(1) Adoption of FAS 142 resulted in a one-time, non cash charge of $29,578, net of income tax benefit of $18,784.
The occurrence of insured or reinsured events with a frequency or severity exceeding our estimates;
Risks factors associated with the impact of rising interest rates on FPIC’s interest costs associated with its long term debt;
The ability to achieve cost savings associated with integration of Anesthesiologists Professional Assurance Company’s (“APAC”) into First Professionals Insurance Company (“First Professionals”)operations;
Risk factors associated with financing and refinancing, including the willingness of credit institutions to provide financing and the availability of credit generally;
Business and financial risks associated with the unpredictability of court decisions;
Risks of impairment of assets, generally, including the risk of impairment or inability to continue to recognize deferred acquisition costs, deferred tax assets, goodwill and other deferred or intangible assets;
Our discussion and analysis of financial condition, results of operations and liquidity and capital resources is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. We generally base our estimates on historical experience or other appropriate assumptions that we believe are reasonable and relevant under the circumstances and evaluate them on an on-going basis. The results of these estimation processes form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the critical accounting policies discussed in remainder of this section of our Management’s Discussion and Analysis (“MD&A”) affect our more significant judgments and estimates used in preparation of the consolidated financial statements. These are further commented upon in applicable sections on Results of Operations, Financial Position and Liquidity and Capital Resources that follow. Information about the significant accounting policies we use in the preparation of our consolidated financial statements is included in Note 2 to our consolidated financial statements included in Item 8 of this Form 10-K and should also be considered.
Our liability for losses and LAE (also referred to as our loss and LAE reserves) is the largest liability of our Company and the most sensitive financial statement item to estimation and judgment. Medical professional liability (“MPL”) insurance, including business written directly and reinsurance assumed, is our primary line of business and accounted for $549.8 million and $425.4 million, or 96% and 97%, of our total consolidated liability for losses and LAE as of December 31, 2003 and 2002, respectively. The remainder of our reserves represent other smaller lines and products.
The primary factors affecting our estimates of how much we will pay and therefore reserve for insurance claims, defense costs and other related costs are:
These factors, in turn, can be affected by the judicial environment and tort-related trends over time. It is also important to note that one or more of the actuarial methods used by us do not rely on specific assumptions for these factors; rather, these assumptions are developed as a by-product of the application of the methods, which may then be monitored and factored into the final judgmental considerations of the selection of the point estimate and range of reasonable values around the point estimate from among the methods. All of the above-mentioned factors individually can and will generally vary from one period to the next over time but are estimated to approximate their ultimate values in setting reserve estimates.
Effective January 1, 2002, we adopted Financial Accounting Standard No. (“FAS”) 142, “Goodwill and Other Intangible Assets.” Under FAS 142, goodwill and indefinite-lived intangible assets are no longer amortized through charges to income, but do continue to be subject to annual (or under certain circumstances more frequent) impairment testing based on estimated fair values.
During the first quarter of 2002, we performed transitional impairment testing required under the new standard and took a charge in the form of a cumulative effect of accounting change for $29.6 million, net of tax effects, as of January 1, 2002.
Our invested assets comprise our largest single asset class and consist mostly of investment securities in the form of fixed income investments in bonds and notes. Our fixed income investment securities are carried at their market values and accounted for $528.6 million and $437.0 million or 85% and 81% of our total cash and invested assets, and 45% and 43% of our total assets, respectively as of December 31, 2003 and 2002. Unrealized gains or losses in their market values are recorded directly in shareholders’ equity, net of tax effects, as a component of other comprehensive income.
Premium income, which is our main source of revenue, is generally recognized pro-rata over the respective period of each policy. Premium receivables are recorded net of an estimated allowance for uncollectible amounts.
The management fees are estimated, billed and collected on a monthly basis. Our entitlement to such fees is ultimately based upon the provision of all of the services necessary to run PRI over the term of the contract. Revenues are recognized as earned when they are billed as this accounting treatment reasonably approximates and accomplishes a recognition pattern that corresponds with the provision of the required services during the quarters and the year. The fees estimated and billed, which are recognized in income, are reduced by an estimated provision for return premiums.
See the MD&A section, Contractual Obligations, Commitments and Off-Balance Sheet Arrangements that follows for a discussion and analysis of an additional commitment and related contingent liability assumed by AFP as a result of an amendment to its management agreement with PRI, effective January 1, 2002.
The financial results for these business arrangements make up our reciprocal management segment and are presented and discussed in the following applicable sections of this MD&A. Additional financial information and disclosures about our reciprocal management segment and business can be found in Note 1, Organization and Nature of Operations, Note 16, Commitments and Contingencies, Note 20, Segment Information, and Note 22, Related Party Transactions, to our consolidated financial statements.
PRI and our subsidiary, AFP, are regulated by the New York State Insurance Department (the “NYSID”). PRI files its annual and quarterly statements with the NYSID containing its statutory-basis financial statements and other data. AFP and PRI are required to file audited financial statements annually with the NYSID obtained from the same qualified independent accounting firm.
The NYSID mandates the insurance rates PRI and other New York carriers are allowed to charge their policyholders. These include the rates charged for the policies in excess of $1.3 million and for covered extended reporting endorsements for death, disability and retirement, which have been reinsured to First Professionals. Under New York insurance statutes, the NYSID is also authorized to surcharge PRI’s policyholders in the event it is determined that those rates were deficient in one or more prior years as a result of adverse loss development. The amount of the surcharge may be up to 8% of PRI’s policyholders’ premiums annually until such deficiency is recovered.
The three years ended December 31, 2003 was a period of significant activity and progress for our company.
Our revenues and expenses were lower in 2003 than 2002. Most of the decline was by design and the result of growth management initiatives we put in place in 2002, designed to level the amount of growth in our policyholder counts following an unprecedented period of growth at our insurance subsidiaries in 2001 and 2002. Our MPL insurance markets have hardened significantly since 2000. Net investment income was also lower in 2003. While the equity markets recovered in 2003, interest rates fell to record lows during 2003 and for the third straight year, although rates did recover somewhat by the end of 2003 and exceeded 2002 year end levels.
One of the most significant financial developments for us in 2002 was our entering into the Hannover Re agreement. It is supplemental to our other reinsurance programs and represents a very large reinsurance cession for us.
Our insurance segment is made up of our four insurance subsidiaries, First Professionals, APAC and The Tenere Group, Inc. (“Tenere”) companies Intermed and Interlex. FPIC operations are also included in the insurance segment due to the segment’s size and prominence and the substantial attention the holding company devotes to the segment. Financial and selected other data of our insurance segment for the years ended December 31, 2003, 2002 and 2001 is summarized in the table below. Dollar amounts are in thousands.
Total professional liability claims with indemnity payment (includes claims that were not closed)
Insurance segment net income increased $8.8 million for the year ended December 31, 2002, from a net loss of ($0.8) million for the year ended December 31, 2001, primarily due to price improvements on our MPL business and growth in the number of policyholders. In addition, net losses and LAE for 2001 reflect adverse development and a corresponding prior year reserve charge (approximately $8.8 million) that did not recur in 2002. Net investment income declined 9% to $20.8 million for the year ended December 31, 2002 from $22.9 million for the year ended December 31, 2001.
Effective October 3, 2002, we sold the renewal rights of Interlex’s LPL insurance business to a subsidiary of Professionals Direct, Inc., a non-affiliate,for $0.4 million. The sale of Interlex’s renewal rights allows us to re-dedicate Interlex’s capital to our core MPL business.
Direct and assumed premiums written decreased 1% to $340.7 million for the year ended December 31, 2003 from $344.7 million for the year ended December 31, 2002. The small decrease primarily reflects the offsetting trends of price improvements at all our insurance companies and growth in our core MPL book of business in Florida, offset by lower premiums on fronted business and LPL business and lower MPL premiums in certain other states.
Direct and assumed premiums written increased 40% to $344.7 million for the year ended December 31, 2002 from $245.4 million for the year ended December 31, 2001. The increase primarily results from rate increases realized and growth in the number of policyholders in our core MPL business. First Professionals implemented rate increases for new and renewal policies in January and December 2001, and again in December 2002; APAC implemented rate increases in July 2001 and 2002; and Intermed implemented rate increases in November 2001 and July 2002. We also experienced growth in direct premiums written under fronting arrangements for workers’ compensation business of $19.4 million for the year ended December 31, 2002 when compared to the year ended December 31, 2001. The growth in direct premiums written was partially offset by a decline of $7.8 million in our group accident and health (“A&H”) programs, which were discontinued in November of 2001.
Under the terms of the Hannover Re agreement, we ceded approximately $50.8 million of our unearned premiums, and $34.7 million of our direct written premiums, net of other reinsurance, in 2002. The agreement, which calls for First Professionals to cede quota share portions of its written premiums, contains adjustable features including sliding scale ceding commissions and a cap on the amount of losses that may be ceded to the reinsurer, all of which serve to make it what is commonly referred to as a finite-type reinsurance contract. The original agreement also contained a loss corridor on business ceded through March 31, 2003, but it was removed and other modifications were made in connection with the amendment and extension of the agreement discussed below. The effect of these features is to limit the reinsurers’ aggregate exposure to loss and reduce the ultimate costs of this reinsurance to First Professionals as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by First Professionals. While First Professionals does not receive pro-rata protection relative to the amount of premiums ceded, the amount of reinsurance protection is significant, as determined in accordance with guidance under both GAAP and statutory accounting practices. In addition to ceding a significant portion of our risks to Hannover Re, the agreement also allows us to reduce our financial leverage and to realize immediate reimbursement for our up-front acquisition costs, which, in turn, lessens strain on our capital.
Net premiums earned increased 16% to $151.7 million for the year ended December 31, 2002 from $131.1 million for the year ended December 31, 2001. The increase in net premiums earned is due to rate increases that we implemented and growth in the number of policyholders. Net premiums earned on our MPL business increased 23% to $148.6 million for the year ended December 31, 2002 from $120.5 million for the year ended December 31, 2001.
Our loss and LAE ratio for the year ended December 31, 2003 was 90%, a decrease of 2% from 92% for the year ended December 31, 2002. Our loss and LAE ratios before the effects of the Hannover Re agreement were 87% and 89% for 2003 and 2002, respectively. A loss ratio is defined as the ratio of loss and LAE incurred to net premiums earned. The 2% decrease in our loss and LAE ratio for 2003 is smaller than the level of pricing improvements we have made. This is because the significant price increases at our smaller companies, APAC and Intermed, occurred relatively recently and there is a corresponding time lag before the underlying written premiums are earned and the resulting underwriting improvements would be recognized. Intermed experienced higher than expected losses in 2003 and took an 83% rate increase in August 2003. APAC also experienced a smaller, unanticipated increase in its loss experience in 2003. In addition, the overall costs of our ceded excess of loss reinsurance increased in 2003, which also had the effect of reducing net premiums earned and increasing our loss and LAE ratios, accordingly.
The negative effects on the loss and LAE ratios of our smaller companies, however, were offset by the more significant improvements in the loss and LAE costs incurred relative to net premiums earned at First Professionals. In addition to being much larger than Intermed and APAC, First Professionals began implementing significant pricing improvements earlier and has continued to do so over a longer period.
Net losses and LAE incurred increased 9% to $139.6 million for the year ended December 31, 2002 from $128.3 million for the year ended December 31, 2001. Net losses and LAE incurred in 2002 were reduced by an increase in ceded losses and LAE incurred under the Hannover Re agreement of $39.0 million. The increase in net losses and LAE incurred for the year ended December 31, 2002 reflects growth in business, taking into consideration expected loss trends. Our loss ratios for the years ended December 31, 2002 and 2001 were 92% and 98%, respectively. The 6% decrease in the reported loss ratio for the year ended December 31, 2002 is primarily due to a significant prior year reserve charge taken in 2001, which was not necessary in 2002 (-5%), loss expense reduction and productivity (-2%), our exit from our former group A&H business (-1%) and other
(-1%); which were partially offset by the effects of the Hannover Re agreement (3%).
The increases in net paid losses and LAE during 2003 and 2002 (22% and 7%, respectively) are in line overall with growth in our business in 2002 and 2001, taking into account the time lag inherent in claims processing and differences in reinsurance terms on business written in 2001 and 2000. Adjusted for the effects of these factors, our average net paid losses and overall severity trends were in line with those assumed in our carried reserves. For the years ended December 31, 2002 and 2001, the consolidated number of our professional liability policyholders grew approximately 21% and 29%, respectively. Our loss and LAE reserves, net of reinsurance, also grew by 14% and 6%, respectively, in 2002 and 2001.
The growth in our business in 2002 and 2001 was also the significant factor in the growth in newly reported claims and incidents in 2002 and our total inventory of unpaid professional liability claims and incidents in 2003 and 2002. Newly reported claims and incidents declined slightly in 2003 as we reduced our book of professional liability business in 2003. This decrease was offset to some extent by an acceleration of claims and incidents at First Professional that occurred as a result of the Florida tort reform legislation, which became effective September 15, 2003. As a result, we received approximately 150 to 200 newly reported claims that we believe were accelerated from future periods to meet the new Florida Tort legislation deadline. We have since experienced an offsetting trend in the form of a reduction in newly reported claims.
Net realized investment gains increased 228% to $4.7 million for the year ended December 31, 2002 from $1.4 million for the year ended December 31, 2001. Certain securities may be liquidated from time to time in order to reposition the portfolio or to take advantage of current market and economic conditions, which result in realized investment gains or losses. However our investment strategy remains focused on high quality, fixed income securities held for the long-term. The increase in net realized investment gains in 2002 is a reflection of this strategy.
Other - Finance Charges and Other Income, Interest Expense, Other Expenses and Income Tax Expenses
Finance charges and other income decreased 24% to $0.9 million for the year ended December 31, 2003 from $1.3 million for the year ended December 31, 2002. Finance charges and other income increased 71% to $1.3 million for the year ended December 31, 2002 from $0.7 million for the year ended December 31, 2001. The fluctuation of finance changes and other income related to the inclusion of $0.4 million received as a result of the sale of the renewal rights on Interlex’s LPL business during 2002.
The decrease in income tax expense for the year ended December 31, 2003 is primarily due to the decrease in income before income taxes and cumulative effect of accounting change when compared with the prior year and additional tax expense recognized in 2002 associated with the examination of FPIC’s 1998 and 1999 Federal income tax returns by the Internal Revenue Service.
Income tax expense increased to $4.3 million for the year ended December 31, 2002 from an income tax benefit of $4.4 million for the year ended December 31, 2001. Income tax expense in 2002 increased primarily as a result of an increase in pre-tax income when compared with 2001. We recognized an income tax benefit in 2001 because our permanent differences, primarily tax-exempt interest, were greater than our pre-tax income. The effect of these permanent differences was proportionately less when compared with pre-tax income in 2002, resulting in tax expense at an effective rate of 37%. In 2001, we also engaged outside investment managers and began re-positioning investments including the re-positioning of investments in tax-exempt municipal securities to investments in taxable securities.
Income from operations before income taxes and cumulative effect of accounting change
The increase in reciprocal management income before cumulative effect of accounting change during the year ended December 31, 2003 was primarily due to higher management fees, commission income and intersegment revenues. The growth in these revenues was the result of growth in 2003 of premiums written at PRI and higher ceded premiums at PRI and our insurance companies, which are co-brokered by FPIC Intermediaries. Intersegment revenues and expenses primarily relate to commission income from First Professionals for the placement of reinsurance and the management of the Pennsylvania fronting program; and the holding company’s overhead allocation, respectively. These amounts are eliminated in the consolidated financial statements.
Effective January 1, 2002, AFP and PRI amended the management agreement, including the elimination of the sharing by AFP of 10% of PRI’s statutory net income or loss, which accounts for the decline in other income. The amendment was approved by the New York State Insurance Department. AFP also agreed to pay 6% annual interest on the 10% profit share amounts already earned and collected under the original agreement for 1999, 2000 and 2001, while those years remain open for possible future re-determination and adjustment, if any. Additional information about our management agreement with PRI appears in the preceding section of this MD&A, Business with PRI.
The increase in intersegment revenues in 2003 was driven by an increase in reinsurance rates that increased the commissions earned on reinsurance treaties brokered for First Professionals.
The increase in reciprocal management expenses for the year ended December 31, 2002 is due to an increase in operating expenses incurred to manage the growth in business at PRI, offset partially by a decline in risk management department expenses when compared to the year ended December 31, 2001. As described above, the management agreement between AFP and PRI was amended in 2002. As part of the amended agreement, PRI is to reimburse AFP for 50% of risk management department expenses. Additional information about our management agreement with PRI appears in the preceding section of this MD&A, Business with PRI.
Income (loss) from operations before income taxes and cumulative effect of accounting change
Our results of operations for the period ended December 31, 2001 include our Albuquerque TPA division, which was disposed of in December 2001. Excluding the effect of the Albuquerque TPA division, claims administration and management fees and claims administration and management expenses increased $2.7 million and $2.3 million, respectively for the year ended December 31, 2002, when compared with the year ended December 31, 2001. These increases reflect the revenues and costs incurred as a result of growth in new business.
The lower increase in claims administration and management expenses for the year ended December 31, 2003 when compared with the increase in claims administration and management fees for the same period in 2002 is the result of certain expense saving initiatives and productivity improvements achieved by servicing growth in covered lives with our existing personnel and service platforms. These initiatives and others have also accounted for the improved margins in 2003 versus 2002.
Management’s Discussion & Analysis of Financial Position: December 31, 2003 Compared to December 31, 2002
Other invested assets declined $6.0 million to $4.8 million as of December 31, 2003 from $10.8 million as of December 31, 2002. We sold our investment in American Physicians Insurance Services, Inc. (“APS”) to its majority shareholder for approximately $2.05 million and recognized a small gain on the transaction (less than $0.1 million). We also recognized other than temporary impairments on two privately held investments totaling $5.3 million in 2003. One of these was our 9.8% investment in APAL, which we wrote down by $4.5 million to $0.8 million in 2003. Partially offsetting the decline were investments in three wholly owned trusts of approximately $1.1 million, in aggregate, established for the sole purpose of issuing our trust preferred securities.
Due from reinsurers on unpaid losses increased $107.6 million to $275.8 million as of December 31, 2003 from $168.2 million as of December 31, 2002. Approximately $64.9 million of the increase in due from reinsurers on unpaid losses is attributable to reserves ceded under the Hannover Re agreement during the year 2003. Of the remaining increase, approximately $34.0 million represents the growth in reinsurance recoverable under our primary excess of loss reinsurance program covering our core business.
Under the terms of the commutation, we received $23.5 million in exchange for a complete release of Gerling from their reinsurance obligations to us under our 2002, 2001 and 2000 primary excess of loss reinsurance programs, in which Gerling participated at 20%, 20% and 15%, respectively, and its assumption of non-standard risks under a small special facultative reinsurance program. The related assets for amounts due from Gerling on reinsured unpaid losses and ceded unearned premiums were eliminated and the remaining funds received were accounted for as an increase in our loss and LAE reserves in the form of bulk reserves. No gain or loss was recognized on the transaction. This transaction resulted in a reduction from the amounts due from reinsurers on unpaid losses, offsetting some of the growth in this asset for 2003.
Insurance Liabilities (Liability for Losses and LAE, Unearned Premiums, Reinsurance Payable and Paid in Advance Premiums)
We conducted in-house actuarial studies of our loss and LAE reserves as of December 31, 2003 and also during the third quarter using data as of June 30, 2003. The results of our most recent actuarial study and review confirm that our aggregate loss and LAE reserves as of December 31, 2003, are adequate.
One item of note was the acceleration of claims (estimated at approximately 150 to 200 claims) at First Professionals as a result of tort reform legislation adopted in Florida, which had the effect of increasing the actuarial point estimate as of December 31, 2003. For additional information about these 2003 developments, please refer to the applicable preceding insurance segment sections of the MD&A, Insurance Underwriting Results (Premiums, Losses and LAE, and Underwriting Expenses), Losses and LAE Incurred and Selected Loss and LAE Data.
Approximately $58.2 million of the increase in reinsurance payable for the year ended December 31, 2003 was the result of business ceded under the Hannover Re net account quota share agreement. This increase in reinsurance payable was partially offset by the payment of premiums due under FPIC’s primary reinsurance agreement.
Our shareholders’ equity increased $20.8 million to $186.7 million as of December 31, 2003 from $165.9 million as of December 31, 2002. Our book value per share increased 8% to $19.10 from $17.67. Net income contributed $16.6 million to the growth in our shareholders’ equity, while accumulated other comprehensive income (“OCI”) declined approximately $1.2 million. The decline in accumulated OCI as of December 31, 2003 versus December 31, 2002, was caused by an increase in prevailing market interest rates on fixed income securities, offset by the elimination of unrealized losses of $1.5 million resulting from the termination interest rate swaps associated with our prior bank term loan and revolving credit facility, and the corresponding decrease in the unrealized gains on our investment securities, which are included in accumulated OCI, net of income tax effects. The remaining increase of $5.4 million was due to the exercise of stock options by directors and employees during 2003 and the associated payments made to FPIC upon exercise of these options.
FPIC has various contractual obligations, which are recorded as liabilities in our consolidated financial statements. FPIC also has items that represent contractual obligations, commitments and contingent liabilities that are not recorded on its balance sheet or that are considered to possess off-balance sheet risks beyond their respective amounts otherwise reflected in the balance sheet. These include: (1) derivative financial instruments, which are used to hedge interest rate risk, (2) guarantees by us of trust preferred securities issued by separately created, unconsolidated trusts, (3) a contingent liability under an amendment made to AFP’s management agreement with PRI, effective January 1, 2002, and (4) an irrevocable letter of credit issued in favor of the lessor under an operating lease.
FPIC uses interest rate collars as a hedge to maintain the total borrowing costs of its long term debt (interest expense on the debt instruments, plus or minus cash flows under the interest rate collar instruments) to within specified ranges. FPIC’s all in borrowing costs on long term debt combined with the corresponding cash flows under the related interest rate collars can fluctuate between $2.3 million to $3.8 million annually, until such time as the interest rate collars expire. The interest rate collars are set to expire on dates corresponding with the first dates under the respective long-term debt agreements at which they can be retired by us at our option, which is five years from the date of issue in each case.
FPIC also had interest rate swaps in effect as hedging instruments for the adjustable rate interest obligations under its former bank credit facility. During 2003, the bank credit facility was retired and the related remaining portions of the interest rate swap agreements were settled. As a result, charges of approximately $2.5 million in aggregate were recognized in 2003, of which $0.9 million was recognized in the fourth quarter of 2003.
See Note 14, Derivative Financial Instruments, to the consolidated financial statements for additional disclosures about FPIC’s derivative financial instruments.
AFP has a 10-year management agreement with PRI, under which it receives a management fee annually equal to 13% of PRI’s direct premiums written. The current term of the management agreement runs through December 31, 2008. Under the terms of the management agreement, AFP receives this fee in exchange for performing services necessary to conduct and manage the entire operation of PRI. The agreement was amended by AFP and PRI to remove the sharing by AFP of 10% of PRI’s statutory net income or loss, effective January 1, 2002. With regard to profit sharing amounts already earned and collected, AFP has agreed to hold the years 1999, 2000 and 2001 open for re-determination and possible adjustment for a period of five years each (expiring 2004, 2005 and 2006, respectively.) Such adjustments would be based primarily on development of and related adjustments, if any, to loss and LAE reserves for those years. AFP has earned and collected profit sharing amounts under the original agreement totaling $3.6 million for the three years ended December 31, 2001. As of December 31, 2003, and based on PRI’s operating results, no amounts were payable under this provision of the amended management agreement. See Note 22, Related Party Transactions, to the consolidated financial statements for additional information about the management agreement with PRI.
In addition, FPIC is contractually committed to make certain minimum lease payments for the use of property under operating and capital lease agreements.
The payment of losses and LAE, insurance operating expenses (including reinsurance costs), claims administration and management expenses, non-insurance operating expenses, interest expense and income taxes in the ordinary course of business and the repayment of debt and assignment of collateral are the principal needs for our liquid funds. The principal sources of cash from our operations to meet our on-going liquidity requirements are the premiums collected for the insurance sold by our insurance subsidiaries, income on the investment of those funds, and claims administration and management fees and reinsurance brokerage and other commission income earned by our non-insurance subsidiaries.
Cash provided by operations has been sufficient during each of the three years in the period ended December 31, 2003, to meet our liquidity needs. As reported in the consolidated statement of cash flows, we generated positive net cash from operating activities of $89.9 million, $98.1 million and $33.2 million for the years ended December 31, 2003, 2002 and 2001, respectively. At December 31, 2003, we had cash and cash equivalents of $85.1 million and held fixed maturity debt securities with a fair value of approximately $15.0 million with scheduled maturities during the next twelve months. We believe that our cash and cash equivalents as of December 31, 2003, combined with cash flows from operating activities and the scheduled maturities of investments in 2004, will be sufficient to meet our cash needs for operating purposes for at least the next twelve months.
A number of factors could cause unexpected changes in liquidity and capital resources available, including but not limited to the following:
Unexpected changes in premium revenue due to higher or lower than expected new business or retention of insurance policies in force;
Failure of one or more of our reinsurers leading to uncollectible reinsurance recoverables;
Unexpected changes in liquidity provided by our reciprocal management and TPA segments.
Attempt to maintain adequate asset diversification and liquidity (by managing our cash flow from operations coupled with the maturities from our fixed income portfolio investments).
Among the internally generated funds used were the proceeds from the sale of FPIC’s 20% interest in APS. We completed the sale of our investment in APS, at a small gain, to that company’s majority shareholder on October 30, 2003, and received the total consideration of $2.05 million in cash. With the repayment and retirement of the bank credit facility, FPIC and its subsidiaries have been released from the corresponding liens on their assets that served as collateral under the bank credit facility and from their respective guarantee agreements. We are also no longer subject to the bank credit facility’s covenants and restrictions.
The sources of liquidity to FPIC, the holding company, for the payment of its operating expenses, taxes and debt-related expenses are management fees from First Professionals (and APAC, effective January 1, 2004), overhead allocations to the non-insurance subsidiaries for which FPIC receives reimbursement and dividends from subsidiaries.
FPIC has management agreements with First Professionals and, effective January 1, 2004, APAC, under which it provides substantially all management and administrative services to these subsidiaries. The management agreement with APAC replaces the former management agreement between APAC and APAM, which expired as of December 31, 2003. Under the terms of the agreements, FPIC receives management fees equal to 115% of the costs incurred to manage the two subsidiaries. The additional 15% provision in the First Professionals and APAC management fees is intended to cover overhead, corporate expenses and profit and is eliminated in the consolidated financial statements. In the case of the new agreement with APAC, the total annual management fees are also to be limited to an amount not to exceed those that would have been paid under the terms of its former management agreement with APAM.
In May 2003, the FASB issued FAS 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” FAS 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. The issuer will be required to classify as liabilities three types of freestanding financial instruments, which are: mandatory redeemable financial instruments, obligations to repurchase the issuer’s equity shares by transferring assets, and certain obligations to issue a variable number of shares. FAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We have reviewed FAS 150 and complied with the reporting requirements therein for the period ended December 31, 2003. Adopting the provisions of FAS 150 did not have a significant impact on our consolidated financial statements.
In our opinion, the accompanying consolidated statements of financial position and the related consolidated statements of income (loss) and comprehensive income (loss), changes in shareholders’ equity and cash flows present fairly, in all material respects, the financial position of FPIC Insurance Group, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the accompanying financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Due from reinsurers on unpaid losses and advance premiums ((Includes related party amounts of $82,474 and $72,256) Note 22)
Unearned premiums ((Includes related party amounts of $47,240 and $43,506) Note 22)
Less: Cumulative effect of accounting change (net of an $18,784 income tax benefit) (Note 9)
The accompanying notes are an integral part of the consolildated financial statements.
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Proceeds from sale or maturity of bonds and U.S. Government securities
FPIC Insurance Group, Inc. (“FPIC”) was formed in 1996 in a reorganization of First Professionals Insurance Company, Inc. (“First Professionals,” formerly named Florida Physicians Insurance Company, Inc.) and McCreary Corporation (“McCreary”). Under the reorganization plan, First Professionals’ shareholders became the shareholders of FPIC. They received five shares of FPIC common stock for each share of their First Professionals’ common stock. McCreary also became a subsidiary of FPIC. Effective January 1, 2002, McCreary was merged into its subsidiary, Employers Mutual, Inc. (“EMI”), with EMI continuing as the surviving entity. FPIC and its subsidiaries operate in three business segments: insurance, reciprocal management and third party administration (“TPA”). The following table provides additional information about FPIC, its business segments and subsidiaries.
Specializes in professional liability insurance products and related risk management services for physicians, dentists, and other healthcare providers.
FPIC subsidiaries (FPIC, the holding company, is also grouped within the insurance segment.):
Provides administrative and claims management services to self-insured employer groups for group accident and health insurance, workers’ compensation insurance and general liability and property insurance plans.
The main sources of revenue for FPIC are dividends, return of capital and management fees from our subsidiaries. The main sources of revenue for the subsidiaries are premiums earned and investment income (insurance segment) and claims administration and management fees and commission income (reciprocal management and TPA segments).
Cash and Cash Equivalents. For purposes of the consolidated statements of cash flows, FPIC considers cash equivalents to include all demand deposits, overnight investments and instruments with an original maturity of three months or less when acquired.
Other invested assets include investments in three limited partnerships and a non-controlling interest in a corporation. The carrying values for these investments approximate their fair values. In addition, other invested assets include investments in three wholly owned trusts established for the sole purpose of issuing trust-preferred securities in three separate private offerings. The proceeds received by the trusts were used to purchase junior subordinated debentures from FPIC as discussed in Note 13, Long Term Debt, Revolving Credit Facility and Term Loan.
Income on investments includes the amortization of premium and accretion of discount on the yield-to-maturity method relating to debt securities acquired at other than par value. Realized investment gains and losses are determined on the basis of specific identification. Declines in the fair value of securities considered to be other than temporary, if any, would be recorded as realized losses in the consolidated statements of income.
We periodically review our real estate investments for impairment and assess whether significant events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. An impairment loss is recognized when the carrying amount of an asset exceeds the anticipated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded, if any, is calculated by the excess of the assets carrying value over its fair value.
Reinsurance. We record our ceded reinsurance contracts under the provisions of FAS 113, “Accounting and Reporting for Reinsurance on Short-Duration and Long-Duration Contracts.” Net premiums written, net premiums earned, losses and LAE and underwriting expenses are reported net of the amounts related to reinsurance ceded to other companies. Amounts recoverable from reinsurers related to the portions of the liability for losses and LAE and unearned premiums ceded to them are reported as assets. Reinsurance assumed from other companies including assumed premiums written and earned, losses and LAE and underwriting expenses (principally ceding commissions) is accounted for in the same manner as direct insurance written.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs consist primarily of commissions and premium taxes that are related to the production of new and renewal insurance business. Acquisition costs are deferred and amortized over the period in which the related premium is earned. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed. Commissions and brokerage fee expenses incurred by FPIC’s non-insurance businesses are expensed as incurred.
Effective January 1, 2002, we adopted FAS 142, “Goodwill and Other Intangible Assets.” In accordance with FAS 142, goodwill and indefinite lived intangible assets are no longer amortized. Instead, they are subject to an annual (or under certain circumstances more frequent) impairment test based on their estimated fair value. Other intangible assets that meet certain criteria continue to be amortized over their useful lives and are also subject to an impairment test based on estimated fair value. We completed the transitional impairment analysis required by FAS 142 during the first quarter 2002 and recorded an impairment charge of $29,578 net of an $18,784 income tax benefit, as the cumulative effect of accounting change. There are many assumptions and estimates underlying the determination of an impairment loss. Another estimate using different, but still reasonable, assumptions could produce a significantly different result. Therefore, additional impairment losses could be recorded in the future.
See Note 9, Goodwill and Note 10, Intangible Assets for a discussion of goodwill and intangible assets.
Revenue Recognition. Premiums are earned and recognized as revenues on a monthly pro rata basis over the terms of our insurance policies. Policy terms do not exceed one year. Unearned premiums represent the portion of written premiums that remain to be earned in future periods. Premiums received in advance of the policy year are recorded as premiums collected in advance in the consolidated statements of financial position.
We use various actuarial techniques to estimate the liability for losses and LAE, including losses that have been incurred but not reported to us (“IBNR”), where applicable. These techniques generally consist of a statistical analysis of historical experience and are commonly referred to as loss reserve projections. Our estimation process is generally performed by line of business, grouping contracts with like characteristics and policy provisions. Our decisions to use particular projection methods and the results obtained from those methods are evaluated by considering the inherent assumptions underlying the methods and the appropriateness of those assumptions to the circumstances. No single projection method is inherently better than any other in all circumstances. We generally apply multiple methods in determining our actuarial estimates.
FPIC elected to adopt FAS 123 on a disclosure basis only and measure stock-based compensation in accordance with Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees,” using intrinsic values with appropriate disclosures under the fair value based method as required by FAS 123 and FAS 148. In accordance with APB 25 and related interpretations, compensation expense for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to an employee equals the fair market value of FPIC common stock at the date of grant, thereby resulting in no recognition of compensation expense. For awards that generate compensation expense as defined under APB 25, FPIC calculates the amount of compensation expense and recognizes the expense over the vesting period of the award.
Had compensation cost for FPIC’s stock option plans been determined based on the fair value method set forth in FAS 123, FPIC’s net income (loss) and basic and diluted earnings (loss) per common share would have been impacted as follows for the years ended December 31, 2003, 2002 and 2001:
Stock-based compensation expense determined under fair value based method, net of income taxes
In April 2003, the FASB issued FAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” FAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of FAS 133, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying derivative to conform it to language used in FASB Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and (4) amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts as either derivative or hybrid instruments. FAS 149 is effective for contracts and hedging relationships entered into or modified after June 30, 2003, with certain exceptions. All provisions of FAS 149 should be applied prospectively. We have reviewed FAS 149 and complied with the reporting requirements therein. Adopting the provisions of FAS 149 did not have a significant impact on our consolidated financial statements.
Cash and cash equivalents - Carrying value approximates the fair value because of the short maturity of these instruments.
Bonds and equity securities - Fair value was estimated based on prices from a third party institution providing administrative services for investments.
Interest rate swaps - Fair value was estimated using quotes from an institutional broker and represents the cash requirement if the existing agreement had been settled at year-end.
As of December 31, 2003, investments in securities and cash with an amortized cost of $15,836 and a market value of $16,354 were on deposit with the insurance departments in various states as required by law. Investments in securities and cash with an amortized cost of $135,639 and a market value of $136,851 were held in trusts as collateral for reinsurance assumed as required by law in various states in which we assume insurance business.
Also included in 2003 net realized gains and losses were charges of $5,301 for other-than-temporary impairments (“OTTI”) of two private equity holdings and gains of $201 on the sale of real estate. Included in the OTTI charge was $4,539 related to our investment in American Professional Assurance, Ltd. (“APAL”). Plans were put into place during the second quarter of 2003 to transition management of our APAC insurance operations to First Professionals and to non-renew our existing management agreement with APA Management, Inc. (“APAM”) and our 25% quota share reinsurance agreements with APAL effective December 31, 2003. The 25% quota share reinsurance agreements with APAL comprise a significant component of its revenues. In addition to this anticipated decline in future revenues, APAL reported net losses and declines in shareholder’s equity in its most recent financial statements provided to FPIC during the second quarter of 2003.
At December 31, 2003 and 2002, real estate investments consisted of the following:
Total depreciation expense on real estate investments was $277, $286 and $256 in 2003, 2002 and 2001, respectively.
Total depreciation expense on property and equipment was $2,448, $2,154 and $1,930 in 2003, 2002 and 2001, respectively.
Changes in deferred policy acquisition costs for the years ended December 31, 2003, 2002 and 2001 were as follows:
FPIC is currently undergoing an audit of its tax returns by the Internal Revenue Service (“IRS”) for the years ended December 31, 2000 and 2001. Management believes that its positions on issues raised in the examination thus far are meritorious and that its current and deferred tax amounts are appropriate. However, there can be no assurance that additional tax adjustments and related penalties and interest will not be proposed and incurred as a result of an IRS examination.
During 2002, FPIC concluded examinations by the IRS of its consolidated Federal income tax returns for the years ended December 31, 1998 and 1999. As a result of these examinations, a net additional provision for income taxes was recognized in the amount of $554.
The changes in the carrying amount of goodwill for the years ended December 31, 2003, 2002 and 2001 are as follows:
FPIC adopted FAS 142 effective January 1, 2002. In connection with the adoption in the first quarter of 2002, FPIC discontinued the amortization of goodwill and engaged independent valuation consultants to perform transitional impairment tests at each of its operating segments: insurance, reciprocal management and TPA. These operating segments meet the reporting unit requirements as defined by FAS 142.
The fair values for each of the reporting units were calculated using one or more of the following approaches: (i) market multiple approach; (ii) discounted cash flow (“DCF”) approach; and/or (iii) asset approach.
The transitional impairment charge at the reciprocal management segment primarily reflects certain intangibles and synergies, which, in our opinion, are opportunistic in nature and carry a relatively significant degree of uncertainty; therefore, we treated these intangibles conservatively in the valuation required by FAS 142. The transitional impairment charge at the TPA segment primarily reflects changes in market conditions and an increase in competition in recent years in the markets served by FPIC’s TPA segment.
The following table provides comparative disclosures of net income excluding the cumulative effect of accounting change and goodwill amortization, net of taxes, for 2003, 2002 and 2001.
Incurred losses and LAE for claims related to prior years represent the changes in estimates charged or credited to earnings in the current year with respect to the liabilities that originated and were established in prior years. Information regarding incurred losses and LAE is accumulated over time and the estimates of the liability are revised accordingly, resulting in gains or losses in the period revisions are made.
The upward development on prior years’ reserves in 2001 included some increase in the initial estimate for 2000 MPL losses and LAE. In addition and while most claims and incidents reported are closed without a loss payment, we also raised our estimates relative to the ratio of claims closed with a loss payment to all claims and incidents closed in 2001.
Refer to Note 12, Reinsurance for information regarding the Gerling commutation.
FPIC cedes business to other insurance and reinsurance carriers under various reinsurance agreements and fronting programs. FPIC’s reinsurance agreements do not relieve FPIC from its obligations as primary insurer to its policyholders. To the extent that any reinsurer might be unable to meet its obligations, FPIC would nonetheless continue to be liable to its policyholders for the insured losses and LAE.
In 2003 and 2002, FPIC reinsured under its primary excess of loss program losses incurred in excess of $500 (retention on FPIC’s anesthesiology programs was $375 per loss because 25% of that business was ceded to APAL, a Cayman Island insurance company of which FPIC owns 9.8%.) In 2001, we reinsured losses incurred under this program in excess of $250 (retention on FPIC’s anesthesiology programs was $187 per loss because of the program between FPIC and APAL.) The 2001 program included an annual aggregate deductible, which was 10.73% of subject written premium or approximately $12.9 million.
The effect of reinsurance on premiums written and earned and losses and LAE incurred for the years ended December 31, 2003, 2002 and 2001, was as follows:
First Professionals has the option to commute the agreement should the business perform such that the underlying protection proves to be unnecessary, in which case the reinsurance would cease, the underlying reinsurance assets and liabilities would unwind, and any net funds under the agreement, less a 4.2% risk charge to be paid to the reinsurers, would be retained by First Professionals. At December 31, 2003 and 2002, this charge would have been $7,131 and $3,592, respectively. The decision of whether to commute the agreement and the timing of any such commutation will depend on the performance of the underlying business, the need for the agreement based on our capital position and other relevant considerations.
The portion of our total aggregate reinsurance recoverables under the excess of loss programs was $115,722 as of December 31, 2003. Of this amount, $101,484, is due from authorized reinsurers under applicable state insurance regulations, and thus, we do not hold collateral for these recoverables. For the amounts due from unauthorized reinsurers, we hold collateral in the form of securities in trust, irrevocable letters of credit or other funds held. Most of the excess of loss reinsurers are rated at least “A-” by the A. M. Best and, in management’s opinion these recoverables are fully collectible or realizable.
Reinsurance recoverables under the Hannover Re agreement, totaled $138,071, in aggregate, as of December 31, 2003. The two companies with which we place this reinsurance are part of the Hannover Ruckversicherungs Group, which is rated “A” by A. M. Best, but these two subsidiaries are not authorized reinsurers under applicable state insurance regulations. Under the terms of the agreement, we have funds withheld in the amount of $118,356. In addition we hold irrevocable letters of credit totaling $25,571 as collateral for these amounts. Hannover Re also participates in our excess of loss program. We do not hold collateral on balances due from the parent company because it is an authorized reinsurer.
For additional information on the above transactions that are with related parties, refer to Note 22, Related Party Transactions, which is presented below.
interest at three-month LIBOR plus 3.85% (5.01% at December 31, 2003).
Revolving credit and term loan agreement with five banks fully repaid
During 2003, we completed the placement of $10,000 in senior notes and created three trusts that issued 30-year trust preferred securities for which the proceeds from such issuances together with cash previously contributed to the trusts were used to purchase junior subordinated debentures from FPIC totaling $36,083. We used the proceeds along with other internally generated funds to retire our bank term loan and revolving credit facility, make a capital contribution to our insurance operations and unwind hedge agreements related to the revolving credit facility and term loan.
For additional information on FPIC’s hedging instruments and interest costs, see the discussion below under Note 14, Derivative Financial Instruments.
On November 10, 2003, we repaid the remaining outstanding balance of our revolving credit facility and retired the credit facility using the proceeds of the third private placement offering and internally generated funds, including proceeds from the sale of FPIC’s 20% interest in American Physicians’ Insurance Services, Inc., a Texas corporation (“APS”). We also used a portion of the proceeds to unwind the remainder of the interest rate swap agreement used as a hedge for the credit facility’s floating rate interest. A corresponding charge to interest expense of approximately $884 was recognized in the fourth quarter of 2003 for the termination of the interest rate swap agreement. With the repayment and retirement of the credit facility, FPIC and its subsidiaries have been released from the corresponding liens on their assets that served as collateral under the credit facility and from their respective guarantee agreements. We are also no longer subject to the credit facility’s covenants and restrictions.
As of December 31, 2003, FPIC had four interest rate collars. The collars are designed to maintain FPIC’s ultimate floating rate interest costs on its trust preferred securities and unsecured senior notes within a specified interest range for five years from the closing date of those liabilities. The initial costs of the hedge instruments acquired for this purpose of $1,134, in aggregate, have been capitalized and will be amortized over their respective five year maturity periods.
Under the interest rate collars, when the three-month LIBOR interest rate exceeds the specified cap rate or falls below the specified floor rate, we receive or pay, respectively, the related cash flow equal to the difference in percentage times the notional principal under the respective contracts. The two portions of each contract working together, therefore, form a hedge against the effects of a rising three-month LIBOR rate above the cap or a falling three-month LIBOR rate below the floor. The notional amounts referenced in the interest rate collars equal the related trust preferred securities or senior notes, as applicable. The notional amounts of the contract are not exchanged. Therefore, working together the excess of the interest expense on our securities over the cap rate, or the shortfall in interest expense under the floor, are offset by related receipts of excess interest under the caps, or the payment of the interest shortfall below the floor, respectively. No other cash payments are made unless the contract is terminated prior to maturity, in which case the amount paid or received in settlement is established by agreement at the time of termination, and usually represents the net present value, at current interest rates, of the remaining obligations to exchange payments under the terms of the contract.
The interest rate collar instruments are reflected at fair value in FPIC’s consolidated statements of financial position and the effective portion of the related gains or losses on the agreements are recognized in shareholders’ equity (as a component of accumulated other comprehensive income (loss)). The net effect of this accounting on FPIC’s operating results is that interest expense on the variable debt being hedged is recorded based on fixed interest rates.
FPIC had interest rate swap agreements that provided a hedge against changes in the amount of cash flows associated with the variable interest expense associated with its former revolving credit facility and term loan. These were terminated in connection with the paydown and retirement of FPIC’s bank credit facility. As a result, charges of $2,493 were recognized as interest expense and the related unrealized loss of $1,532 after income taxes was eliminated from accumulated other comprehensive income. The fair value of the interest rate
swaps was a loss of $3,383 and $2,943 at December 31, 2002 and 2001, respectively, which was reported within other liabilities in the statements of financial position.
For additional information regarding the 100% quota share agreement with PRI, see Note 22, Related Party Transactions.
Total rental expense was $2,636, $2,581 and $2,410 for 2003, 2002 and 2001, respectively.
FPIC’s insurance subsidiaries from time to time become subject to claims for extra-contractual obligations or risks in excess of policy limits in connection with their insurance claims. These claims are sometimes referred to as “bad faith” actions as it is alleged that the insurance company acted in bad faith in the administration of a claim against an insured. Bad faith actions are infrequent and generally occur in instances where a jury verdict exceeds the insured’s policy limits. Under such circumstances, it is routinely alleged that the insurance company failed to negotiate a settlement of a claim in good faith within the insured’s policy limit. FPIC has evaluated such exposures as of December 31, 2003, and believes its position and defenses are meritorious. However, there can be no absolute assurance as to the outcome of such exposures. FPIC currently maintains insurance for such occurrences, which serves to limit exposure to such claims. However, in one case arising in 1993, no such coverage is available and an estimate of possible loss above the amount currently reserved cannot be made. In addition, multiple claims for extra contractual obligations in a single year could result in potential exposures materially in excess of insurance coverage or in increased costs of insurance coverage.
FPIC may also become involved in legal actions not involving claims under its insurance policies from time to time. FPIC has evaluated such exposures as of December 31, 2003, and in all cases, believes its position and defenses are meritorious. However, there can be no absolute assurance as to the outcome of such exposures.
FPIC’s insurance subsidiaries are subject to assessment by the financial guaranty associations in the states in which they conduct business for the provision of funds necessary for the settlement of covered claims under certain policies of insolvent insurers. Generally, these associations can assess member insurers on the basis of written premiums in their particular states.
While management has evaluated the incidents and circumstances surrounding the above-mentioned asserted or unasserted legal claims and assessments of which it is aware and believes that these will not have materially adverse effects on FPIC beyond amounts already recognized and accrued, there can be no absolute assurance as to their ultimate outcomes.
At December 31, 2003 and 2002, 578,380 and 558,641 shares of FPIC’s common stock, respectively were reserved for issuance in connection with the stock option plans. A summary of the status of FPIC’s stock options is presented below:
The fair value of options granted, which is amortized to expense over the option vesting period in determining the pro-forma information presented in Note 2, Significant Accounting Policies, to the consolidated financial statements about stock-based compensation, is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
The FPIC defined contribution profit sharing plan is available to all employees of FPIC after meeting certain eligibility requirements. The plan is comprised of two parts. The first part of the plan is a defined contribution plan that allows employees to contribute up to 12.5% of their annual compensation, subject to IRS limits. FPIC contributes a matching amount equal to 2.5% of the employee’s annual compensation. The second part of the plan is a profit sharing plan, whereby FPIC may at its discretion make an additional contribution to the plan up to a maximum of 10% of the employee’s annual compensation. FPIC’s policy is to fully fund the liability for the matching portion at the end of each year. At December 31, 2003 and 2002, the fair market value of defined contribution profit sharing plan assets was $8,174 and $5,121, respectively. The expense for this plan amounted to $1,189, $990 and $1,138 in 2003, 2002 and 2001, respectively.
The FPIC defined benefit plan is available to all eligible employees of FPIC who have six months of service and whose ages are twenty and one half years of age or older. The amount of benefits is based on years of service and 0.75% of the employee’s average monthly salary not over the Social Security base plus 1.4% of the employee’s average monthly salary over the Social Security base. FPIC’s policy is to contribute the maximum amount towards funding benefits under the plan subject to IRS limits. At December 31, 2003 and 2002, the fair market value of defined benefit plan assets was $3,281 and $1,651, respectively. FPIC had a net periodic pension cost of $463, $277 and $217 for this plan in 2003, 2002 and 2001, respectively. The expense for this plan amounted to $1,275, $183 and $143 in 2003, 2002 and 2001, respectively.
The Tenere defined contribution profit sharing plan and trust is available to all employees of Tenere upon meeting certain eligibility requirements. The plan is comprised of two parts. The first part is a defined contribution plan that allows employees to contribute a portion of their annual compensation, subject to IRS limits. The second part is a profit sharing plan, whereby Tenere may at its discretion contribute an employer contribution to the plan. At December 31, 2003 and 2002, the fair market value of plan assets was $881 and $773, respectively. The expense for this plan amounted to $62, $76 and $66 in 2003, 2002 and 2001, respectively.
The Tenere money purchase plan is available to all employees of Tenere upon meeting certain eligibility requirements. The plan is designed to provide benefits based on length of service, whereby Tenere will make contributions to the plan on behalf of the participants for each year of service until the employee retires. At retirement, the employee will be eligible to receive the value of the contributions made to the plan on the employee’s behalf. Tenere contributes on behalf of each participant an amount equal to 6.0% of the employee’s annual compensation plus 5.7% of the employee’s annual compensation in excess of the Social Security Taxable Wage Base. At December 31, 2003 and 2002, the fair market value of plan assets was $290 and $358, respectively. The expense for this plan amounted to $71, $94 and $94 in 2003, 2002 and 2001, respectively.
The actuarially computed net periodic pension cost for our two defined benefit plans and SERP combined for the years ending December 31, 2003, 2002 and 2001, included the following:
At the present time, the target asset allocation for FPIC is approximately 60% in debt securities and 40% in equity securities. AFP’s target asset allocation is approximately 35% in debt securities, 20% in convertible debt securities, and 45% in equity securities. Debt securities in both FPIC and AFP include a combination of money market, bond and mortgage backed investments. Equity securities are fairly evenly distributed in a diversified portfolio of large, medium and small cap investments, with a modest international component.
FPIC and AFP’s portfolios are subject to review periodically and rebalanced accordingly, if market conditions change or the portfolio needs to be rebalanced to meet target allocations.
In accordance with the provisions of FAS 131, “Disclosures about Segments of an Enterprise and Related Information,” FPIC has determined that it has three reportable operating segments: insurance, reciprocal management and TPA. Our insurance segment specializes in professional liability insurance products and services for physicians, dentists and other healthcare providers. The reciprocal management segment contains our subsidiary AFP, which serves as the exclusive manager and attorney-in-fact of PRI, an insurance reciprocal in New York. PRI is a major client of ours and our revenues and results of operations are financially sensitive to its revenues and financial condition. We do not own PRI, or have a controlling financial interest in PRI, nor is PRI considered a variable interest entity under FIN 46R and so PRI’s financial statements are not consolidated or included in ours. Instead, PRI is similar to a mutual insurer and the risks and rewards of ownership basically vest with the policyholders of PRI. The reciprocal management segment also provides brokerage, administration and intermediary services for insurance and reinsurance programs to PRI and FPIC. Our TPA segment provides administrative and claims management services to self-insured employer groups for group accident and health, workers’ compensation and general liability and property insurance plans.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies found in Note 2. FPIC evaluates a segment’s performance based on net income or loss and accounts for intersegment sales and transfers as if the sales or transfers were to a third party. Holding company operations are included within the insurance segment due to the size and prominence of the segment and the substantial attention devoted to it. Intersegment revenues for transactions between the segments are based on actual costs incurred and are similar to services that may have been obtained from an unrelated third party. All segments are managed separately because each business requires different technology and marketing strategies.
The following table provides a reconciliation of reportable segment assets to FPIC’s consolidated assets:
First Professionals, APAC, Intermed and Interlex are required to file statutory-basis financial statements with state insurance regulatory authorities. The insurance subsidiaries are restricted under the Florida and Missouri Insurance Codes as to the amount of dividends they may pay without regulatory consent. In 2004, and based on the amounts of capital and surplus of our insurance subsidiaries as of December 31, 2003, dividends of $13,407 may be paid to FPIC, the holding company, without regulatory consent.
The restricted net assets for FPIC’s insurance subsidiaries at December 31, 2003, 2002 and 2001, are as follows:
The statutory capital and surplus for FPIC’s insurance subsidiaries at December 31, 2003, 2002 and 2001, is shown in the table below.
In March 1998, the National Association of Insurance Commissioners (“NAIC”) adopted the Codification of Statutory Accounting Principles (the “Codification”) as the NAIC supported basis of accounting. Codification affects all statutory financial statements issued after January 1, 2001. The Codification was approved with a provision allowing for discretion by each state’s Department of Insurance (“DOI”) in determining appropriate statutory accounting for insurers. Accordingly, such discretion will continue to allow prescribed or permitted accounting practices that may differ from state to state or company to company. The Codification does not affect FPIC’s consolidated financial statements, which have been prepared in accordance with GAAP.
FPIC’s insurance subsidiaries: First Professionals, APAC, Intermed and Interlex prepare financial statements for regulatory purposes on a statutory-basis in conformity with the accounting practices prescribed or permitted by the states of Florida and Missouri. On a consolidated basis and at the subsidiary level, FPIC’s statutory capital and surplus exceeded applicable regulatory and risk-based capital requirements.
Corresponding liability for losses and LAE under fronting arrangements was ($71,620) and ($63,529) as of December 31, 2003 and 2002, respectively.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the management agreements with APAM and CGA.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the 25% quota share reinsurance agreement with APAL.
Corresponding liability for losses and LAE was ($14,938) and ($4,976) as of December 31, 2003 and 2002, respectively.
Corresponding direct premiums earned were ($26,262), ($17,998) and ($5,726) for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
Corresponding direct losses and LAE incurred were $20,014, $7,427 and $3,881 for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
On July 1, 1998, First Professionals began assuming reinsurance from PRI, a writer of medical liability insurance in the state of New York. PRI is managed by an attorney-in-fact, AFP, which is a wholly owned subsidiary of FPIC. Under one contract, which reinsures PRI for policies with limits of $1.0 million in excess of $1.0 million, First Professionals assumes losses only and pays PRI a ceding commission on the premiums assumed. Effective April 1, 2002, the contract was changed to reinsure PRI for policies with limits of $1.0 million in excess of $1.3 million. Under another contract, which First Professionals and PRI ceased to renew for periods subsequent to December 31, 2000, First Professionals reinsured PRI for losses of $0.25 million in excess of $0.5 million on each claim. Premiums on these contracts are paid by PRI on a quarterly basis.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the reinsurance agreements with PRI.
AFP has an exclusive ten-year management agreement with PRI with the current term ending December 31, 2008. During 2002, the management agreement between AFP and PRI was amended to remove the sharing by AFP of 10% of PRI’s statutory net income or loss, effective January 1, 2002. Compensation under the agreement as originally in effect was equal to 13% of PRI’s direct premiums written, with an adjustment for expected return premiums, plus or minus 10% of PRI’s statutory net income or loss. With regard to profit sharing amounts already earned and collected, AFP has agreed to hold the years 1999, 2000 and 2001 open for re-determination and possible adjustment for a period of five years each (expiring 2004, 2005 and 2006, respectively.) Such adjustments would be based primarily on development of and related adjustments, if any, to loss and LAE reserves for those years. AFP has earned and collected profit sharing amounts under the original agreement totaling $3.6 million for the three years ended December 31, 2001. In accordance with the amended agreement, AFP has agreed to pay 6% annual interest on the 10% profit share amounts already earned and collected under the original agreement for 1999, 2000 and 2001, while those years remain open for possible future re-determination and adjustment, if any. In addition, AFP is reimbursed for 50% of the costs associated with the risk management department it maintains for PRI insureds. The management agreement and amendments were reviewed and approved by the New York State Insurance Department.
The following table summarizes the related party assets as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the management agreement with PRI.
In addition to the management agreement with PRI, AFP through its subsidiary FPIC Intermediaries provides brokerage, administration and intermediary services for insurance and reinsurance programs to PRI with the brokerage commissions being paid by the reinsuring company. As a result of its relationship with PRI, FPIC Intermediaries earned brokerage placement commissions of $1,718, $1,744 and $1,335 for the years ended December 31, 2003, 2002 and 2001 for the placement reinsurance on behalf of PRI with other reinsurance carriers. FPIC Intermediaries also earned brokerage commissions of $1,008, $952 and $1,012 from First Professionals for the years ended December 31, 2003, 2002 and 2001 for the placement of reinsurance with First Professionals from PRI. The brokerage commissions from First Professionals are eliminated in the consolidated financial statements.
Effective July 1, 2000, First Professionals entered into an agreement with PRI whereby, First Professionals, through PMA, manages an MPL insurance program in Pennsylvania for PRI. Under this program, whereby business is written on First Professionals’ policy forms and ceded to PRI under a 100% quota share reinsurance agreement, FPIC receives a fronting fee of 7% and PMA receives an administration fee of 20% of premiums written, in return for its services to PRI, which include underwriting, claims management and other administrative aspects of this program. PMA also pays all commissions and brokerage to outside agents and brokers for the placement of business under the program. Effective January 1, 2002, the terms of this agreement were amended to cede 100% of the premiums written to PRI. The amendment has been filed with the New York State Insurance Department.
FPIC had an insurance program with APIE, a Texas medical professional liability insurance exchange, whereby, through December 31, 2002, business was written on First Professionals’ policy forms and substantially all the underlying insurance risks and premiums were ceded to APIE for a fronting fee. We owned 20% of the outstanding common stock of APS, which serves as the exclusive management company for APIE until October 1, 2003, at which time we sold our 20% investment to the majority (80%) owner for $2,050 in cash. A small gain was recognized on this transaction. One of our senior officers also served on the APS board of directors. This program was terminated effective December 31, 2002.
The APIE fronting program expired December 31, 2002, at which time we ceased writing business for APIE on our policy forms and placed the existing business in run-off. As of December 31, 2003, there are no more active policies in this program.
The following table summarizes the related party assets and liabilities as of December 31, 2003 and 2002 and revenues and expenses for the years ended December 31, 2003, 2002 and 2001 resulting from the fronting program with APIE. The corresponding direct business with non-related parties is indicated as a footnote to the table.
Corresponding liability for losses and LAE was ($18,228) and ($37,878) as of December 31, 2003 and 2002.
Corresponding direct losses and LAE incurred were $3,678, $9,352 and $20,268 for the twelve months ended December 31, 2003, 2002 and 2001, respectively.
The principal individual owner of one of FPIC’s insurance agents and brokers serves as a director of FPIC. This director’s firm also acts as FPIC’s agent in purchasing its internal insurance. The commissions paid by FPIC to the director’s firm were approximately $338, $227 and $112 during the years ended December 31, 2003, 2002 and 2001, respectively. In addition, FPIC obtains corporate legal services from time to time from an outside law firm, a partner of which is also a director of FPIC. Costs incurred during the years ended December 31, 2003 and 2002 by FPIC with respect to these legal services were $136 and $11, respectively.
During the fourth quarter of 2001, FPIC recorded a pre-tax charge of $632 in connection with the disposition of its unprofitable TPA division in Albuquerque, New Mexico. Under the plan, FPIC sold the division’s assets and cancelled its service agreements with self-insured customers. Certain other contracts were retained and are serviced by FPIC’s Jacksonville, Florida, TPA division. The 2001 restructuring activity was a continuation of FPIC’s consolidation of the TPA operations and brings to an end the restructuring activities of the Albuquerque division that began during the fourth quarter of 2000 when FPIC incurred a pre-tax charge of $500. As a result of the plan, fifty-two employees were terminated at December 31, 2001. This reduction represented 24% of the TPA workforce and 100% of the New Mexico office. Thirty employees were terminated at December 31, 2000. This reduction represented 12% of the TPA workforce and 35% of the New Mexico office. All employees terminated in 2001 and 2000 were located in the Albuquerque location.
Restructuring activity for years 2003, 2002 and 2001 was as follows:
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2003, 2002 and 2001: