currently anticipate that we will reduce or eliminate this debt in 2008. However, any such debt reduction is subject to cash flow and other liquidity factors as discussed in “- Liquidity and Capital Resources” below.
The effective tax rate for 2006 was 31.5% compared with -62.3% for 2005. The 2006 rates differ from the statutory rate of 35% primarily as a result of tax exempt investment income and the effect of the reversal of the deferred tax asset valuation allowance, which created a $44.1 million tax benefit during 2005. The effect of the reversal of the deferred tax valuation allowance is more fully described in Note 10 of the Notes to Consolidated Financial Statements included elsewhere in this report. The effect of tax exempt investment income increased in 2006 due to an increase in the allocation of such investments in our portfolio from 2.2% in 2005 to 23.8% in 2006.
The following table shows our direct premiums written by major geographical market for the years ended December 31, 2005 and 2004.
The decrease in direct premiums written was related to exiting the Florida and Nevada medical professional liability markets, discontinuing an alternative risk transfer program in West Virginia, non-renewing a large hospital account in Michigan due to underwriting considerations and exiting the workers’ compensation and health lines of business. In addition, premiums decreased from 2004 due to a change in the composition of our book of business in Ohio and Kentucky, as we reduced exposures in higher risk geographic markets and specialties in those states.
We made changes in our reinsurance program in 2005 with respect to participation. These changes in our reinsurance program did not have a significant impact on the amount of medical professional liability premium
ceded under the contracts, as ceded premiums written, excluding amounts attributable to PIC-Florida, were 11.8% and 12.6% of direct premiums written during 2005 and 2004, respectively.
The decrease in underwriting expenses was primarily the result of reduced expenses as a result of the exit from the health and workers’ compensation lines of business and a decrease in medical professional liability net premiums earned. As a percentage of net premiums earned, underwriting expenses decreased to 20.1% in 2005 compared to 21.3% in 2004. The decrease in the underwriting expense ratio is primarily due to the exit from the workers’ compensation line of business, which had a relatively high ratio in 2004 as a result of the declining premium base associated with this line.
The decrease in investment income for the year ended December 31, 2005 compared to the same period of 2004 was due to call premiums of approximately $1.5 million in 2004 and the liquidation of our high-yield bond portfolio in 2004, which resulted in a large cash position in 2005. In addition, the change in fair value of certain investment securities that management had determined contained embedded derivative financial instruments was also included in investment income. As a result of fluctuations in interest rates, the estimated fair value of these securities decreased approximately $1.1 million during the year ended December 31, 2005 compared to decreases of $338,000 for the same period of 2004. These securities were sold in late 2005.
As a result of the changes discussed above, the overall annual yield on our investment portfolio decreased to 5.43% for the year ended December 31, 2005 compared to 5.93% for the year ended December 31, 2004.
The decrease in other expenses was primarily the result of a decrease in depreciation expense in 2005 as a result of the sale of a major portion of our Grand Rapids real estate properties in 2004 (investment expenses), unusually high costs incurred in 2004 in connection with the Board of Directors’ exploration of strategic alternatives, as well as audit and other professional service fees incurred in connection with the initial assessment and opinions on the Company’s internal controls required under the Sarbanes-Oxley Act (general and administrative expenses) and employee separation costs and contract termination costs incurred in connection with our exit from the workers’ compensation line of business as well as the sub-lease of office space in Chicago, Illinois (“other” expenses). These decreases were partially offset by the increase in interest expense as the result of an increase in short-term interest rates.
Federal income taxes do not bear the usual relationship to pre-tax income for the year ended December 31, 2005 as a result of the effect of the reversal of the deferred tax valuation allowance. In 2005 we reassessed the need
The primary sources of our liquidity, on both a short and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers, proceeds from the maturity or sale of invested assets and principal receipts from our mortgage-backed securities. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, the repayment of long-term debt and the purchase of shares of APCapital’s outstanding common stock.
We continue to repurchase shares of our outstanding common stock, including 1,075,350 shares for $34.8 million in 2006. See Note 11 of the Notes to Consolidated Financial Statements for details of our share repurchase plan.
At December 31, 2006, we had no material planned expenditures for the acquisition of assets, or other expenditures, other than expenses incurred in the normal course of operations. However, in February 2007, the Board of Directors approved funding for a project to implement a new policy administration system. The cash outflow associated with the project over the next 12-18 months is anticipated to be approximately $6 million.
Our net cash flow provided by operations was approximately $56.0 million for the year ended December 31, 2006, compared to $39.0 million provided by operations in 2005 and $42.1 million in 2004. Cash generated by operations fluctuates primarily based on premiums received, net of reinsurance, in excess of net paid loss and loss adjustment expenses as shown in the table below.
Additional cash was provided in 2006, 2005 and 2004 by investment returns in excess of operating expenses.
Our statutory capital and surplus, which we refer to collectively as surplus, at December 31, 2006, was approximately $248.9 million. This results in a net premiums written to surplus ratio of 0.59:1 based on $146.7 million of net premiums written. Statutory surplus at December 31, 2005 was approximately $240.1 million, and our net premiums written to surplus ratio was 0.64:1, which excluded PIC - FL surplus and net premiums written, as required by statutory reporting. The Company’s Risk Based Capital and IRIS Ratios considered by regulators are discussed under “Item 1. Business - Insurance Regulatory Matters.” Such cross referenced information is incorporated herein by reference.
The favorable development on prior years’ loss reserves in 2006 is primarily the result of the emergence of lower frequency and severity trends than originally projected, especially related to the 2003 through 2005 accident years in our Ohio and Michigan markets. These positive trends are the result of the more stringent underwriting standards we have put in place over the last few years, and our efforts to discontinue writing higher-risk specialties and in higher-risk geographic markets. These positive factors were partially offset by an increase in prior year reserves in our Florida market.
Excludes previously reported reserves, payments and development related to PIC-Florida, which was deconsolidated effective January 1, 2006.
The likelihood of reserves emerging differently than the carried reserves diminishes as the low and high end of the ranges is approached. However it is meaningful to note the potential variability in the Company’s net income before the effect of income taxes if reserves develop to either the low or high end. The following table shows the effects on pre-tax net income if the carried reserves as of December 31, 2006 actually prove to be at the low or high end of the range:
Due to the long-tailed nature of the medical professional liability line of insurance, changes in the actuarially projected ultimate loss severity can have an even greater impact on the balance of recorded reserves than with most other property and casualty insurance lines. While we believe that our estimate for ultimate projected losses are adequate based on our open and reported 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.
Premiums receivable decreased $7.7 million, or 15.1%, to $43.1 million at December 31, 2006. This decrease is relatively consistent with the 15.4% decrease in direct premiums written.
Accrued expenses and other liabilities at December 31, 2006 were $37.1 million, a decrease of $4.7 million compared to December 31, 2005. This decrease was primarily attributable to a decrease in ceded reinsurance
premiums payable as a result of our increased participation in the 2006 treaties and the fact that they are no longer “swing-rated.”
Shareholders’ equity at December 31, 2006 was $268.8 million, an increase of $7.6 million, from $261.2 million at December 31, 2005. Retained earnings increased $43.2 million as a result of the net income recorded for the year ended December 31, 2006. This increase was partially offset by a decrease of $33.3 million in additional paid-in-capital related primarily to the purchase and retirement of the Company’s common stock and a $2.3 million, net of tax, decrease in the unrealized gains associated with investment securities. The Company’s book value per common share outstanding at December 31, 2006 was $23.26 per share, based on 11,556,575 shares outstanding, compared to $20.90 per common share outstanding at December 31, 2005. Total shares outstanding at December 31, 2005 were 12,500,126.
We have formed two subsidiary statutory trusts for the purpose of issuing mandatorily redeemable trust preferred securities, referred to as “trust preferred securities”. The proceeds from the trust preferred securities that were issued were used by the trusts to purchase debentures issued by APCapital, which are shown as long-term debt in the Consolidated Balance Sheets included elsewhere in this report. APCapital used the amounts borrowed pursuant to these debentures to increase its available capital and has subsequently contributed substantially all of the proceeds to American Physicians to increase its statutory surplus. The debentures and the trust preferred securities have terms and maturities that mirror each other. In accordance with the guidance given in Financial Accounting Standards Board Interpretation No. 46, “Variable Interest Entities,” we have not consolidated these subsidiary trusts. APCapital has guaranteed that amounts paid to the trusts related to the debentures, will subsequently be remitted to the holders of the trust preferred securities. In accordance with the nature of the transactions, the amounts guaranteed by APCapital, are also recorded as liabilities in the Consolidated Financial Statements, as they represent obligations to the trusts, which are in turn obligated to the holders of the trust preferred securities. The obligations are more fully described in Note 8 of the Notes to Consolidated Financial Statements included elsewhere in this report, which description is incorporated herein by reference.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and Subsidiaries at December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the two years in the period December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
In our opinion, the consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of American Physicians Capital, Inc. and its subsidiaries (the “Company”) for the year ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of American Physicians Capital, Inc. (“APCapital”) and its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation (“APSpecialty”), Alpha Advisors, Inc. and American Physicians Assurance Corporation (“American Physicians”). Effective January 24, 2005, APCapital’s wholly owned subsidiaries, APConsulting LLC and APDirect Sales, LLC, were dissolved. APManagement Ltd and APIndemnity (Bermuda) Ltd. were liquidated effective February 28, 2006 and May 10, 2006, respectively. APCapital and its consolidated subsidiaries are referred to collectively herein as the Company. All significant intercompany accounts and transactions are eliminated in consolidation.
The most significant estimates that are susceptible to significant change in the near-term relate to the determination of the liability for unpaid losses and loss adjustment expenses, estimated fair value of investments, income taxes, reinsurance, the reserve for extended reporting period claims, the recoverability of deferred policy acquisition costs and the estimation of the grant date fair value of share-based compensation awards. Although considerable variability is inherent in these estimates, management believes that the current estimates are reasonable in all material respects. The estimates are reviewed regularly and adjusted as necessary. Adjustments related to changes in estimates are reflected in the Company’s results of operations in the period in which those estimates changed.
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers. The Company also historically provided workers’ compensation, health and personal and commercial insurance, the results of which were combined and reported as the Company’s other insurance lines segment in 2005 and 2004. With the expiration of all other insurance lines policies in 2005, and the diminished financial significance of these lines, the Company, in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” has determined that effective January 1, 2006, it has a single reportable segment, which includes all of the Company’s operations.
The Company writes business throughout the United States of America, with an emphasis on markets in the Midwest, specifically the states of Illinois, Kentucky, Michigan and Ohio, as well as the state of New Mexico. These five states accounted for 97.9%, 93.4% and 91.4% of the Company’s total medical professional liability direct premiums written during the years ended December 31, 2006, 2005 and 2004, respectively.
Available-for-sale fixed income and equity securities are carried at their estimated fair value, with any unrealized gains and losses reported, net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized gains or losses, net of any related tax effects, in other comprehensive income. Held-to-maturity securities, other than those transferred to the held-to-maturity category as described above, are carried at amortized cost. Fair values of fixed income securities are determined on the basis of dealer or market quotations, or comparable securities on which quotations are available.
Other investments on the accompanying Consolidated Balance Sheets consists of investment real estate, investment real estate limited partnerships and non-marketable equity securities. Investment real estate is carried at the lesser of historical cost or at estimated fair market value based on recent sales or offers for similar properties. Real estate limited partnerships are accounted for using the equity method. The Company’s share of earnings in equity method investees is included in investment income. Non-marketable equity securities, which included our investment in Physicians Insurance Company of Wisconsin, Inc. (“PICW”) at December 31, 2005, are carried at fair value based on management’s estimate of the securities anticipated liquidation value.
The Company offers quarterly and monthly payment plans for policies with an annual term. Accordingly, premiums receivable include $40.8 million at December 31, 2006 and $47.7 million at December 31, 2005 of premium installments. Receivable balances consist principally of written premiums from physicians in the states of Michigan, Ohio, Illinois and New Mexico. Payment plans are designed so that credit risk associated with receivables is generally offset by the liability for unearned premiums. However, an allowance for doubtful accounts of approximately $25,000 at December 31, 2006, and $75,000 at December 31, 2005, has been established and is included in the premium receivable balance, primarily for receivable balances that may not be collectable and have no associated unearned premiums.
Insurance premium income is typically recognized on a daily pro rata basis over the respective terms of the policies in-force which is generally one year. Certain extended reporting endorsements, often referred to as tail coverage allow extended reporting of insured events after the termination of the original claims-made policy by modifying the exposure period of the underlying contract. Tail coverage can modify the exposure period for a definite or indefinite period. Premiums associated with tail policies that provide coverage for a definite period are earned over the period additional coverage is provided using the daily pro rata method. Premiums for tail policies that provide additional coverage for an indefinite period are fully earned at the date of issuance. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.
The Company’s reinsurers are reviewed for financial solvency, at least quarterly. This review includes, among other quantitative and qualitative factors, a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2006 and 2005, the Company had established an allowance of $0 and $200,000, respectively, for amounts in dispute. See Note 9 for recoverable amounts from individually significant reinsurers.
In 2004 changes in the valuation allowance were allocated to federal income tax expense, which is included as a component of net income, components of comprehensive income, or other components of shareholders’ equity, depending on the nature of the temporary differences that created the change in the valuation allowance. In 2005, after several consecutive quarters of reporting a pre-tax profit, the Company determined that a valuation allowance was no longer necessary, so it reversed the entire deferred tax asset valuation allowance in the second quarter. The reversal of the entire valuation allowance was recorded as a federal income tax benefit, with the exception of the valuation allowance associated with certain deferred tax assets relating to share-based awards. The reversal of the valuation allowance pertaining to these excess tax benefits related to share-based awards was credited directly to additional paid-in-capital and did not affect net income for these periods.
On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment.” The adoption and its impact on amounts reported in the accompanying Consolidated Financial Statements are more fully described in Note 16.
Minority interest in the accompanying December 31, 2005 Consolidated Balance Sheet and Statements of Income for the years ended December 31, 2005 and 2004, represents the 51% ownership interest of other investors in PIC-Florida. PIC-Florida was included in the Company’s Consolidated Financial Statements at and for the years ended December 31, 2005 and 2004, as it had been determined to be a variable interest entity and the Company’s subsidiary, American Physicians, had been determined to be the primary beneficiary in accordance with the guidance given in Financial Accounting Standards Board Interpretation (“FIN”) 46(R), “Consolidation of Variable Interest Entities.”
In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, Accounting for Income Taxes,” which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation requires that the Company recognize in the financial statements, the impact of a tax position, if that position is more likely than not to be sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006 with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial position or results of operations. However, additional disclosures may be required in the notes to future consolidated financial statements.
provisions of SFAS No. 155 are effective for fiscal years beginning after September 15, 2006. The adoption of SFAS No. 155 is not expected to have a material impact on the Company’s financial condition or results of operations.
SFAS No. 157, “Fair Value Measurements,” which was issued in September 2006, defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Based on assets held and liabilities carried as of this reporting date, the adoption of SFAS No. 157 is not expected to have a material impact on the Company’s consolidated financial position or results of operations. However, assets acquired or liabilities assumed in future periods prior to the adoption of SFAS No. 157 may result in a different assessment of the impact of adoption.
In September 2006 the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance to registrants on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 has not had a material impact on the Company’s results of operations or financial position.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FAS 115,” which permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this statement is to provide entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The provisions of SFAS No. 159 are effective for fiscal years beginning after November 15, 2007. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
The composition of the Company’s available-for-sale investment security portfolio, including unrealized gains and losses at December 31, 2006 and 2005, was:
The following table shows the carrying value, gross unrecognized holding gains and losses, as well as the estimated fair value of the Company’s held-to-maturity fixed-income security portfolio as of December 31, 2006 and 2005. The carrying value at December 31, 2006 and 2005, includes approximately $3.8 million and $4.9 million of unrealized gains, respectively, which are included in the carrying value of securities transferred to the held-to-maturity category in 2005, as described in Note 1, and as a component of accumulated other comprehensive income in the accompanying Consolidated Balance Sheets.
The components of pre-tax investment income and net realized gains for the years ended December 31, 2006, 2005 and 2004 were:
The estimated fair value of fixed-income securities classified as available-for-sale and the carrying value and estimated fair value of fixed-income securities classified as held-to-maturity at December 31, 2006, by contractual maturity, were:
The carrying amount of bonds that were on deposit with various state regulatory authorities as of December 31, 2006 and 2005, was $8.5 million and $8.6 million, respectively.
Changes in deferred policy acquisition costs for the years ended December 31, 2006, 2005, and 2004 are summarized as follows:
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and three-month LIBOR plus 4.20% for the second trust issuance, payable quarterly. The interest rate is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 12.50%. The weighted average interest rates of 9.28% (Trust I issuance) and 9.38% (Trust II issuance) resulted in interest expense of approximately $2.8 million for the year ended December 31, 2006. Interest expense for the years ended December 31, 2005 and 2004 was $2.3 million and $1.7 million, respectively. At December 31, 2006 and 2005, accrued interest payable to the trusts was approximately $333,000 and $298,000, respectively. The Debentures are callable by APCapital at par beginning in May 2008. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS. As the amounts that could potentially be payable under the guarantees are recorded as liabilities by the Company, no additional liability related to these guarantees has been accrued.
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation. A
reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2006, 2005 and 2004, is as follows:
Losses and loss adjustment expenses incurred are net of ceded losses and loss adjustment expenses of $10.4 million for 2006, $20.5 million for 2005, and $29.8 million for 2004.
The Company commuted its ceded reinsurance treaties with Gerling Global Reinsurance Corporation (“Gerling”) during 2004. The Company recognized the $13.5 million cash settlement received from Gerling as reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses
The Company’s income tax reconciliation for the years ended December 31, 2006, 2005 and 2004, is as follows:
At December 31, 2006 and 2005, the components of the net deferred federal income tax asset were as follows:
The following table shows the intraperiod allocation of the change in the deferred tax valuation allowance for the years ended December 31, 2005 and 2004, and the impact of the reversal of the valuation allowance on federal income tax benefit included in net income, other comprehensive income and shareholders’ equity for the years ended December 31, 2005 and 2004.
In addition to the shares above, which were repurchased in connection with publicly announced plans, the Company repurchased 8,289 shares and 249,026 shares in 2006 and 2004, respectively, which were tendered in lieu of cash in connection with the exercise of stock options.
The activity in the liability for termination benefits for the years ended December 31, 2006, 2005 and 2004 was as follows:
In 2004 the Company subleased approximately 10,000 square feet of office space in Chicago, Illinois to an unrelated third party. In 2005 the Company subleased an additional 3,000 square feet. The difference in the cash flows between the Company’s obligations for the subleased space, in accordance with the original lease terms, and the rent the Company will receive from the sublessor over the next seven years has been discounted using an interest rate of approximately six-percent to approximate the fair value of the liability incurred in connection with the contract termination. Other costs incurred in connection with the subleased space, such as broker commissions, were also included in the calculation of the original liability.
Activity in the liability for contract termination costs for the years ended December 31, 2006, 2005 and 2004, was as follows:
Certain costs associated with the original lease and subleases are variable. As additional information regarding these variable costs becomes available, the estimated future cash flows are adjusted to reflect the revised estimates. Any changes in the liability for contract termination costs associated with estimated cash flow adjustments are charged or credited to expense in the period the change in estimates is first known.
All costs associated with termination benefits and contract terminations are included in the other expenses line item in the accompanying Consolidated Statements of Income.
The former President and CEO of the Company is a majority owner of SCW Agency Group, Inc., an agency that sells the Company’s medical professional liability insurance in Michigan, Illinois and Kentucky. Direct premiums written by the agency during 2006, 2005 and 2004 totaled $50.5 million, $63.9 million and $74.4 million, respectively, representing, 32.2%, 34.5%, and 34.8% of total direct premiums written by the Company during such years. Commission expense incurred related to SCW approximated $3.7 million, $4.8 million and $5.8 million in 2006, 2005 and 2004, respectively.
During 2004, the Company’s former President and CEO, and majority owner of SCW, received payments totaling $120,000 for consulting services.
The Company offers benefits under certain defined contribution plans. In 2006, 2005 and 2004 the defined contribution plans provide for Company contributions of 5% of employee compensation, as defined in the plan, and a 100% match of employee contributions on the first 3% of contributions and 50% match on the next 2% of contributions. Employer contributions to the plans were approximately $831,000, $937,000 and $1,001,000 for 2006, 2005 and 2004, respectively.
Effective November 29, 2006, the Company’s Board of Directors amended the Plan with respect to the exercise of options and tax withholding. Holders of options under the Plan may exercise their outstanding options and pay the exercise price pursuant to a net share settlement feature. This feature allows the option holder to elect to have shares of stock withheld upon exercise to pay the option exercise price and the payment of taxes attributable to the option exercise.
The following table summarizes activity in the Company’s equity compensation plans for stock options awards for the year ended December 31, 2006:
In January 2004, the Company issued 45,000 shares of non-vested stock under the Plan to certain employees with a market price at the date of grant of $11.47 per share. The shares granted in 2004 vest annually at a rate of 33%, 33% and 34% in January 2005, 2006 and 2007, respectively, as long as the grantees remain employed by the Company. In 2004, the Company also granted a total of 1,500 shares of unrestricted stock to newly appointed directors of the Company’s Board. The market value of the Company’s stock at the date of grant for these unrestricted shares was $18.14, resulting in compensation expense of approximately $27,000 during 2004.
The total fair value, at the date of vesting, of stock options and other share awards vested during the years ended December 31, 2006, 2005 and 2004 was $3.5 million, $5.7 million and $8.5 million, respectively.
As of December 31, 2006, the Company had $205,000 of unrecognized compensation costs related to non-vested share-based payment awards that are expected to be recognized over a weighted average period of seven months.
The Company adopted SFAS No. 123(R), “Share-Based Payment,” beginning January 1, 2006 using the modified prospective transition method. Accordingly, for the year ended December 31, 2006, the Company recorded share-based compensation expense for awards granted prior to, but not yet vested, as of January 1, 2006, adjusted for estimated forfeitures, using the fair value method. Share-based compensation for option awards is being recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award were, in substance, multiple awards. Compensation expense for restricted shares granted is being recognized on a straight-line basis over the requisite service period for the entire award, which is three years. The impact on our results of operations of recording share-based compensation for the year ended December 31, 2006, was a pre-tax charge to underwriting expense of $571,000. Net of taxes, the effect on net income was $371,000, or $0.03 per basic and diluted share.
originally disclosed pro forma effects of share-based compensation expense have been included here for purposes of comparison to the results of operations for the years ended December 31, 2006. In accordance with adoption pursuant to the modified-prospective method, previously reported amounts in the income statement have not been changed.
The pro forma information for the years ended December 31, 2005 and 2004, was as follows:
There were no stock options or other share-based awards granted during the year ended December 31, 2006. The grant date fair value of stock options for award grants made in 2005 was estimated using a binomial lattice model. Prior to 2005 the Company used a Black-Scholes option pricing model to estimate the fair value of option grants at the date of grant. The following table indicates the assumptions used, or in the case of the binomial lattice model the range of assumptions, in estimating the grant date fair value for options granted during the years ended December 31, 2005 and 2004.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004:
The Company was not subject to any litigation at December 31, 2006 other than routine litigation in the ordinary course of the Company’s business. Management does not expect these cases to have a material adverse effect on the Company’s financial condition or results of operations.
American Physicians, APSpecialty and ICA, insurance companies each domiciled in the State of Michigan, are included in the accompanying Consolidated Financial Statements in accordance with GAAP. These entities are subject to regulation by the State of Michigan Office of Financial and Insurance Services and file financial statements using statutory accounting practices prescribed or permitted by the state insurance regulators. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Such practices vary in certain respects from GAAP. The principal variances are as follows:
The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding net realized gains (losses) on the sale of investments, or 10% of statutory surplus as of the preceding year end on an individual company basis. Accordingly, $49.2 million of dividends can be paid in 2007 without prior regulatory approval. However, as dividends totaling $43.0 million were paid in 2006, only $6.2 million of dividends could be paid as of January 1, 2007, without regulatory approval. The remaining $43.0 million of dividends that can be paid in 2007 is subject to limitation based on the timing and amount of the dividends that were paid in the preceding 12 months.
financial statements and notes thereto of American Physicians Capital, Inc. and Subsidiaries.
Alpha Advisors, Inc. - an Illinois corporation that provides investment management services.
APCapital Trust II - a trust formed in Delaware for the purpose of issuing mandatorily redeemable trust preferred securities to institutional investors (Note 8).
In June 2005 and December 2005, American Physicians paid dividends to APCapital of $6.0 million and $11.3 million, respectively.