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 and the Company moved its headquarters and principal operations in March 1999. The Company intends to lease its former headquarters entirely to third parties. The Company expended $5.2 million for leasehold improvements through 1999.
The availability of medical malpractice insurance, or the industry's underwriting capacity, is determined principally by the industry's level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy. Historically, the financial performance of the medical malpractice industry has tended to fluctuate between a soft insurance market and a hard insurance market. In a soft insurance market, competitive conditions could result in premium rates and underwriting terms and conditions that may be below profitable levels. For a number of years, the medical malpractice insurance industry in California has faced a soft insurance market. There can be no assurance as to whether or when industry conditions will improve or the extent to which any improvement in industry conditions may improve the Company's financial condition and results of operations.
The vast majority of the Company's business is professional liability insurance for physicians and medical groups in California. In recent years, the Company has followed a strategy for growth, which includes diversifying geographically into states other than California and by expanding the insurance products offered by the Company.
the loss experience is unfavorable. The Company has recently adopted more stringent underwriting procedures and guidelines for its hospital policies. The Company expects little or no improvement in this market, as long as the current conditions exist.
Dentists and Oral Surgeons. The Company has written professional liability -------------------------- insurance for oral surgeons in California for a number of years. Beginning in 2000, the Company will expand its relationship with Brown & Brown to include professional liability coverage for dentists in California and Texas and for oral surgeons nationally. These programs had been underwritten by another insurance company and marketed by Brown & Brown previously. The Company will initially reinsure the policies issued and renewed by the other insurance company, and will issue its own dentist policies as soon as regulatory approvals are obtained.
Assumed Reinsurance. The Company has written a modest portfolio of assumed ------------------- reinsurance business for a number of years, which has been profitable. The Company formed a Ceded and Assumed Reinsurance Division in the third quarter of 1999 to materially expand its reinsurance operations. The strategic objective of this division is to create a well-balanced portfolio of carefully underwritten assumed reinsurance lines of insurance other than medical malpractice to add diversity to the direct business of the company. A primary source of business will be placements from reinsurance brokers and intermediaries. Another source will be generated from strategic investments, such as the Company's purchase of approximately 9.5% of the outstanding common stock of GoshawK Insurance Holdings plc ("GoshawK") during the fourth quarter of 1999. GoshawK is a publicly held underwriter at Lloyd's of London. As part of this transaction, the Company entered into a quota share reinsurance treaty effective January 1, 2000, under which the Company will assume 7.5% of GoshawK's annual premium. This general expansion into assumed reinsurance is in its initial stages. There is no assurance that the Company will be successful in attracting appropriate reinsurance opportunities or that this business will be profitable.
The Company believes that a combination of these and other factors have contributed to the recent redundancies in reserves established for prior years. The original reserves were established without full knowledge of the effect of these factors. Redundant reserves, which have been released in every year since 1985, have contributed significantly to reported earnings in recent years. The Company reduced reserves for prior years by $61.2 million, $93.8 million, and $53.2 million in the years ended December 31, 1999, 1998 and 1997, respectively. The 1998 redundancies were offset, in part, by a $28.1 million increase in the loss and LAE reserves for the medical malpractice insurance business assumed from Fremont in January 1998. The Company cannot predict whether similar redundancies will be experienced in future years. The Company continues to establish its loss and LAE reserves at what it believes is at the upper end of a reasonable range of reserve estimates, but there is no assurance that such reserves will ultimately prove to be redundant. During 1999 the Company experienced some reduction in the amount of the redundancy and believes additional reductions are reasonably likely. If such redundancies do not occur or loss and LAE experience does not improve, the Company's net income could be significantly reduced or a net loss could occur.
With its continued expansion into other states and markets, the Company has experienced an increase in its operating expense levels to achieve and service this expansion. Commissions for policies that are sold through agents and brokers typically range from 7.0% to 17.5% of premiums, whereas the Company does not incur commissions on products sold directly. Hospital and other healthcare provider policies are typically sold through brokers, as are physician and medical group policies sold through Brown & Brown and in the program acquired from Fremont. To the extent that these policies represent an increased percentage of the Company's business in the future, expense ratios will increase.
PREMIUMS EARNED Premiums earned decreased approximately $4.8 million, or 3.0%, to $153.2 million in 1999 from $158.0 million in 1998. Medical Malpractice premiums from physicians and medical groups decreased to approximately $133.0 million in 1999 from $143.2 million in 1998. Of this decrease, approximately $4.5 million was attributable to additional ceded premiums under the Company's reinsurance treaties to reflect premium adjustments and additional premiums resulting from some significant excess losses borne by the reinsurers in 1999. The decrease in premiums was also attributable to the loss of physician insureds during the second and third quarters of 1999 in medical specialties that experienced 1999 rate increases. Hospital medical malpractice premiums were approximately $9.2 million in 1999 compared to $8.8 million in 1998. Assumed reinsurance premiums, other than those received in the Fremont and Brown & Brown arrangements, were approximately $6.8 million in 1999 compared to $5.5 million in 1998. Other healthcare provider-related liability premiums totaled $4.0 million in 1999 compared to $0.9 million in 1998.
NET INVESTMENT INCOME Net investment income decreased approximately $2.7 million, or 6.7%, to $37.7 million in 1999 from $40.4 million in 1998. Invested assets decreased $138.2 million to $655.4 million at December 31, 1999, from $793.6 million at December 31, 1998, due principally to the sale of securities to fund the Company's repurchase of approximately 2.0 million shares of
REALIZED INVESTMENT GAINS (LOSSES) Realized investment losses were approximately $0.3 million in 1999 compared to realized gains of $11.1 million in 1998. Through the nine months ended September 30, 1999, the Company had net realized gains of $5.3 million. The Company recorded a realized loss in the 1999 fourth quarter related to the sale of securities to fund the repurchase of its common stock and to reposition the Company's investment portfolio.
LOSSES AND LAE Losses and LAE decreased to $122.8 million in 1999 from $132.2 million in 1998. As a percentage of premiums earned, losses and LAE decreased to 80.2% in 1999 from 83.7% for the same period in 1998. For 1999, the Company reduced loss and LAE reserves incurred in prior policy years approximately $61.2 million as compared to a reserve reduction of $93.8 million for 1998 for claims incurred in prior policy years.
PREMIUMS EARNED Premiums earned increased approximately $24.1 million, or 18%, to $158.0 million in 1998 from $133.9 million in 1997. The increase was principally due to a $30.0 million increase in physician and medical group medical malpractice insurance premiums to approximately $143.2 million in 1998 compared to $113.2 million in 1997. This increase was a result of the Company's acquisition of the medical malpractice book of business of Fremont on January 1, 1998, and premiums attributable to an agency relationship with Brown & Brown, Inc., which commenced on January 1, 1998. Hospital medical malpractice premiums were approximately $8.8 million in 1998 compared to $14.6 million in 1997. This decrease in 1998 hospital premiums is due principally to the loss of one large integrated hospital account in Florida in late 1997. Assumed reinsurance premiums, other than interim premiums relating to the Fremont and Brown & Brown arrangements, increased slightly in 1998.
REALIZED INVESTMENT GAINS Realized investment gains were approximately $11.1 million in 1998 compared to $6.6 million in 1997. In December 1998, sales were made in the fixed-maturity portion of the investment portfolio to reposition the portfolio by increasing the percentage of corporate securities.
OTHER OPERATING EXPENSES Other operating expenses increased $10.2 million, or 56.8%, to $28.2 million in 1998 from $18.0 million in 1997. The ratio of other operating expenses to premiums earned is referred to as the expense ratio, which increased to 17.9% in 1998 from 13.4% in 1997. This increase is due primarily to certain one-time charges and the amortization of nonrecurring costs related to the acquisition of the Fremont business. Additionally, other operating expenses include higher commission expenses associated with the greater percentage of business written through brokers in 1998 and general personnel increases necessary to produce and service the higher 1998 premium volume.
The primary sources of the Company's liquidity are insurance premiums, net investment income, recoveries from 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 1999, the Company had negative cash flow from operations of $9.9 million compared to a positive cash flow of $9.2 million in 1998. The negative cash flow during 1999 was due to unusually high payments of losses during the second and third quarters of 1999. During that period, the Company experienced a number of settlements and judgments in physician medical malpractice insurance claims (and in one hospital malpractice claim) that were at or near the policy limits involved.
The Company invests its cash flow from operations in both fixed-maturity securities and equity securities. The Company's current policy is to limit its investment in equity securities and real estate to no more than 8.0% of the total market value of its investments. Accordingly, the Company's portfolio of unaffiliated equity securities had a fair value of $33.5 million at December 31, 1999. The Company plans to continue this focus on fixed-maturity securities for the indefinite future.
The Company has made limited investments in real estate, which have been used almost entirely in the Company's operating activities, with the remainder leased to third parties. 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 and the Company moved its headquarters and principal operations to this space in early March 1999. The Company intends to lease its former headquarters entirely to third parties. The Company expended $5.2 million for leasehold improvements through December 31,1999.
The Company maintains a portion of its investment portfolio in high-quality, short-term securities to meet short-term operating liquidity requirements, including the payment of losses and LAE. Short-term investments totaled $72.9 million, or 11.1% of invested assets, at December 31, 1999. The Company believes that all of its short-term and fixed-maturity securities are readily marketable.
Common stock dividends paid to stockholders were $0.32 per share in 1999. These dividends were funded through dividends from the Company's insurance subsidiaries. The Company expects to pay dividends in the future. However, payment of dividends is subject to Board approval, earnings and the financial condition of the Company.
On May 25, 1999, the company entered into a credit agreement with the Union Bank of California, N. A., First Union Bank and Dresdner Bank AG, as lenders. Under the Credit Agreement, the company may borrow up to $75.0 million from time to time, subject to certain conditions. The proceeds from the Credit Agreement may be used by the company for general corporate purposes and certain other permitted uses. As of December 31, 1999, borrowings under the Credit Agreement totaled $13.0 million.
Based on historical trends, market conditions and its business plans, the Company believes that its sources of funds will be sufficient to meet its liquidity needs over the next 18 months and beyond. However, because economic, market and regulatory conditions may change, there can be no assurance that the Company's sources of funds will be sufficient to meet these liquidity needs. The short- and long-term liquidity requirements of the Company may vary because of the uncertainties regarding the settlement dates for unpaid claims.
For all its financial assets and liabilities, the Company seeks to maintain reasonable average durations, consistent with the maximization of income without sacrificing investment quality and providing for liquidity and diversification.
The estimated fair values at current market rates for financial instruments subject to interest rate risk in the table above are the same as those disclosed in Note 2 (Investments) to the consolidated financial statements. The estimated fair values at the adjusted market rates (assuming a 100 basis point increase in market interest rates) are calculated using discounted cash flow analysis and duration modeling where appropriate. The estimated values do not consider the effect that changing interest rates could have on prepayment activity (e.g. mortgages underlying mortgage-backed securities).
The Company's Consolidated Financial Statements and related notes, including supplementary data, are set forth in the "Index" on page 41 hereof.