We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be approximately five years in length. We currently lease a total of approximately 70,000 square feet of
The weighted average shares outstanding for the years ended December 31, 2002 and 2001, were 9,339,739 and 11,071,529 basic common shares, respectively. As the Company was in a net loss position for the years ended December 31, 2002 and 2001, no effect of awards or options were calculated as the impact would have been anti-dilutive. The weighted average shares outstanding for the period from December 13, 2000, the date of the conversion, to December 31, 2000 were 11,134,981 basic common shares and 11,260,797 common shares assuming dilution. There were no cash dividends declared during the periods presented.
We are a leading provider of medical professional liability insurance coverage, writing this coverage in 17 states throughout the country. This insurance coverage protects physicians and other health providers from claims filed against them for alleged acts of medical malpractice. Medical professional liability insurance represented 66.6% of our direct premiums written in 2002. In addition, we write workers’ compensation insurance in 11 states, insuring a variety of business classes. During 2002, we also provided a limited amount of general personal and commercial coverage and participated in a health insurance program.
Our policy liability limits vary by line and state. In workers’ compensation insurance, state statutes dictate the coverage we offer our policyholders. For medical professional liability insurance, most states allow physicians to choose their own coverage limits. The limits of liability purchased by our medical professional liability policyholders differ by state. In Michigan and New Mexico, the most common limits purchased by our policyholders are $200,000 per claim, with a $600,000 annual aggregate ($200,000/$600,000). In Florida, the most common limits purchased are $250,000/$750,000. In all other states, the most common limit purchased is $1 million per claim, with a $3 million annual aggregate. Higher limits and excess coverage may be written in conjunction with special reinsurance arrangements.
The principal agency through which we write medical professional liability insurance is SCW Agency Group, Inc. and its wholly owned subsidiaries. SCW is 91.1% owned by William Cheeseman, our president and chief executive officer. Bridget Cheeseman, Mr. Cheeseman’s adult daughter, is a vice president of SCW and owns approximately 2.5% of SCW. During the last three years, Mr. Cheeseman has received no cash or other compensation, dividends or other distributions from SCW and his only benefit from SCW from this relationship is the potential appreciation of his ownership interest in that company. If SCW increases the amount of business it writes for us, SCW will earn more commission revenue from us. To the extent the increase in commission revenue we pay SCW increases SCW’s profits, Mr. Cheeseman’s ownership interest may appreciate. Also, to the extent our financial performance as a whole improves or deteriorates, whether due to the business relationship with SCW or otherwise, the Compensation Committee is likely to consider such improvement or deterioration in Company performance when determining Mr. Cheeseman’s compensation.
SCW sells insurance written by several companies. However, the commissions it receives on premiums it writes for the Company typically account for 65% to 75% of its revenues. Direct premiums written for us by SCW during 2002, 2001 and 2000 totaled $70,810,000, $68,896,000 and $67,758,000, respectively, representing 26.6%, 29.9% and 33.4% of our direct premiums written during such years. Commission expense we incurred and paid to SCW approximated $5,560,000, $4,660,000 and $4,633,000 in 2002, 2001 and 2000, respectively.
We have put in place various safeguards to protect the Company from actual or potential conflicts of interest arising from this relationship. The commission rates we currently pay to SCW were determined by negotiations between our marketing staff and SCW’s management and approved by our board of directors without involvement by Mr. Cheeseman. In rendering its approval, the board of directors considered the fairness of the agreed rates and determined they were fair to the Company based upon, among other things, an evaluation of market rates and other Company agency agreements. A new agency contract is currently being negotiated by a special committee of our board of directors and SCW management without involvement by Mr. Cheeseman. The new contract is expected to have an extended term and to provide for payment of commission rates which are at least as favorable to the Company as those paid under the prior contract. Mr. Cheeseman is prohibited from acting as a director, officer or employee of SCW and, pursuant to Company policy, does not participate in day-to-day discussions between the Company and SCW or in decisions about whether to underwrite business proposed to be written by SCW. Moreover, we apply the same underwriting rules to business written by SCW as we apply to business written by other agencies. These underwriting rules are generally filed with the regulatory agencies in the various states in which we do business and are established solely by the Company in order to control the quality of business submitted by all agents, including SCW. We also monitor our loss experience on the business written by our agents, including SCW.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect amounts reported in the accompanying consolidated financial statements and related footnotes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. The following policies are those we believe to be the most sensitive to estimates and judgments. Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements.
Unpaid losses and loss adjustment expenses. The reserves for unpaid losses and loss adjustment expenses are actuarially estimated using the Company’s claim experience. These estimates are subject to the effects of trends in loss severity and frequency. When a claim is reported to us, claims personnel establish a
We currently have a staff of internal actuaries who develop projections of ultimate losses that are used to establish recorded reserves. Management utilizes these actuarial projections, as well as qualitative input from the actuarial staff, and an independent actuarial firm, to establish a “best estimate” recorded reserve amount. While management does not explicitly calculate an acceptable “range” of probable reserves, historical results have shown ultimate losses can vary from our initial estimates in a range of plus or minus 7%.
Investments. Investments represent our largest asset and are the primary source of funds to pay insurance claims. All of our fixed maturity securities are classified as available-for-sale, which are those securities that would be available to be sold in the future in response to our liquidity needs, changes in market interest rates and asset-liability management strategies. Available-for-sale securities are reported at their estimated fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income, net of deferred taxes. Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method relating to investments acquired at other than par value.
Equity securities are carried at quoted market values. Fair values of fixed maturities and equity securities are determined on the basis of dealer or market quotations or comparable securities on which quotations are available. Mortgage loans at December 31, 2001 were carried at the unpaid principal balance, which approximated the fair market value as they bore current market interest rates at that date. There were no mortgage loans at December 31, 2002. Real estate is carried at historical cost, less accumulated depreciation. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
We periodically review our investment portfolio for any potential credit quality or collection issues. We specifically reviewed for any securities that we considered to have any decline in market value to be other than temporary. Investments which are considered impaired are written down to their estimated net realizable value. We utilize both quantitative and qualitative evaluation methods to evaluate the potential for other than temporary impairment (“OTTI”). At December 31, 2002, we established a reserve of $1.0 million on investment real estate primarily due to depressed real estate prices and lower than expected cash flows. Additionally, we wrote down our investment in Frontier bonds $520,000 in 2002 and $5.9 million in 2001. We noted no other investments that required a write down for OTTI. We did analyze $6.5 million of enhanced equipment trust certificates we owned that were issued by Delta Airlines. These certificates traded at 75.53% of par at December 31, 2002. However, based on the economic performance of Delta, its strong balance sheet position, and the fact that the certificates are collateralized by newer, fuel-efficient aircraft, no impairment was deemed necessary.
$1.7 million of this loss. Management analyzed the United Airlines bonds at September 30, 2002 and concluded that the decline in fair market value as of that date was temporary. In the fourth quarter, United Airlines filed for bankruptcy. As a result of that event, management believed that the impairment was now other than temporary, and management made the decision to sell the security at a loss.
Reserve for extended reporting period claims. The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, utilizing the pure-premium approach, in amounts believed to be adequate to pay for estimated future claims reported subsequent to a current policyholder’s death, disability or retirement. Amounts are estimated on a basis similar to the estimates made in respect of the reserve for unpaid losses and loss adjustment expenses. Changes in this reserve are reflected as an expense in the period in which the adjustment is made.
We annually review the financial stability of all of our reinsurers. This review includes a ratings analysis of each reinsurer participating in a reinsurance contract. On the basis of this review, as of December 31, 2002, we concluded that there was no material risk of not being paid by our reinsurers. We performed additional analysis on Gerling Global given its recent downgrade to B- and actions by its parent company to put its United States subsidiary into run-off. Despite Gerling Global’s B- A.M. Best rating at December 31, 2002, our review indicates that Gerling Global still has adequate surplus and cash flow, and we have not experienced any difficulties in collecting amounts due from Gerling Global, or any other reinsurers. However, we will continue to monitor Gerling Global situation carefully, and may pursue an economic settlement or commutation if we determine that is the best long-term course of action. We believe that our reinsurance is maintained with financially stable reinsurers and that any reinsurance security we have is adequate to protect our interests. However, our inability to collect on our reinsurance, or the inability of our reinsurers to make payments under the terms of reinsurance, due to insolvency or otherwise, could have a material adverse effect on our future results of operations and financial condition.
Income Taxes. Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. We review our deferred federal income tax asset on a quarterly basis for recoverability based on the availability of future taxable income in the years when the deductible temporary differences are expected to reverse. Our deferred tax assets primarily relate to deductible temporary differences (“DTD’s”) for unpaid loss and loss adjustment expenses and unearned premiums, as well as minimum tax credit carryforwards. Most of our DTD’s reverse in the next three years and will more likely than not be realized as management has taken premium rate increases and other underwriting actions that are anticipated to generate taxable income in those years.
Loss ratio - This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The calendar year loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The accident year loss ratio uses only those loss and loss adjustment expenses that relate to the current accident year (i.e., excludes the effect of development on prior year loss reserves). The lower the percentage, the more profitable our insurance business is, all other things being equal.
Combined ratio - This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income.
The statutory ratios will differ from GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, versus net premiums written for the statutory underwriting expense ratio.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our medical professional liability insurance operations for the years ended December 31, 2002 and 2001.
In the second quarter of 2002, the Company announced its intention to discontinue writing medical professional liability insurance in Florida. Medical professional liability direct premiums written in the state of Florida for the year ended December 31, 2002 were $23.6 million and the Company reported net loss and loss adjustment expenses for that period of $35.2 million in Florida. The Florida Department of Insurance has approved the Company’s plan to exit this market and in October 2002, the Company began mailing non-renewal notices to medical professional liability policyholders in Florida whose renewals would have been effective in December 2002. Florida law requires the Company to offer extended reporting coverage, commonly referred to as “tail policies,” at the time of non-renewal. Tail policies typically have written premiums of approximately two times the last annual policy premium. The Company expects that some physicians will opt for this extended reporting coverage, which will result in additional direct premiums written in 2003. The amount of these future premiums cannot be reasonably estimated due to the uncertainty regarding the number of physicians who will opt for the coverage. The Company is exploring various
In the fourth quarter of 2002, the Company began to exit the Kentucky workers’ compensation market, as well as non-renew certain higher-risk construction policies in all markets. These actions had the effect of decreasing workers’ compensation direct premiums written for the three months ended December 31, 2002, to $9.5 million from $13.4 million for the same period of 2001. Management expects the trend of decreasing direct premiums written to continue into the near future as it implements its business plans to replace the Kentucky and construction policy premiums as discussed below.
Net premiums earned were $63.5 million for the year ended December 31, 2002, an increase of $5.1 million, or 8.8% compared to 2001. Net premiums earned increased more than direct premiums written due to a change in one of the Company’s reinsurance treaties that resulted in decreased ceded premiums in 2002.
Incurred loss and loss adjustment expenses totaled $55.2 million for the year ended December 31, 2002, a decrease of $7.6 million, or 12.0 % compared to 2001. The workers’ compensation incurred loss and loss adjustment expense ratio decreased to 86.8% for the year ended December 31, 2002, from 107.4 % for 2001. The decrease in the loss ratio was due to an overall pattern of increasing premium rates and reduced discounts in all markets, as well as a $5.0 million reserve enhancement related to prior accident years recorded in 2001. Without the adverse development related to prior accident years the 2001 loss ratio, on an accident year basis, was 97.8%. There was no reserve development related to prior accident years in 2002.
Net premiums earned were $23.8 million for the year ended December 31, 2002, an increase of $5.2 million, or 27.6% compared to 2001. Health net premiums earned increased less than direct premiums written due to a change in reinsurance treaties that resulted in increased ceded health premiums in 2002.
Underwriting expenses were $4.8 million for the year ended December 31, 2002, an increase of $656,000, or 15.6% compared to 2001. The health underwriting expense ratio decreased to 20.4% for 2002 from 22.5% for the year ended December 31, 2001. Health commission expense for the year ended December 31, 2002 was $2.5 million, compared to $2.3 million during 2001. The decrease in the health underwriting ratio was primarily the result of holding underwriting salaries and employee benefit costs relatively constant, while net premiums earned increased 27.6% during the year ended December 31, 2002.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our personal and commercial insurance operations for the years ended December 31, 2002 and 2001.
Because net premiums earned in 2002 were a negative amount, calculated ratios are not meaningful.
Effective December 31, 2001, the Company exited the personal and commercial lines of business with the exception of a single alternative-risk-transfer program. Direct premiums written associated with this program were $380,000 for the year ended December 31, 2002. Direct written premiums for the year ended December 31, 2001, represent premiums returned to insureds of ($466,000).
During the year ended December 31, 2002, the Company recorded net premiums earned of $(432,000). This amount represents additional ceded premiums earned of $(590,000) in connection with one of the Company’s reinsurance treaties and $158,000 of net premiums earned related to the alternative-risk-transfer program mentioned above. The premiums and risk related to this alternative-risk-transfer program were originally 100% ceded; however, in the fourth quarter of 2002, the Company began to participate in a portion of this program and will continue to earn premiums associated with the program into 2003. Personal and commercial net premiums earned were $5.7 million for the year ended December 31, 2001.
The average yield on the Company’s investment portfolio was 6.09% for the year ended December 31, 2002 compared to 6.36 % for 2001. The market value of the Company’s fixed income security portfolio is inversely related to interest rates; therefore, as interest rates have declined, the market value of the Company’s fixed income security portfolio has increased. Unrealized gains, net of deferred income taxes, on the Company’s investments were $24.6 million at December 31, 2002, an increase of $18.8 million compared to December 31, 2001.
The Company’s general and administrative expenses decreased $263,000, or 11.8%, to $1.9 million during the year ended December 31, 2002 compared to 2001. The decrease in general and administrative expenses was primarily the result of the elimination of positions at the Company’s non-insurance subsidiaries.
In 2001, the Company recorded a restructuring charge of $2.5 million. There were no restructuring activities initiated in 2002. See Note 13 to the Consolidated Financial Statement, included elsewhere in this report, for a further discussion of our restructuring activities.
The net loss for the year ended December 31, 2002 was $18.5 million on revenues of $280.5 million, compared to a net loss of $43.8 million on revenues of $245.1 million for 2001. The net loss for the year ended December 31, 2002 included a $9.1 million charge, net of tax, for the cumulative effect of a change in accounting principle. The 2002 net loss before the cumulative effect of a change in accounting principle was $9.4 million. The decrease in net loss was due primarily to increases in net premiums earned, which decreased the incurred loss and loss adjustment expense and underwriting expense ratios for the year ended December 31, 2002, compared to 2001. Unfavorable development on prior year loss reserves decreased $23.4 million to $5.6 million for the year ended December 31, 2002 from $29.0 million for the year ended December 31, 2001. This decrease in unfavorable prior year development also had the effect of decreasing the net loss for the year ended December 31, 2002 as compared to 2001.
Medical professional liability direct premiums written were $149.3 million for the year ended December 31, 2001, an increase of $25.3 million, or 20.4% compared to 2000. The increase in direct premiums written was primarily the result of premium rate increases, reduced discounts, and policy growth in our Florida and Illinois markets; however, these factors were offset by the reduction in the number of insured physicians in Ohio and Kentucky as a result of our re-underwriting efforts.
Net premiums earned were $119.7 million for the year ended December 31, 2001, an increase of $10.2 million, or 9.3%, compared to 2000. Net premiums earned did not increase as much as direct premiums written in 2001 as many of the premium rate increases and reduced discounts were instituted in the second half of the year, and remained to be earned at December 31, 2001. In addition, we recorded additional ceded premium on all affected swing-rated reinsurance treaties due to the higher losses, which amounted to a $6.3 million increase in ceded premiums.
Incurred loss and loss adjustment expenses totaled $168.6 million for the year ended December 31, 2001, an increase of $72.6 million, or 75.7%, compared to 2000. The incurred loss and loss adjustment expense ratio increased to 140.9% for the year ended December 31, 2001 from 87.6% for 2000. The increase in the loss ratio was due primarily to reserve adjustments taken in the third and fourth quarters of 2001 that related to prior accident years, and revisions made to current year, expected losses. Due to the unexpected significant increase in reported losses and claim severity primarily in our newer markets in the third quarter of 2001, including an unusually high frequency of large claims, we undertook and completed a comprehensive internal actuarial study. As a result of this study, we revised the actuarial assumptions that loss reserves are based upon, and adjusted loss reserves accordingly.
The reserve adjustments included a total of approximately $22.7 million increase on prior accident years, primarily the 2000 and 1999 years. In addition, the current accident year loss estimates were increased to approximately $145.9 million to reflect our revised assumptions regarding loss development patterns. The adjustments were made primarily as a result of losses in our Ohio, Florida and Kentucky medical professional liability markets. Ohio and Florida were relatively new markets for us and had higher policy limits. Thus, actual loss development was volatile and difficult to predict. With these revised loss assumptions, the 2001 accident year net loss and loss adjustment expense ratio is 121.9%. We discontinued offering higher policy limits in Ohio and Florida in the third quarter of 2001.
Underwriting expenses were $23.3 million for the year ended December 31, 2001, an increase of $2.7 million, or 12.9%, compared to 2000. The underwriting expense ratio was 19.5% for the year ended December 31, 2001, compared to 18.8% for 2000. This increase was due primarily to the growth of premiums in states where we pay higher commissions than we pay in Michigan, where we have an arrangement with SCW, which results in commissions at rates that are substantially the same or lower than we pay to other agents.
Incurred loss and loss adjustment expenses totaled $62.7 million for the year ended December 31, 2001, an increase of $25.1 million, or 66.7%, compared to 2000. The incurred loss and loss adjustment expense ratio increased to 107.4% for the year ended December 31, 2001 from 80.1% for 2000. The increasing loss ratio was due to an overall pattern of increasing losses, especially in our newer states, Illinois, Iowa and Kentucky, where we have less historical data on which to base our estimates. As a result of these high loss patterns, we increased our prior year reserves in almost all markets by a total of $5.6 million. The current accident year loss
Workers’ compensation underwriting expenses were $16.4 million for the year ended December 31, 2001, an increase of $3.1 million, or 23.6%, compared to 2000. The underwriting expense ratio decreased to 28.1% for the year ended December 31, 2001, from 28.3% for 2000. The decrease resulted primarily from our expense reduction initiatives, lower assessments and fees, and premium increases.
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our health insurance operations for the years ended December 31, 2001 and 2000.
Health direct premiums written were $18.0 million for the year ended December 31, 2001, an increase of $4.8 million, or 36.2% compared to 2000. The increase in direct premiums written was due to a single health insurance program through a preferred provider organization in West Michigan. We discontinued all other health programs in 2001.
Net premiums earned were $18.7 million for the year ended December 31, 2001, an increase of $7.6 million, or 68.7% compared to 2000. Health net premiums earned increased more dramatically than direct premiums written in 2001 due to a change in reinsurance treaties that resulted in decreased ceded premiums in 2001.
Incurred loss and loss adjustment expenses totaled $18.4 million for the year ended December 31, 2001, an increase of $8.4 million or 83.9%, compared to 2000. The incurred loss and loss adjustment expense ratio increased to 98.7% for the year ended December 31, 2001, from 90.5% for 2000. The increase in the loss ratio was due to overall increases in health care costs, primarily in the state of Michigan. We increased health insurance premium rates in 2002 to offset these higher health loss costs.
Underwriting expenses were $4.2 million for the year ended December 31, 2001, an increase of $517,000, or 14.1%, compared to 2000. The underwriting expense ratio decreased to 22.5% for the year ended
The following table sets forth summary premium, loss and expense information regarding the underwriting results of our personal and commercial insurance operations for the years ended December 31, 2001 and 2000.
Net premiums earned were $5.7 million for the year ended December 31, 2001, a decrease of $7.1 million, or 55.7% compared to 2000. Personal and commercial net premiums earned did not decrease as dramatically as direct premiums written in 2001 as premiums written in 2000 continued to be earned in 2001.
Incurred loss and loss adjustment expenses totaled $8.1 million for the year ended December 31, 2001, a decrease of $1.7 million or 17.3%, compared to 2000. The incurred loss and loss adjustment expense ratio increased to 143.2% for the year ended December 31, 2001, from 76.7% for 2000. The increasing loss ratio was due primarily to a higher amount of winter storm-related losses in 2001, and the adverse effect on premium of discontinuing this line of business.
Underwriting expenses were $1.2 million for the year ended December 31, 2001, a decrease of $3.3 million, or 73.0%, compared to 2000. The underwriting expense ratio decreased to 21.8% for the year ended December 31, 2001 from 35.8% for 2000. The reduction was directly related to our exit from this line of business beginning in the fourth quarter of 2000.
APCapital itself is a holding company whose only material assets are the capital stock of APAssurance and its other subsidiaries, and a portion of the net proceeds from the stock offering. APCapital’s ongoing cash flow will consist primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. The payment of dividends to APCapital by its insurance subsidiaries is subject to limitations imposed by applicable law.
The Company’s only indebtedness is to its President and Chief Executive Officer (the “CEO”) in the amount of $8.0 million, (reflected on the balance sheet at its present value of $6.6 million) in connection with the purchase of Stratton-Cheeseman Management Company. The indebtedness is due in annual installments, with the final installment due in April 2008. The amount of the annual payments will increase or decrease by $200,000 for each corresponding half-grade level increase or decrease in the Company’s A.M. Best Company, Inc. rating. Certain events, such as the termination, death or disability of the President and CEO or a change in control of the Company, could accelerate these payments.
At December 31, 2002, the Company had planned expenditures of approximately $3.4 million related to various information technology initiatives.
At December 31, 2002, the Company had $151.8 million of cash available and an investment portfolio of $649.7 million. The portfolio includes $20.1 million of bonds maturing in the next year to meet short-term cash flow needs. On a long-term basis, fixed income securities are purchased on a basis intended to provide adequate cash flows from future maturities. As of December 31, 2002, $318 million of bonds mature in the next one to five years and $199 million mature in the next five to ten years. In addition, the Company has $2.1 million of mortgage-backed securities that provide periodic principal repayments.
Loss and loss adjustment expense reserves increased $40.5 million, or 6.8%, to $637.5 million at December 31, 2002, from $597.0 million at December 31, 2001. This increase was due to increased writings, primarily in our medical professional liability segment, and adverse development on prior year estimates.
The unearned premium reserve increased $3.4 million, or 3.4%, to $103.4 million at December 31, 2002, from $100.1 million at December 31, 2001. The increase was primarily due to premium rate increases in 2002.
Based on historical trends, market conditions and our business plans, we believe that our existing resources and sources of funds will be sufficient to meet our short-term liquidity needs. However, economic, market and regulatory conditions may change and there can be no assurance that our funds will be sufficient to meet our short-term liquidity needs.
In June 2001, the Financial Accounting Standards Board issued SFAS No. 142, “Goodwill and Other Intangible Assets.” With the adoption of SFAS No. 142, goodwill is no longer amortized, but rather, is reviewed at least annually for impairment in accordance with the provisions set forth in the statement. In addition, SFAS No. 142 introduced the concept of definite and indefinite lived intangible assets. Definite lived intangible assets are amortized over their useful life, unless circumstances indicate that the asset has been impaired. Indefinite lived intangible assets, similar to goodwill, are no longer amortized, but rather reviewed annually for impairment. See Notes 2 and 4 to the Consolidated Financial Statements, included elsewhere in this report, for a discussion on the impact of the adoption of SFAS No. 142.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15, present fairly, in all material respects, the financial position of American Physicians Capital, Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for goodwill in conformity with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” which was adopted as of January 1, 2002.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of American Physicians Capital, Inc. (“APCapital”) and its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation, formerly RML Insurance Company, (“APS”), APConsulting LLC, APDirect Sales, LLC, Alpha Advisors, Inc. and American Physicians Assurance Corporation, formerly Mutual Insurance Corporation Of America, (“APAssurance”), together referred to as “the Company”. All significant intercompany accounts and transactions are eliminated in consolidation.
The Company is principally engaged in the business of providing medical professional liability, workers’ compensation and health insurance throughout the United States of America with a concentration of writings in the Midwest.
All of the Company’s fixed maturities are classified as available-for-sale, which are those securities that would be available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates and asset-liability management strategies. Available-for-sale securities are reported at estimated fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income, net of deferred taxes.
Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method relating to investments acquired at other than par value. Realized gains or losses on sales or maturities of investments are determined on a specific identification basis and are credited or charged to income.
Included in the premium receivable balance is an allowance for doubtful accounts of approximately $1 million and $1.3 million at December 31, 2002 and 2001, respectively.
Deferred policy acquisition costs (“DAC”) (carried on the accompanying balance sheet in other assets) include commissions, premium taxes and other costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Future investment income has been considered in determining the recoverability of deferred costs.
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. The Company reviews, at least quarterly, deferred federal income tax assets for recoverability based on the availability of future taxable income in the years when the deductible temporary differences are expected to reverse.
Goodwill consists of the excess of cost over fair market value of net assets of acquired businesses. Prior to 2002, Goodwill is amortized on a straight-line basis over a period of ten years.
Effective January 1, 2002, the Company completed the transitional impairment testing required by Standard of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). See Note 4 for additional information regarding the effects of the adoption of SFAS No. 142.
In accordance with APB Opinion No. 25, the Company records compensation expense for stock options only if the market price of the Company’s stock, on the date of grant, exceeds the amount an individual must pay to acquire the stock.
In June 2001, the Financial Accounting Standards Board issued SFAS No. 142. With the adoption of SFAS No. 142, goodwill is no longer amortized, but rather, is reviewed at least annually for impairment in accordance with the provisions set forth in the statement. In addition, SFAS No. 142 introduced the concept
of definite and indefinite lived intangible assets. Definite lived intangible assets are amortized over their useful life, unless circumstances indicate that the asset has been impaired. Indefinite lived intangible assets, similar to goodwill, are no longer amortized, but rather reviewed annually for impairment. Effective January 1, 2002, the Company adopted SFAS No. 142. See Note 4 for further discussion regarding the impact of SFAS No. 142.
Effective January 1, 2002, the Company adopted SFAS No. 142. In accordance with the guidance given in SFAS No. 142, the Company has completed its transitional impairment testing of all goodwill and other intangible assets as of January 1, 2002. At that date, the only goodwill or other intangible asset recorded by the Company was the $13.9 million associated with the purchase of Stratton-Cheeseman Management Company in 1999. Based on the results of the impairment testing, the recorded net goodwill of $13.9 million was written off as the fair value of the Company’s reporting units did not support the carrying value of previously recorded goodwill. For purposes of the impairment testing, fair value was estimated using various methods, including multiples of projected net income and market capitalization. The goodwill impairment was recorded as a cumulative effect of a change in accounting principle, net of a deferred income tax benefit of $4.9 million.
The adoption of SFAS No. 142 has had a significant impact on the Company’s 2002 operating results, as goodwill is no longer being amortized. The Company’s net (loss) income per share for the years ended December 31, 2002 and 2001, and for the period December 13, 2000 to December 31, 2000 (Notes 1 and 17), in the consolidated statements of income, exclusive of amortization expense recognized in those periods related to goodwill no longer being amortized, would have been as follows:
Net income and net income per share for 2000 are based on the period December 13, 2000 to December 31, 2000 (Notes 1 and 17)
Net investment (loss) gain in the above table excludes approximately $293,000 in 2002, $528,000 in 2001, and $4,000 in 2000 of realized losses on the sale of disposal of fixed assets.
The amortized cost and estimated fair value of debt securities at December 31, 2002, by contractual maturity, was:
Proceeds on the sales of investments in bonds totaled $45,337,000 in 2002, $27,400,000 in 2001, and $212,701,000 in 2000.
Deferred acquisition costs are included in other assets on the accompanying balance sheets.
Depreciation expense associated with property and equipment for the years ended December 31, 2002, 2001 and 2000 was $1.5 million, $1.4 million, and $1.0 million, respectively.
Activity in unpaid losses and loss adjustment expenses for the years ended December 31, 2002, 2001, and 2000 was as follows:
losses was the result of an over 20% increase in an average severity of claims reported in 2001. The 2001 adjustment was also unusually large because Ohio and Florida markets were relatively new for the Company, making our initial reserve estimates very difficult to predict. These higher than expected loss trends continued into 2002, but at a much lower level. As a result, we also added to prior year reserves in 2002, primarily in our Ohio and Florida markets.
Reinsurance arises from the Company seeking to reduce its loss exposure on its higher limit policies. The Company has mainly entered into excess of loss contracts for medical malpractice and workers’ compensation. A reconciliation of direct premiums to net premiums, on both a written and earned basis, for the years ended December 31, 2002, 2001, and 2000 is as follows:
At December 31, 2002 and 2001, the components of the net deferred federal income tax asset were as follows:
Approximately $1.037 billion of consolidated assets represents assets of the Company’s insurance operations that are subject to regulation and may not be transferred to APCapital in the form of dividends, loans or advances. The amount of dividends that the Company’s insurance subsidiaries can pay to APCapital in any 12-month period is limited to the greater of statutory net income for the preceding year, excluding realized gains (losses) on sales of investments, or 10% of surplus as of the preceding year end. As of January 1,
2003, approximately $18.8 million could be paid by the Company’s insurance subsidiaries without prior regulatory approval.
SFAS No. 107, “Disclosures About Fair Value of Financial Instruments”, requires disclosures of fair-value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In situations where quoted market prices are not available, fair values are to be based on estimates using present value or other valuation techniques. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements.
Under SFAS No. 107, the Company’s investment securities, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, and note payable constitute financial instruments. The carrying amounts of all financial instruments, other than investment securities, which are presented in Note 5, approximated their fair values at December 31, 2002 and 2001.
In April 2000, the Company began de-emphasize its health segment and restructure its New Mexico operations. A total of six people were severanced at the time, resulting in charges of $408,000 for severance costs and $105,000 of other charges. In October 2000, the Company began to phase out its personal and commercial lines in Lapeer, Michigan. A total of 14 people were terminated, resulting in a charge of $406,000.
At December 31, 2002, substantially all activities related to the restructuring initiatives were complete; however, structured severance packages will not be completely paid out until the first quarter of 2003.
The remaining amounts to be paid for restructuring charges are as follows:
The note payable to an officer represents the remaining annual installment payments, discounted at approximately 6%, due to the Company’s President and CEO in connection with the purchase of Stratton-Cheeseman Management Company in 1999. The scheduled annual payments will increase or decrease by $200,000 for each corresponding half-grade increase or decrease in the Company’s A.M. Best Company, Inc. rating during the term of the payments. Any amounts paid or credited for changes in the industry rating will be recorded as compensation expense in the period earned. Certain events, such as the termination, death or disability of the Company’s President and CEO or a change in control of the Company could accelerate these payments. If the commitment is accelerated or cancelled, any remaining discount or amounts forfeited will be recorded as expense as the goodwill associated with the purchase has been completely written off. This note aggregated $6,556,800 and $7,194,000, at December 31, 2002 and 2001, respectively.
The President and CEO of the Company is a majority owner of SCW Agency Group, Inc., (“SCW”), an agency that sells the Company’s medical professional liability insurance in Michigan, Illinois, Kentucky, Florida and Nevada and workers’ compensation insurance in Michigan, Kentucky and Nevada. Direct premiums written by the agency during 2002, 2001, and 2000 totaled $70,810,000, $68,896,000, and $67,758,000, respectively, representing, 26.6%, 29.9%, and 33.4% of direct premiums written during such years. Commission expense incurred related to SCW approximated $5,560,000, $4,660,000, and $4,633,000 in 2002, 2001 and 2000, respectively.
SCW leased approximately 13,000 sq. feet of office space from the Company in 2002 and approximately 10,000 sq. feet in 2001 and 2000. The Company received $283,000, $216,000 and $192,000 in rental income in 2002, 2001 and 2000 respectively.
In connection with the conversion, the Board of Directors adopted the American Physicians Capital, Inc. Stock Compensation Plan (the “Plan”). The Plan provides for the award of stock options and stock awards for officers, directors and employees of the Company. These awards must be approved by the compensation committee of the board of directors. The total number of shares of the Company’s common stock which shall be available for options and stock awards is 1,200,000 shares.
Certain executive officers, board members and employees have been granted options to purchase shares of APCapital common stock. Options granted during 2000 vest in annual installments of 10%, 15%, 20%, 25% and 30% on the first through the fifth anniversaries, respectively, of the date of grant. Options granted during 2002 and 2001 vest in annual installments of 33%, 33%, and 34% on the first through the third anniversaries, respectively, of the date of grant. All options expire on the tenth anniversary of the grant date.
In connection with the offering, the Company also granted 200 shares of restricted stock to each employee for a total grant of 39,600 shares at $13.50 per share. These shares vest at a rate of 20%, 35% and 45%, in 2001, 2002, and 2003, respectively. Upon issuance of the stock award, unearned compensation is charged to shareholders’ equity and amortized over the vesting periods. A total of 26,580 and 18,110 shares vested under terms of these stock award programs during 2002 and 2001, respectively. A total of 5,530 and 21,700 shares were forfeited as a result of employee terminations prior to vesting during 2002 and 2001, respectively. The vesting of stock awarded to officers, directors and employees resulted in a total compensation expense of $421,000, $435,000 and $83,000 in 2002, 2001 and 2000, respectively.
In management’s opinion, existing stock option valuation models do not provide an entirely reliable measure of the fair value of non-transferable employee stock options with vesting restrictions.
Basic and diluted earnings per share are calculated in accordance with SFAS Statement No. 128, “Earnings per Share.”
As the Company was in a net loss position for the years ended December 31, 2002 and 2001, no effect of awards or options were calculated as the impact would be anti-dilutive.
The Company participates in various guaranty associations in the states in which it writes business, which protect policyholders and claimants against losses due to insolvency of insurers. When an insolvency occurs, the associations are authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written
The Company is the first and second guarantor of approximately $1.8 million and $5.3 million, respectively, of debt owed by one of the Company’s real estate partnership investments. At December 31, 2002 and 2001, the Company has not recorded any liability related to these guarantees.
The Company is obligated under operating leases, which have various expiration dates through December 2007. Minimum future lease payments are as follows: 2003 - $1,416,000; 2004 - $920,000; 2005 - $579,000, 2006 - $351,000 and 2007 - $269,000. Rental expense was $1,900,000 in 2002, $2,177,000 in 2001, and $2,419,000 in 2000.
APAssurance, APS and ICA, domiciled in the State of Michigan, are included in the accompanying consolidated financial statements in accordance with GAAP. These organizations are subject to regulation by the State of Michigan Office of Financial and Insurance Services and file financial statements using statutory accounting practices prescribed or permitted by the state insurance regulators. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Such practices vary in certain respects from GAAP. The principal variances are as follows:
Bonds and U. S. government securities are generally carried at amortized cost for statutory accounting purposes.
The following is statutory surplus at December 31, 2002, 2001, and 2000 and net (loss) income for the years then ended.
The Company is organized and operates principally in the property and casualty insurance industry and has five reportable segments - medical professional liability, workers’ compensation, health, personal and commercial and corporate and other. The accounting policies of the segments are the same as those described in the basis of presentation.
The significant losses in the third and fourth quarters of 2001, as compared to the first and second quarters of the same year, were primarily the result of adverse development on prior year loss reserves (Note 8).
American Physicians Assurance Corporation - a stock insurance company incorporated under Michigan law (APAssurance), formerly Mutual Insurance Corporation Of America
APIndemnity (Bermuda) Ltd. - A Bermuda company that provides a rent-a-captive vehicle for clients and prospects.
APManagement Ltd. - A Bermuda company that provides management and compliance services to APIndemnity and to clients and prospects of the financial group.
Income tax provisions for the individual companies are computed on a separate company basis.
In connection with the conversion, 331,638 shares of common stock of APCapital were sold at $13.50 per share under a subscription rights and best efforts offering to APAssurance policyholders, officers, directors, employees, and others. APCapital then sold 9,668,362 shares of its common stock in an underwritten public offering (“the offering”) that closed December 13, 2000. On December 13, 2000, an additional 1,450,254 shares were sold to underwriters of the offering pursuant to an over-allotment option contained in the offering agreement. The net proceeds of the offering were approximately $142.6 million, consisting of gross proceeds of $154.6 million less conversion and offering expenses of $12.0 million.