The actions taken by the Company have significantly reduced capital requirements related to the net premium written to surplus ratio in both the A.M. Best and NAIC capital adequacy models. The capital requirements associated with the reserve to surplus ratio continue to decline as the Company settles the claims in its non-core businesses.
Unpaid losses and loss adjustment expenses are comprised of case reserves for known claims, incurred but not reported reserves for unknown claims and “Bulk Reserves” for any potential development for known claims, and reserves for the cost of administration and settlement of both known and unknown claims. Such liabilities are established based on known facts and interpretation of circumstances, including the Company’s experience with similar cases and historical trends involving claim payment patterns, loss payments and pending levels of unpaid claims, as well as court decisions and economic conditions. The effects of inflation are implicitly considered in the reserving process. Establishing appropriate reserves is an inherently uncertain process; the ultimate liability may be in excess of or less than the amount provided. Any increase in the amount of reserves, including reserves for insured events of prior years, could have an adverse effect on the Company’s results for the period in which the adjustments are made. The Company utilizes both its internal actuarial staff and independent consulting actuaries in establishing its reserves. The Company does not discount its loss and loss adjustment expense reserves.
For most, if not all medical malpractice and other long tail liability lines of business, Bulk and IBNR reserves (which include loss adjustment expense reserves not allocated to specific cases) are the mathematical result of subtracting tabular case reserves from projected ultimate losses derived by the actuarial process. Bulk and IBNR reserves in the case of medical malpractice insurance written on a claims-made reporting policy do not generally represent late reported claims but rather expected upward case reserve movement which will be recognized as additional information develops on individual cases. In addition, Bulk and IBNR reserves relating to the assumed reinsurance business include the Lloyd’s Syndicates balances for which the Company provided capital. The Company does not possess the detailed information necessary to allocate these reserves between case reserves and bulk reserves. As of the years ended 2005, 2004 and 2003, the net reserves for these syndicates were $-0-, $21.9, and $39.1 million respectively.
The primary factor affecting the adequacy of reserve estimates in the core area is the trend in pure loss costs (the combination of frequency and average severity changes) related to malpractice coverage. The inherent pure loss cost trend included in the setting of the 2003, 2004 and 2005 reserves has been 4.4%, 3.3% and 2.2%, respectively. At 2005 reserve levels, a 1% change in pure loss costs trend produces a change in prior reserves of approximately $5.2 million. Such changes are reflected in the period of change. Reserves related to medical malpractice coverage account for over 90% of core reserves.
The net reserves as of December 31, 2005 consist of the following:
During 2005 the Company closed 218 cases and opened 16 new cases. The adequacy of these reserves is primarily dependent upon achieving fair settlements with the injured parties and reasonable litigation results.
As the individual cases mature and more information becomes available for evaluating individual cases, there is a declining need for Bulk and IBNR reserves. While the Company believes its reserves are adequate, several jurisdictions where the Company issued policies allow extended periods of time to elapse before the judicial or settlement process is completed. Individual settlements or judgments will determine the final incurred losses and thus the adequacy of these reserves. The recent experience has been generally consistent with Company expectations, but no assurance can be given that the Company’s current experience will continue. The current average reserve (including Bulk and IBNR reserves) is approximately $260,000 per outstanding case. If the average settlement ultimately achieved is different by $12,000 for the current average reserve, the ultimate reserves will be affected by approximately $2.5 million.
The sensitivity of the Company’s reserves for Assumed Reinsurance is impacted primarily by three factors: the accuracy of independent actuarial reviews of particular contracts; timely reporting of losses through the worldwide reinsurance system; and the ultimate severity of large excess of loss claims.
The Company believes that Occupational and Accident reserves should be relatively stable at this point and the remaining reserves are based on amounts currently reported to the Company. As time passes, the ability of the underlying insureds to accurately reserve the large excess of loss type cases should improve. However, since the reporting of losses through the worldwide reinsurance market is often slow and is dependent upon the reporting by the ceding companies, the adequacy of these reserves has a potential for volatility and no assurances can be given that further adverse development will not occur.
The Company evaluates the securities in its available-for-sale investment portfolio on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other than temporary declines. Some of the factors the Company considers in the evaluation of its investments are:
the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
The Company believes it is more likely than not that the deferred income tax assets will be realized through its future earnings. As a result, the Company has not recorded a valuation allowance. The Company’s core operations have historically been profitable on both a GAAP and tax basis. The losses incurred in 2001 to 2004 were primarily caused by losses in the non-core healthcare and assumed reinsurance
businesses. Since the core healthcare liability operation has remained strong and improved over the past years and the non-core healthcare liability and assumed operations are now in run-off, the Company believes it should return to a position of taxable income, thus enabling it to utilize the net operating loss carryforward.
The Company encountered intense price competition in its hospital expansion efforts. During 2000, the Company incurred unacceptable losses under its hospital policies. The Company experienced adverse loss development in its prior years loss reserves for hospitals and significant ongoing losses in this program. The Company substantially reduced its hospital exposures during 2000 through policy nonrenewals and rate increases. At the beginning of 2001, it insured only 15 hospitals, and this was reduced to 10 hospitals at December 31, 2001, and the last hospital policy expired in December 2002.
The loss ratio (losses and LAE related to premiums earned) for 2005 was 70.9% compared to a loss ratio of 80.6% and 88.6% for 2004 and 2003, respectively. The change in loss ratio primarily reflected increases in average claim costs offset by a significant decline in the frequency of claims, favorable development on prior year reserves and the effect of the average rate increases on earned premiums.
The underwriting expense ratio (expenses related to premiums earned) remained relatively unchanged at 20.3% in 2005 compared to 20.9% and 20.5% in 2004 and 2003.
The Company made significant progress in 2005 in settling claims related to non-core healthcare liability business in run-off. Total net reserves declined from $97.3 million at December 31, 2004 to $60.6 million at December 31, 2005, and outstanding claims decreased from 431 at December 31, 2004 to 229 at December 31, 2005. Sixteen new claims were reported in 2005 compared to 78 in 2004.
Assumed reinsurance represents the book of assumed worldwide reinsurance of professional, commercial and personal liability coverages, commercial and residential property risks, accident and health and workers’ compensation coverages and marine coverages. Ultimate loss experience in this segment is based primarily on reports received by the Company from the underlying ceding insurers. Actual losses may take several years to be reported through the system.
As a result of the Company’s decline in capital and surplus from the World Trade Center losses and losses incurred in healthcare insurance outside California, A. M. Best reduced the Insurance Subsidiaries ratings below the A- (Excellent) rating. Many ceding companies and companies in assumed reinsurance syndicates are reluctant to deal with insurers whose ratings are below A-, which made it more difficult for the Company to remain in the assumed reinsurance market.
GoshawK, the parent of Rosemont, suffered serious underwriting losses in late 2003. As a result, the Company incurred significant losses attributable to its participation in the GoshawK underwriting syndicate and a $9.6 million loss in its holdings of GoshawK capital stock. The losses suffered by GoshawK did not materially affect the financial condition of Rosemont Re at that time. However, due to significant hurricane losses reported in 2005, A.M. Best has reduced its rating of Rosemont Re to B (Fair) and the company has been placed in run-off and will be liquidated. Assets approximately equal to Rosemont Re’s estimated liabilities under its reinsurance agreement with the Company are currently held in trust to satisfy the liabilities under the agreement. If the estimated recoveries were to increase in the future, the Company would have to rely on Rosemont Re’s continuing ability to fund these amounts.
The underwriting loss incurred in 2005 in the assumed reinsurance segment was primarily attributable to adjustments made to amounts ceded to Rosemont Re following a review by the parties in the third quarter, costs associated with closing the last syndicate at Lloyd’s for which the Company provided capital, and upward development on London based business, including Lloyd’s syndicates.
The underwriting loss in 2004 was principally attributable to unexpected adverse loss development during 2004 principally in connection with the Lloyd’s syndicates, additional losses incurred under a single excess of loss directors and officers liability insurance treaty, and losses involving issuers of bail and immigration bonds. The 2003 underwriting loss was principally attributed to the failure of GoshawK Syndicate 102 and upward development in World Trade Center losses.
The Rosemont Re reinsurance treaty entered into in December 2002 effectively ceded all of the unearned premium and future reported premium after June 30, 2002, for the assumed business written for underwriting years 2001 and 2002 by the Company ($38.0 million in 2003, $(0.1) million in 2004 and $(0.4) million in 2005). This treaty relieved the Company of significant underwriting risk and written premium leverage and significantly improves the Company’s risk-based capital adequacy ratios under both the A.M. Best and NAIC models.
In 2005 the Company sold its stock interest in a privately held insurance company for a $4.4 million dollar gain.
The Company maintains a significant portion of its investment portfolio in high-quality, short-term securities and cash to meet short-term operating liquidity requirements, including the payment of losses and LAE. Cash and cash equivalents investments totaled $68.8 million, or 12.9% of invested assets, at December 31, 2005. The Company believes that all of its short-term and fixed-maturity securities are readily marketable and have scheduled maturities in line with projected cash needs.
The Company invests its cash flow from operations principally in taxable fixed maturity securities. The Company’s current policy is to limit its investment in unaffiliated equity securities and mortgage loans to no more than 8.0% of the total market value of its investments. The market value of the Company’s portfolio of unaffiliated equity securities was $2.1 million at December 31, 2005 compared to $16.2 million at December 31, 2004. The Company plans to continue its emphasis on fixed maturity securities investments.
SCPIE Holdings is an insurance holding company whose assets primarily consist of all of the capital stock of its Insurance Subsidiaries. Its principal sources of funds are dividends from its subsidiaries and proceeds from the issuance of debt and equity securities. The Insurance Subsidiaries are restricted by state regulation in the amount of dividends they can pay in relation to earnings or surplus, without the consent of the applicable state regulatory authority, principally the California Department of Insurance. SCPIE Holdings’ principal insurance company subsidiary, SCPIE Indemnity, may pay dividends to SCPIE Holdings in any 12-month period, without regulatory approval, to the extent such dividends do not exceed the greater of (i) 10% of its statutory surplus at the end of the preceding year or (ii) its statutory net income for the preceding year. Applicable regulations further require that an insurer’s statutory surplus following a dividend or other distribution be reasonable in relation to its outstanding liabilities and adequate to meet its financial needs, and permit the payment of dividends only out of statutory earned (unassigned) surplus unless the payment out of other funds receives regulatory approval. The amount of dividends that SCPIE Indemnity is able to pay to SCPIE Holdings during 2005 without prior regulatory approval is approximately $14.5 million.
Unlike many other forms of contractual obligations, loss and LAE reserves do not have definitive due dates, and the ultimate payment dates are subject to a number of variables and uncertainties. The liability shown in the table represents the Company’s best estimate of the unpaid cost of settling claims, including claims that have been incurred but not yet reported, and the time period in which such claims will be resolved. The amounts shown are net of any reinsurance that the Company estimates will be recoverable on resolution of the claims. A portion of the assumed reinsurance business, principally the occupational and accident reserves, are on a funds withheld basis and therefore the projected reserve payments ($21.8 million after 2010) in the preceding table will be settled by a draw down of funds withheld balances rather than cash.
In November 2001, the Company arranged a letter of credit facility in the amount of $50 million with Barclays Bank PLC. This facility was amended in June, 2005. Letters of credit issued under the facility fulfill the requirements of Lloyd’s and guarantee loss reserves under reinsurance contracts. As of December 31, 2005, letter of credit issuance under the facility was approximately $44.5 million. Securities of $48.9 million are pledged as collateral under the facility.
After reviewing this matter, E&Y concluded that there was no impairment of its independence for its audits of the fiscal years 2002 through 2005. The Board of Directors and the Audit Committee of the Company concluded that E&Y’s capacity for objective judgment was not and is not diminished and that a reasonable investor would not perceive that an impairment of independence affecting the integrity of the financial statements has occurred.
The Company’s Consolidated Financial Statements and related notes, including supplementary data, are set forth in the “Index” on page 52 hereof.