Net premiums written for 2001 and 2000 reflect the Company’s recognition of written premiums on the effective date of the policy rather than on the date premiums were billed. This change had no impact on the income statement. If 1999 premiums had been recognized under this method, net premiums written would have approximated $174.5 million.
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, which is reflected in the results for the year ended December 31, 2000. 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 year-end. The Company did not incur material losses during 2001 under its hospital policies.
In 2001, the Company derived approximately 30% of its direct healthcare liability insurance direct premiums earned from physician and medical groups outside the state of California, principally under the Brown & Brown and nonstandard physician programs. During the second quarter of 2001, the Company recognized that its loss reserves for these programs were severely deficient and that its current premium levels were inadequate. The Company strengthened its loss reserves by $18.7 million at mid-year to reflect this adverse development and recorded an additional provision of $7.5 million to cover expected premium deficiencies. At the end of 2001, significant additional losses emerged under these programs, principally involving adverse experience in the fourth quarter. The Company increased its loss reserves for the 2001 policy year by an additional $27.3 million, and established a premium deficiency reserve at year-end of $7.9 million. This non-California business was the principal reason for an underwriting loss of approximately $109.7 million in the segment for 2001.
The Company and Brown & Brown have agreed to terminate their programs no later than March 6, 2003. In the interim, Brown & Brown is attempting to identify another insurance company or companies to replace the Company. The Company has agreed to
YEAR ENDED DECEMBER 31, 2001, COMPARED TO YEAR ENDED DECEMBER 31,
Income from affiliates in 2001 was $1.3 million compared to $0.9 million in 2000. These amounts were primarily attributable to a minority equity interest in a small personal lines insurance company.
Medical malpractice premiums from physicians and medical groups increased to approximately $143.7 million in 2001 from $131.2 million in 2000. The principal increase was in physicians and small medical groups written through Brown & Brown outside California, which increased approximately $7.9 million to $30.0 million from $22.1 million in 2000. Dentist and oral surgeon premiums written through Brown & Brown increased approximately $2.1 million to $7.2 million from $5.1 million in 2000. In California, premiums earned from physician and medical groups increased slightly to approximately $96.6 million in 2001, from $95.3 million in 2000. This increase reflected the 10.6% average rate increase instituted in California at the beginning of 2001, somewhat offset by a decrease in the number of policyholders. The Company has instituted an average rate increase of 8.4% in 2002 for physicians and medical groups in California.
Losses and LAE-Losses and LAE in the direct healthcare liability insurance segment increased to $220.3 million, or 140.8% of premiums earned in 2001, from $129.3 million, or 86.5% of premiums earned in 2000. The ratio of losses and LAE to premiums earned is referred to as the loss ratio. This deterioration in loss experience was almost entirely due to significant unexpected losses incurred in the physician and medical group programs outside the state of California, including principally the Brown & Brown and substandard physician programs.
Other Operating Expenses-Other operating expenses for the direct healthcare liability insurance segment in 2001 were approximately $45.8 million, compared to approximately $32.3 million in 2000. The ratio of other operating expenses to premiums earned is referred to as the expense ratio, which increased to 29.3% in 2001 for the direct healthcare liability insurance segment from 21.6% in 2000. The increase was due partially to accelerated recognition of deferred acquisition costs totaling $4.7 million related to physician business outside of California recorded during 2001. The remaining increase was attributable to higher commission expenses associated with the greater proportion of broker-produced premiums in 2001 compared to 2000, costs related to the closure of three sales and marketing offices in 2001 and higher operating expenses.
The Company has significantly increased its writings of assumed reinsurance. As of December 31, 2001, the Company had treaties in effect that are estimated to produce more than $141 million in premiums earned in 2002.
As of December 31, 2000 the Company adopted FASB No. 131, Disclosure About Segments of an Enterprise and Related Information, and classified its operations into the direct healthcare liability insurance segment and the assumed reinsurance segment. See Note 13 to Consolidated Financial Statements.
Net investment income decreased approximately $3.5 million, or 9.4%, to $34.2 million in 2000 from $37.7 million in 1999. This change reflects a decrease in average invested assets from $724.5 million in 1999 to $665.3 million in 2000, due principally to the sale of securities to fund the Company’s repurchase of approximately 2.0 million shares of its Common Stock from its public stockholders in November 1999. The average annual return before taxes on the Company’s portfolio of fixed-maturity securities was 5.4% in both 1999 and 2000.
Total expenses were $189.9 million in 2000, an increase of 24.9% over total expenses of $152.1 million in 1999. The increase in total expenses was attributable to a decrease in the recognition of prior-year loss reserve development and an increase in loss costs generally in the direct healthcare liability insurance segment and higher operating expenses. The increased operating expenses reflect a greater proportion of commissioned premiums and higher employee related expenses in 2000.
Premiums Earned-Premiums earned in the direct healthcare liability insurance segment increased approximately $3.0 million, or 2.0%, to $149.4 million in 2000 from $146.4 million in 1999. Medical malpractice premiums from physicians and medical groups decreased to approximately $131.2 million in 2000 from $132.8 million in 1999. This decrease in premiums was principally due to the loss of physician and medical group insureds in the highly rate competitive California market. Physicians and small medical groups written through Brown & Brown outside California increased approximately $3.7 million to $22.1 million from
$18.4 million in 1999, and the Company earned an additional $5.1 million in dentist and oral surgeon premiums in 2000 written through Brown & Brown.
Premiums Earned-Premiums earned in the assumed reinsurance segment increased to $27.1 million in 2000, the segment’s first full year of operation, from $6.8 million in 1999. The Assumed Reinsurance Division was formed in August of 1999, although the Company had written small amounts of assumed reinsurance for a number of years. Premiums earned during 2000 included approximately $8.8 million under casualty programs, $6.3 million under property programs, $9.4 million under accident and health programs and $2.6 million under its marine program. The Company also earned $6.2 million in other assumed premiums in 2000 under fronting arrangements related to its dentist and oral surgeon programs marketed by Brown & Brown. In 1999, the Company had assumed premiums earned of $11.1 million relating to fronting insurance arrangements that are no longer in effect.
Other Operating Expenses-Other operating expenses for the assumed reinsurance segment were $4.2 million in 2000, or an expense ratio of 15.3%. No allocation of operating expenses was made for 1999. Operating expenses consist primarily of commissions and employee-related expenses.
reinsurers and proceeds from the maturity or sale of invested assets. Funds are used to pay losses, LAE, operating expenses, reinsurance premiums and taxes.
Because of uncertainty related to the timing of the payment of claims, cash from operations for a property and casualty insurance company can vary substantially from period to period. During 2001, the Company had positive cash flow from operations of $33.4 million compared to $2.5 million in 2000. The increase in positive cash flow in 2001 was principally attributable to increased assumed reinsurance premiums received by the Company for which incurred losses had not yet been paid.
The Company has made limited investments in real estate which was formerly used as its corporate headquarters. Both buildings are fully leased to unaffiliated third parties. These leases expire on April 2005 and November 2005 with no provisions for renewal. Future minimum rentals are $1.8 million for each of the years 2002 through 2004 and $1.1 million for year 2005. The buildings are recorded at cost and depreciated principally under the straight-line method over the useful life of the buildings. Accumulated depreciation at December 31, 2001 and 2000, was $3.8 million and $3.4 million respectively. In July 1998, the Company entered into a lease covering approximately 95,000 square feet of office space for new Company headquarters. The lease is for a term of 10 years ending in 2009 and contains two options to renew the lease for a period of five years each. The Company moved its headquarters and principal operations to this space in March 1999.
increased. Failure to generate significant profitability in 2002 or obtain additional capital will limit the Company’s ability to increase or maintain its premium writings. There is no assurance that additional capital, if necessary, will be available to the Company on favorable or acceptable terms. See Business -Risk Factors-Necessary Capital and Surplus.
During May 2001, the Board of Directors authorized the continuation of the Company’s 1999 program to repurchase up to 1,000,000 shares of its common stock on the open market. This authorization extended the company’s 1999 program that would have otherwise expired in May 2001. Under this extended 1999 program, 391,420 shares have been repurchased of which 30,600 were purchased during 2001.
The Company also holds an investment in a limited partnership, which invests in a portfolio of offshore hedge funds. The investment return depends on the performance of the portfolio, which includes both interest rate risk and credit risk. This investment had a value of $14.9 million at December 31, 2001.
The Company’s invested assets are subject to interest rate risk. The following table presents the effect on current estimated fair values of the fixed-maturity securities available for sale and common stocks assuming a 100-basis-point increase in market interest rates and a 10% decline in equity prices. The analysis excludes real estate and the other investment.
This sensitivity analysis provides only a limited, point-in-time view of the market risk sensitivity of certain of the Company’s financial instruments. The actual impact of market interest rate and price changes on the financial instruments may differ significantly from those shown in the sensitivity analysis. The sensitivity analysis is further limited as it does not consider any actions the Company could take in response to actual and/or anticipated changes in interest rates and equity prices.
During 2000 and 2001, the Company entered into certain insurance and reinsurance transactions in the ordinary course of its business with insurance company subsidiaries of Highlands Insurance Group, Inc. (HIG). A director of the Company was the chief executive officer of Highlands during this period until November 2001. These transactions include:
fee of 1% of the gross policy premiums written by the HIG subsidiaries of approximately $88.0 million for the subject policies. See Business-Risk Factors-Highlands Insurance Group Contingent Liability for more information relating to these endorsement contracts.
Arrangements under which the Company ceded to an HIG subsidiary during 2001 36%, or $2.2 million of earned premium, of the excess of loss medical malpractice policies covering healthcare facilities and physicians and other professional liability underwritten by a Lloyd’s syndicate in which the Company bears 100% of the risk. The Corporation of Lloyd’s holds all of the premiums, and the HIG subsidiary has deposited an additional $4.9 million with Lloyd’s to secure its obligations.
Arrangements under which the Company retroceded to HIG subsidiaries a portion of the business assumed under four assumed reinsurance agreements. During 2001, premiums of approximately $3.1 million were ceded to HIG subsidiaries under these agreements.
The Company entered into contracts with Brown & Brown, Inc. under which Brown & Brown acts as an insurance producer for the Company. A director of the Company serves as chairman of the board, president and chief executive officer and principal shareholder of Brown & Brown. Brown & Brown produced $45.0 million, $46.0 million and $21.3 million in gross written premiums in 2001, 2000 and 1999 respectively (including $4.5 million and $7.6 million from fronting arrangements related to dentist and oral surgeon programs in 2001 and 2000), and received commissions of $7.2 million, $7.6 million and $3.2 million. The Company and Brown & Brown have reached agreement to terminate these programs no later than March 6, 2003.
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). Preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related notes. Management believes that the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of the Consolidated Financial Statements. Actual results may differ from these estimates under different assumptions or conditions.
Direct healthcare liability insurance premiums written are primarily earned on a daily pro rata basis over the terms of the policies. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired portion of the policies in force. Reinsurance premiums assumed are estimated based on information provided by ceding companies. The information used in establishing these estimates is reviewed and subsequent adjustments are recorded in the period in which they are determined. These premiums are earned over the terms of the related reinsurance contracts.
Unpaid losses and loss adjustment expenses are comprised of case reserves for known claims, incurred but not reported reserves for unknown claims and any potential development for known claims, and reserved 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 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 actuaries in establishing its reserves. The Company does not discount its loss and loss adjustment expense reserves.
The reserves for unpaid loss and loss adjustment expense attributable to insured events prior to 2001 increased during 2001 by $13.8 million. The adverse development was principally due to non-California medical malpractice business.
The Company has a growing volume of assumed reinsurance. Assumed reinsurance is a line of business with an inherent volatility. Also in the absence of a historical data base of our own experience due to the newness of the program, greater reliance is placed on underwriting and industry information to estimate the appropriate loss reserves.
The assumed reinsurance business exposure to losses from the events of September 11, 2001. Estimation of ultimate liabilities for this exposure is unusually difficult and thus subject to significantly greater than normal variation and uncertainty.
The primary effect of inflation on the Company is considered in pricing and estimating reserves for unpaid losses and LAE for claims in which there is a long period between reporting and settlement, such as medical malpractice claims. The actual effect of inflation on the Company’s results cannot be accurately known until claims are ultimately settled. Based on actual results to date, the Company believes that loss and LAE reserve levels and the Company’s rate-making process adequately incorporate the effects of inflation.