The Company leases 49,000 square feet of space from the Medical Society in Lawrenceville, New Jersey, where its home office and Mid-Atlantic Region office are located. The Company also leases 28,000 square feet of space in a second Lawrenceville office building, where its claim department and a subsidiary are based. The Company's regional office facilities are located in rented office space in Indianapolis (5,000 square feet), Boston (3,670 square feet), Atlanta (4,190 square feet) and Dallas (5,000 square feet). The Company believes that its office space is adequate for its present needs and that it will be able to secure additional office space in the future if necessary. The Company is considering the purchase of its headquarters in Lawrenceville, New Jersey, which it currently leases from the Medical Society and has retained an independent appraisal firm to determine its fair market value.
(1) Gives effect to the assumed aggregate issuance of approximately 12,000,000 shares of Common Stock to Distributees. Does not give effect to the sale of Common Stock in the anticipated Public Offering, to the issuance of Common Stock to the Medical Society in connection with the acquisition of the Attorney-in-Fact, or to the sale of Common Stock to certain officers of the Company pursuant to the Stock Purchase and Loan Agreements between such officers and The MIIX Group. See "Executive Compensation -- Stock Purchase and Loan Agreements."
The following discussion should be read in conjunction with the financial statements and the related notes thereto appearing elsewhere in this Form 10-K.
Currently, a substantial portion of the Company's policies have January 1 effective dates. Premium is recognized as written in the quarter the policy is effective, yet the premiums are earned ratably throughout the year. As the Company expands geographically, new policies are being written with effective dates other than January 1.
Reinsurance. The Company reinsures its risks primarily under two reinsurance contracts, a specific excess of loss treaty ("Specific Contract") and an aggregate excess of loss treaty ("Aggregate Contract"). Under the Specific Contract, the Company's retention for casualty business is $10 million per loss. For medical professional liability and commercial general liability business, coverage is provided up to $65 million per loss above the retention. For other casualty business, coverage is provided up to $15 million per loss above the retention. Property coverage is also provided under the Specific Contract in the amount of $14.5 million in excess of a Company retention of $500,000 per loss per policy. The Company retains an 8% co-participation in covered losses. The Company has maintained specific excess of loss reinsurance coverage generally similar to that just described for several years.
Loss and LAE Reserves. The determination of loss and LAE reserves involves the projection of ultimate losses through an actuarial analysis of the claims history of the Company and other professional liability insurers, subject to adjustments deemed appropriate by the Company due to changing circumstances. Included in the Company's claims history are losses and LAE paid by the Company in prior periods, and case reserves for anticipated losses and ALAE developed by the Company's Claim Department as claims are reported and investigated. Management relies primarily on such historical loss experience in determining reserve levels on the assumption that historical loss experience provides a good indication of future loss experience despite the uncertainties in loss trends and the delays in reporting and settling claims. As additional information becomes available, the estimates reflected in earlier loss reserves may be revised. Any increase in the amount of aggregate reserves reported in the financial statements, including reserves for insured events of prior years, could have a material adverse effect on the Company's results of operations for the period in which the adjustments are made.
The Company offered traditional occurrence coverage from 1977 through 1986 and has offered a form of occurrence-like coverage, "modified claims made," from 1987 to the present. The Company's modified claims made policy is the PPP. Under the PPP, coverage is provided for claims reported to the Company during the policy period arising from incidents since inception of the policy. The PPP includes "tail coverage" for claims reported after expiration of the policy for occurrences during the policy period and thus is reserved on an occurrence basis. Loss and LAE reserves carried for this policy and traditional occurrence policies constitute approximately 87% of the gross loss and LAE reserves at December 31, 1998.
With the additional uncertainties associated with occurrence business, as discussed above, incurred but not reported ("IBNR") reserves have consistently represented a majority of the gross reserves recorded by the Company.
The Company uses a disciplined approach to setting and adjusting financial statement loss and LAE reserves that begins with the claims adjudication process. Claims examiners establish case reserves by a process that includes extensive development and use of statistical information that allows for comparison of individual claim characteristics against historical patterns and emerging trends. This process also provides critical information for use in pricing of products and establishing the IBNR component of the financial statement reserves.
Net premiums earned. Net premiums earned increased approximately $39.2 million, or 31.8% to $162.5 million, for the year ended December 31, 1998 from $123.3 million for the same period in 1997. This increase is generally consistent with the increase in direct premiums written.
In July 1998, the Company liquidated its equity portfolio as part of a medium term portfolio strategy which the Company believes will increase investment yield. Following liquidation, the proceeds were reinvested in fixed income securities. The remaining $12.0 million of gains recognized during 1998 pertain to the sale of government and tax exempt bonds in a generally falling interest rate environment.
Other revenue. Other revenue decreased approximately $2.0 million or 69.1% to $0.9 million for the year ended December 31, 1998 from $2.9 million for the same period last year and is composed primarily of finance charge income associated with the Company's financing of policyholder premiums, which declined as the Company outsourced its installment payment plans in the second quarter of 1998.
Additionally, the aggregate excess reinsurance contracts, in place since 1993, provide coverage for losses and allocated loss adjustment expenses above aggregate retentions. The aggregate excess reinsurance contracts, therefore, have the effect of holding net incurred losses and allocated loss adjustment expenses at a constant level as long as losses and allocated loss adjustment expenses remain within the coverage limits, which was the case for the years ended December 31, 1998 and 1997.
Underwriting expenses. Underwriting expenses increased $16.6 million or 65.5% to $42.1 million for the year ended December 31, 1998, from $25.4 million for the year ended December 31, 1997. The expense ratio was 25.9% for the year ended December 31, 1998 compared to 20.6% for the same period in 1997. Approximately $5.5 million of this increase was attributable to the cost of acquiring new business, primarily through a broker distribution network, and an additional $10.1 million related to the expansion of both facilities and staff necessary to service the increased volume of business activity in 1998. Also in 1998, the Company recognized approximately $1.0 million in connection with guaranty fund assessments associated with insurance company insolvencies, primarily in Pennsylvania and Ohio which are not offset against premium taxes.
Funds held charges. Funds held charges of $13.4 million remained unchanged from 1997 and relate primarily to the interest credited on amounts held under ceded aggregate reinsurance contracts in effect since 1993. This result is the net effect of an increase of $1.9 million in interest expense accrued on funds held under the aggregate reinsurance agreements, consistent with the increase in the related funds held balances, reduced by an adjustment to funds held interest of $1.9 million associated with adjustments to losses and premium ceded under those reinsurance contracts.
Net income. Net income was $29.7 million for the year ended December 31, 1998, a 2.1% increase from the $29.1 million for the year ended December 31, 1997. This increase was the net result of a number of factors, but is primarily due to higher realized gains and net investment income, partially offset by higher underwriting costs and income taxes and the one time charge of $12.7 million for the impairment of capitalized system development costs.
Direct premiums written. Direct premiums written were $162.4 million for the year ended December 31, 1997, a $19.2 million or 13.4% increase over the $143.2 million for the year ended December 31, 1996, as the Company significantly accelerated its geographic expansion. An almost three-fold increase (to $44.1 million) in premiums written outside of New Jersey more than offset a 7.3% decrease (to $118.3 million) in New Jersey business, which was primarily attributable to policies that were not renewed due to rate increases for certain exposure classes that resulted from the Company's annual underwriting process.
Net investment income. Net investment income was $53.9 million for the year ended December 31, 1997, an increase of 9.7% over the $49.1 million for the year ended December 31, 1996. Cash flow from operations of $64.0 million for the year ended December 31, 1997 provided the majority of the increase in the Company's invested asset base which totaled approximately $1 billion at December 31, 1997. Although the invested asset base increased, the pre-tax book yield on invested assets remained comparable at 5.61%.
Realized investment gains. Net realized investment gains were approximately $10.3 million for the year ended December 31, 1997 compared to $5.8 million for the year ended December 31, 1996. Substantially all of these gains resulted from the sale of equity securities during 1997 and from the sale of bonds in 1996.
Other revenue. Other revenue was $2.9 million for the year ended December 31, 1997, a decrease of 8.8% from the $3.2 million for the year ended December 31, 1996 and is composed primarily of finance charge income associated with the Company's financing of policyholder premiums.
Income taxes. Income taxes were $2.0 million for the year ended December 31, 1997, a decrease of 79.9% from the $10.0 million for the year ended December 31, 1996. The effective tax rate was 6.4% for the year ended December 31, 1997 compared to 36.2% for 1996, primarily due to the reversal of reserves for potential tax contingencies, the majority of which were provided for in 1996 and which were resolved in the Company's favor in 1997.
In 1998, another equity collar was implemented with a notional value of $85 million around the equity portfolio. Again, the purpose of the collar was to reduce equity market volatility and to stabilize unassigned surplus. The collar was constructed using European style S&P 500 options. The collar transaction was executed on January 13, 1998 and expired on July 13, 1998.
Since the expiration of the equity collar mentioned above, the Company has not held any derivative investments.
In July, 1998 the Company liquidated its equity portfolio as part of a medium term portfolio strategy that the Company believes will increase investment yield. Following liquidation, the proceeds were reinvested in fixed maturity securities.
Unpaid losses and LAE, reinsurance recoverable on unpaid losses and LAE and funds held under reinsurance treaties. Gross unpaid losses and LAE were $951.7 million at December 31, 1998 and $876.7 million and $795.4 million at December 31, 1997 and 1996, respectively. The increases in these amounts were consistent with the continued growth in the Company's book of business. Reinsurance recoverable on unpaid losses and LAE was $325.8 million at December 31, 1998 and $270.7 million and $221.7 million at December 31, 1997 and 1996, respectively. Funds held under reinsurance treaties, which are unrestricted, collateralize a significant portion of reinsurance recoverable on unpaid losses and LAE and were $228.1 million at December 31, 1998, and $182.6 million and $154.5 million at December 31, 1997 and 1996, respectively.
The MIIX Group, Incorporated. The MIIX Group is a holding company whose only material assets immediately after the Reorganization will be the capital stock of MIIX Insurance and the Attorney-in-Fact. The net proceeds of the anticipated Public Offering will be used for general corporate purposes, which may include, without limitation, increasing the capitalization of The MIIX Group's insurance subsidiaries in order to support their continued growth and for financing potential acquisitions. The MIIX Group's ongoing cash flow will consist primarily of dividends and other permissible payments from its subsidiaries. The MIIX Group will depend upon such payments for funds for general corporate purposes and for the payment of dividends on the Common Stock.
MIIX Insurance. The primary sources of MIIX Insurance's liquidity, on both a short- and long-term basis, will be funds provided by insurance premiums collected, net investment income, recoveries from reinsurance and proceeds from the maturity or sale of invested assets. Funds are generally used to pay claims, LAE, operating expenses, reinsurance premiums and taxes. The Company's net cash flow from operating activities was approximately $90.1 million for the year ended December 31, 1998 and $64.0 million and $43.2 million for the years ended 1997 and 1996, respectively. The higher amount of cash flow from operations in 1998 compared to 1997 was principally due to an increase in collected premiums in 1998 somewhat offset by increases in paid losses and loss adjustment expenses and in paid underwriting expenses during 1998. Because of the inherent unpredictability related to the timing of the payment of claims, it is not unusual for cash flow from operations for a medical malpractice insurance company to vary, perhaps substantially, from year to year.
The Company began evaluating this issue in 1996 in connection with an overall evaluation of the Company's systems and during 1997 assigned a project manager to study the Company's information systems and computers to determine whether they will appropriately handle post-1999 date codes. The identification of compliance issues included the Company's internal systems and processes, as well as exposure from service providers, brokers and other external business partners. Software applications, hardware and information technology ("I/T") infrastructure and non I/T systems such as the Company's telephone, security and heating and ventilating systems have been reviewed to identify those requiring upgrading or replacement to improve current computing capabilities and to ensure that they are Year 2000 compliant. In the course of evaluating the Year 2000 readiness of its internal systems, the Company determined that its claims administration system is not Year 2000 compliant. The Company has purchased a replacement system that the vendor has represented to be Year 2000 compliant and is expected to be operational in 1999. The Company has also determined that its telephone equipment is not Year 2000 compliant. The Company is currently choosing among different methods of making its telephone equipment Year 2000 compliant. The new telephone equipment is expected to be operational in 1999.
During 1997 and 1998 the Company upgraded all its I/T systems to improve their performance and efficiency. As part of this process, the Company obtained certifications from the vendors of such new systems that such systems would be Year 2000 compliant. The Company has conducted internal tests of its new systems to ensure that they are Year 2000 compliant and continues to conduct such tests. To date, such tests have not revealed any Year 2000 issues other than in connection with the claims administration system discussed above. However, the Company has retained an outside expert to independently evaluate the Year 2000 readiness of the Company's internal systems. The Company may also be adversely affected if Year 2000 issues result in additional claims being made against the Company's insureds. The Company's liability for such claims, if any, is not clearly established. A number of companies who underwrite liability coverage in the healthcare industry have submitted applications to various state regulators requesting that policy exclusions for such liability, if any, be approved. Other carriers have advised their clients of their intent to deny coverage in certain circumstances. The Company has not yet taken a formal position and is still conducting research on the matter.
The Company is in the process of sending inquiries to its service providers, brokers and other external business partners to determine whether they may experience Year 2000 problems that could affect the Company. Management is currently evaluating alternative contingency plans that could become necessary if its own or its significant external business partners' Year 2000 remediation efforts fail. Such alternatives will most likely involve the assignment of internal and external resources to process business manually during the duration of any non-compliance. All contingency planning and testing efforts are scheduled for completion in the third quarter of 1999. It is not possible at this time to estimate the cost, if any, of such contingency plans or system failures.