We own a 156,000 square foot office building located in Birmingham, Alabama where we currently occupy approximately 78,000 square feet. The remaining office space is leased to unaffiliated persons or is available to be leased. We also own a 53,000 square foot office building in Okemos, Michigan that we fully occupy. Both buildings are currently unencumbered.
Includes acquired entities since date of acquisition, only. Professionals Group was acquired on June 27, 2001. NCRIC Corporation was acquired on August 1, 2005.
Net income for the year ended December 31, 2002 was increased by $1.7 million due to the adoption of SFAS 141 and 142. See Note 13 to our consolidated financial statements in the 2004 published 10K. In accordance with SFAS 142, we wrote off the unamortized balance of deferred credits that related to business combinations completed prior to July 1, 2001. The cumulative effect increased net income per share (basic and diluted) by $0.07 per share.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Preparation of these financial statements requires us to make estimates and assumptions in certain circumstances that affect the amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that 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 affected by changes in these estimates and assumptions.
Management considers the following accounting policies to be critical because they involve significant judgment by management and the effect of those judgments could result in a material effect on our financial statements.
Our reserve for losses represents our estimate of the future amounts necessary to pay claims and expenses associated with the settlement and investigation of claims. These estimates consist of case reserves and bulk reserves. The estimates take into consideration our past loss experience, available industry data and projections as to future claims frequency, severity, inflationary trends and settlement patterns. External actuaries review our reserve for losses each year. We consider the views of the external actuaries as well as other factors, such as known, anticipated or estimated changes in frequency and severity of claims and loss retention levels and premium rates, in establishing the amount of our reserve for losses. Estimating casualty insurance reserves, and particularly liability reserves, is a complex process. These claims are typically resolved over an extended period of time, often five years or more, and estimating loss costs for these claims requires multiple judgments involving many uncertainties. Our reserve estimates may vary significantly from the eventual outcome. The assumptions used in establishing our reserve for losses are regularly reviewed and updated by management as new data becomes available. Any adjustments necessary are reflected in then-current operations. Due to the size of our reserve for losses, even a small percentage adjustment to these estimates could have a material effect on our results of operations for the period in which the adjustment is made.
Our receivable from reinsurers on unpaid losses and loss adjustment expenses represents our estimate of the amount of our reserve for losses that will be recoverable from our reinsurers. Our estimate is based upon our estimates of the ultimate losses that we expect to incur and the portion of those losses that we expect to be allocable to reinsurers based upon the terms of our reinsurance agreements. We also estimate premiums ceded under reinsurance agreements wherein the premium due to the reinsurer, subject to certain maximums and minimums, is based on losses reimbursed under the agreement. Our estimates of the amounts receivable from and payable to reinsurers are regularly reviewed and updated by management as new data becomes available. Given the uncertainty of the ultimate amounts of our losses, these estimates may vary significantly from the eventual outcome. Any adjustments necessary are reflected in then-current operations. Due to the size of our reinsurance balances, even a small adjustment
to these estimates could have a material effect on our results of operations for the period in which the adjustment is made.
Our assessment of the collectibility of the recorded amounts receivable from reinsurers considers both the payment history of the reinsurer and publicly available financial and rating agency data. At December 31, 2005 we believe all of our recorded reinsurance receivables to be collectible.
We consider our fixed maturity securities as available-for-sale and our equity securities as either available-for-sale or trading portfolio securities. Both available-for-sale and trading portfolio securities are carried at fair value. Changes in the market value (unrealized gains and losses) of available-for-sale securities, whether positive or negative, are included, net of the related tax effect, in accumulated other comprehensive income, a component of stockholders’ equity, and are excluded from current period net income. Positive and negative changes in the market value of trading portfolio securities are included in current period net income as a component of net realized investment gains (losses).
the length of time for which the market value of the security has been less than its cost basis,
our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
In accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” we make an annual assessment as to whether the value of our goodwill assets is impaired. We completed such assessments in 2005 and 2004 and concluded that the value of our goodwill assets related to continuing operations of approximately $29.5 million was not impaired. We use both market-based valuation models and a capital asset pricing model to estimate the fair value. These models require the use of numerous assumptions regarding market perceptions of value as related to our consolidated and reporting unit historical and projected operating results and those of other economically similar entities. Changes to these assumptions could significantly lower our estimates of fair value and result in a
We are an insurance holding company and our operating results are almost entirely derived from the operations of our insurance subsidiaries. Our core operating subsidiaries are The Medical Assurance Company, Inc., ProNational Insurance Company, NCRIC, Inc. and Red Mountain Casualty Insurance Company, Inc.; all principally write professional liability insurance. We also write a limited amount of medical professional liability insurance through Woodbrook Casualty Insurance, Inc. (formerly Medical Assurance of West Virginia, Inc.).
Our goal is to build upon our position as a leading writer of professional liability insurance and expand principally within the mid-Atlantic, Midwest and Southeast, while maintaining our commitment to disciplined underwriting and aggressive claims management. According to A.M. Best, based on 2004 data, we are the fourth largest active medical liability insurance writer in the nation, and we believe we are the largest medical liability writer in our collective states of operation. We believe that our strong reputation in our regional markets, combined with our financial strength, strong customer service and proven ability to manage claims, should enable us to profitably expand our position in select states. We have successfully acquired and integrated companies and books of business in the past and believe our financial size and strength make us an attractive acquirer. We continually evaluate these opportunities to leverage our core underwriting and claims expertise.
We emphasize disciplined underwriting and do not manage our business to achieve a certain level of premium growth or market share. We apply our local knowledge to individual risk selection and determine the appropriate price based on our assessment of the specific characteristics of each risk. In addition to prudent risk selection, we seek to control our underwriting results through effective claims management. We investigate each claim and have fostered a strong culture of aggressively defending claims that we believe have no merit. We manage claims at the local level, tailoring claims handling to the legal climate of each state, which we believe differentiates us from national writers.
We believe we are viewed as a market leader because of our financial strength and stability, and our ability to deliver excellent service at the local level. There have been several highly publicized insolvencies in our industry in recent years, and regulators have taken action against former competitors because of financial concerns. Thus, we believe our balance sheet strength and financial stability will continue to be a differentiating factor in the market.
We have seen an increase in competition during the year by both existing professional liability insurers as well as new entrants, primarily in the form of risk retention groups and other risk pooling mechanisms. While most existing competitors appear to be maintaining pricing and underwriting discipline, we are seeing an increase in competition, especially on price. The new entrants are typically more aggressive in seeking new business and are generally more willing to compete on price. As a result of these market forces, profitable growth in the coming year will be challenging. Nevertheless we will continue to price our products at levels that we believe meet our return objectives and we will continue to disregard business that does not.
Additional information regarding the previously described transactions is provided in Note 2 “Acquisition of NCRIC” and Note 3, “Discontinued Operations” of the Notes to the Consolidated Financial Statements included herein.
Within our operating subsidiaries our primary need for liquidity is to pay losses and operating expenses in the ordinary course of business. Our operating activities provided positive cash flow of $323.6 million for the year ended December 31, 2005, which is comparable to cash provided by operations of $336.3 million for the year ended December 31, 2004. Our December 31, 2005 operating cash flow includes $16.3 million generated by NCRIC operating activities from the August 3 purchase date forward. The primary sources of our operating cash flows are net investment income and the excess of premiums collected over net losses paid and operating costs. Timing delays exist between the collection of premiums and the payment of losses. A general measure of this timing delay is the ratio of paid to incurred losses, which is computed by dividing paid losses for the period by incurred losses. Our paid to incurred loss ratios for the years ended December 31, 2005 and 2004 are 51.6% and 46.5%, respectively.
We believe that rate adequacy is critical to our long-term liquidity. We continually review rates and submit requests for rate increases to state insurance departments as we consider necessary to maintain rate adequacy. We are unable to predict whether we will continue to receive approval for our rate filings. In most jurisdictions we are required to receive approval of these rate increases before we can factor them into the pricing of our products.
Cash and invested assets increased $482.6 million over the prior year. The increase is attributable to the aforementioned operating cash flow as well as the addition of NCRIC, which held cash and investments of $237.1 million at December 31, 2005. The fair value of our investment portfolio decreased $43.2 million as a result of the rising rate environment in 2005. We transfer most of the cash generated from operations into our investment portfolio. We held cash and cash equivalents of approximately $34.5 million at December 31, 2005 and $20.7 million at December 31, 2004.
At December 31, 2005 our investment in fixed maturity securities is $2.4 billion, representing 91.4% of our total investments. Substantially all of our fixed maturities are either United States government agency obligations or investment grade securities as determined by national rating agencies. The fixed maturity securities in our investment portfolio have a dollar weighted average rating of “AA” at December 31, 2005. Our investment policy implements an asset allocation that uses length to maturity as one method of managing our long-term rate of return. The weighted average effective duration of our fixed maturity securities at December 31, 2005 is 3.91 years. Changes in market interest rate levels generally affect our net income to the extent that reinvestment yields are different than the original yields on maturing securities. Additionally, changes in market interest rates also affect the fair value of our fixed maturity securities. Bond interest rates have increased since December 31, 2004 and as a result average bond market values have decreased. On a pre-tax basis, net unrealized gains/losses related to our available-for-sale fixed maturity securities decreased from a net unrealized gain of $27.3 million at December 31, 2004 to a net unrealized loss of $15.2 million at December 31, 2005.
Our investment in short-term securities at December 31, 2005 is $93.1 million as compared to $37.9 million at December 31, 2004. Approximately $17.0 million of this increase is attributable to NCRIC. We have elected to hold more funds in short-term securities during 2005 in order to increase our investment flexibility in a rising rate environment. As our investment managers identify investment opportunities that are consistent with our longer range investment strategy we plan to move funds from short-term securities to longer term fixed maturity securities.
We may redeem the Convertible Debentures on or after July 7, 2008 with notice. Holders may require us to repurchase their debentures on June 30 of 2008, 2013, and 2018. Also, holders may convert their debentures if the market value of our common stock exceeds the product of the conversion price (currently $41.83) multiplied by 120% for 20 of the 30 trading days ending on the last trading day of the immediately preceding quarter. Upon conversion, holders will receive 23.9037 shares of common stock for each $1,000 principal amount of debentures surrendered for conversion. We have the right to deliver, in lieu of common stock, cash or a combination of cash and shares of common stock.
See Note 10 of our Consolidated Financial Statements for additional information regarding our long-term debt.
As a result of the acquisition of NCRIC, we assumed the risk of loss for a judgment entered against NCRIC on February 20, 2004 by a District of Columbia Superior Court in favor of Columbia Hospital for Women Medical Center, Inc. (“CHW”) in the amount of $18.2 million (the “CHW judgment”). By order of September 30, 2005, the trial court denied all post-trial relief sought by NCRIC and NCRIC has appealed the judgment. NCRIC posted a $19.5 million appellate bond and associated letter of credit to secure payment of the CHW judgment plus interest and costs, in the event the judgment is ultimately affirmed and paid. In accordance with SFAS 141, we established a liability of $19.5 million for this judgment and included the liability as a component of the fair value of assets acquired and liabilities assumed in the allocation of the NCRIC purchase price.
underlying the estimation of our loss reserve and we make adjustments that we believe the emerging data indicate. Any adjustments necessary are reflected in the then-current operations.
As a result of the variety of factors that must be considered by management there is a significant risk that actual incurred losses will develop differently from these estimates. We use a variety of actuarial methodologies in performing these analyses. Among the methods that we have used are:
The table includes losses on both a direct and an assumed basis and is net of reinsurance recoverables. The gross liability for losses before reinsurance, as shown on the balance sheet, and the reconciliation of that gross liability to amounts net of reinsurance are reflected below the table. We do not discount our reserves to present value. Information presented in the table is cumulative and, accordingly, each amount includes the effects of all changes in amounts for prior years. The table presents the development of our balance sheet reserves; it does not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
The line entitled “Reserve for losses, undiscounted and net of reinsurance recoverables” reflects the Company’s reserve for losses and loss adjustment expense, less the receivables from reinsurers, each as showing in the Company’s consolidated financial statements at the end of each year (the Balance Sheet Reserves).
In each year reflected in the table, we have utilized the actuarial methodologies discussed previously to estimate reserves. These techniques are applied to the data in a consistent manner and the resulting projections are evaluated by management to establish the estimate of reserves.
Factors that have contributed to the variation in loss development include the following:
Our volume of business and the corresponding data in the late 1980’s and early 1990’s, while substantial, was not of a sufficient size to fully support the actuarial projection process without the use of industry-based data. Substantially all of our business was derived from medical professional liability insurance written in Alabama until we began to geographically expand our business in the mid to late 1990s. We utilized a rigorous and disciplined approach to investigating, managing and defending claims. This philosophy generally produced results in Alabama that were better than industry averages in terms of loss payments and the proportion of claims closed without indemnity payment. Ultimately, actual results proved better than the industry data, creating redundancies.
Our reserves established in the late 1980’s and early 1990’s were strongly influenced by the dramatically increased frequency and severity that we, and the industry as a whole, experienced during the mid-1980s. Some of these trends moderated, and in some cases, reversed, by the late 1980s or early 1990s. However, the ability to recognize the improved environment was delayed due to the extended time required for claims resolution. When these negative trends moderated, the reserves we established during those periods proved to be redundant.
At December 31, 2005 our gross loss reserves included case reserves of approximately $1.240 billion and IBNR reserves of approximately $984 million. Our insurance subsidiaries had consolidated reserves for losses on a GAAP basis that exceeded those on a statutory basis by approximately $29.6 million, which is principally due to the portion of GAAP reserves that are reflected for statutory accounting purposes as unearned premiums. These unearned premiums are applicable to extended reporting endorsements (“tail” coverage) issued without a premium charge upon death, disability, or retirement of an insured.
We use reinsurance to provide capacity to write large limits of liability, to reduce losses of a catastrophic nature and to stabilize underwriting results in those years in which such losses occur. The purchase of reinsurance does not relieve us from the ultimate risk on our policies, but it does provide reimbursement from the reinsurer for certain losses paid by us.
We reinsure professional liability risks under treaties pursuant to which the reinsurer agrees to assume all or a portion of all risks that we insure above our individual risk retention of $1 million per claim, up to the maximum individual limit offered (currently $16 million). Historically, per claim retention levels have varied between the first $200,000 and the first $2 million depending on the coverage year and the state in which business was written. Periodically, we provide insurance to policyholders above the maximum limits of our primary reinsurance treaties. In those situations, we reinsure the excess risk above the limits of our reinsurance treaties on a facultative basis, whereby the reinsurer agrees to insure a particular risk up to a designated limit.
Our risk retention level is dependent upon numerous factors including our risk appetite and the capital we have to support it, the price and availability of reinsurance, volume of business, level of
experience and our analysis of the potential underwriting results within each state. Our 2005-2006 reinsurance treaties renewed with minimal change in terms or conditions from the prior year.
We have not experienced any significant difficulties in collecting amounts due from reinsurers due to the financial condition of the reinsurer. Should future events lead us to believe that any reinsurer is unable to meet its obligations to us, adjustments to the amounts recoverable would be reflected in the results of current operations.
A schedule of our non-cancelable contractual obligations at December 31, 2005 follows:
Results of Operations - Year Ended December 31, 2005 Compared to Year Ended December 31,
The 2005 increases in our annualized ROE and our operating results for the year are primarily attributable to our success in reducing our net loss ratio. In addition, we held more invested assets while market interest rates were increasing, which generated additional investment income.
Premiums written vary from period to period for a number of reasons. Some of the more common differences result from changes to premium rates, changes in the coverages chosen by our insureds, the volume of new business written during the period, the loss of business to competitors or due to our own underwriting decisions, and the percentage of our policies that renew, which may also affect the level of tail premiums written. Changes in the markets in which we operate, such as the entry or exit of a competitor in a given market and changes in the rate structures of our competitors, also affect written premiums from period to period. The effect of any of these changes also varies by the proportion of policies written or renewed during each period in the various geographical regions and classes of business in which we operate.
Tail policies are offered to insureds that are discontinuing their claims-made coverage with us, and the amount of tail premium written in any annual period can and does vary widely. Tail premiums represented approximately 5% of total written premiums in 2005 and approximately 6% of total written premiums in 2004. Tail premiums declined by approximately $7.7 million in 2005 as compared to 2004. While we offer tail coverage to departing insureds as an obligation under our policy provisions, our preference is to sell less rather than more of this coverage since it represents a long-term liability with increased pricing risk.
Hospital premiums, which comprise 7% of our premiums written in 2005 and 2004, declined by approximately $1.9 million as compared to 2004. Such business is highly price sensitive. As in all our lines, we choose not to compete primarily on price because our focus is on maintaining adequate margins on the policies we sell. Thus, our hospital premiums fluctuate based on competitive forces largely beyond our control.
The increase in 2005 earned premiums reflects on a pro rata basis the changes in written premiums that occurred during both 2005 and late 2004, reduced by lower tail premiums written in 2005 as discussed in the section on premiums written.
We reduced ceded premiums by $8.9 million in 2004 to reflect changes in our estimates of the amount of reinsurance premiums due for certain prior accident years, based on the provisions of the reinsurance contracts and our estimates of the reinsured losses for those prior accident years. We also reduced ceded premiums in 2004 by approximately $1.6 million due to the commutation of certain reinsurance contracts. After consideration of the effect of these adjustments, there is little change in 2005 ceded premiums as compared to 2004.
The estimation of medical professional liability losses is inherently difficult. Injuries may not be discovered until years after an incident, or the claimant may delay pursuing the recovery of damages. Ultimate loss costs, even for similar events, vary significantly depending upon many factors, including but not limited to the nature of the injury and the personal situation of the claimant or the claimant’s family, the judicial climate where the insured event occurred, general economic conditions and the trend of health care costs. Medical liability claims are typically resolved over an extended period of time, often five years or more. The combination of changing conditions and the extended time required for claim resolution results in a loss cost estimation process that requires actuarial skill and the application of judgment, and such estimates require periodic revision.
the operating results for the current accident year and, as discussed in critical accounting policies, any changes in estimates related to prior accident years.
The following tables summarize net losses and net loss ratios for the years ended December 31, 2005 and 2004 by separating losses between the current accident year and all prior accident years.
When discussing losses that are reinsured and losses that are retained, it is common to refer to “layers” of loss. The retained layer is the cumulative portion of each loss, on a per-claim basis, which is less than our reinsurance retention for a given coverage year. Likewise, the reinsured layer is the cumulative portion of each loss that exceeds the reinsurance retention.
Our 2005 actuarial analysis of our reserve indicated that our claims severity had continued to increase as expected in our retained layers, but not to the degree anticipated in our original reserve estimates. This was also true in our reinsured layers, but the variance between our original estimates and the 2005 actuarial estimate was smaller. Accordingly, we reduced our estimates of prior accident year gross losses by $24.6 million and reduced the prior accident year reinsurance recoveries by $1.6 million, for a net adjustment to prior year losses of $23.0 million.
Our 2004 actuarial analysis of our reserve indicated that our claims severity had continued to increase as expected in risk retained by ProAssurance. However, in risks ceded to our reinsurers actual loss experience proved to be lower than we originally anticipated and for which we established our reserve. Accordingly, we reduced our estimates of prior accident year gross losses by approximately $60.4 million and reduced the corresponding reinsurance recoveries by $51.7 million, for a net adjustment to prior year losses of $8.7 million. The decrease to reinsurance recoveries for prior accident years more than offset reinsurance recoveries for current accident years resulting in a non-traditional relationship between gross losses and recoveries for the year ended December 31, 2004.
Net investment income is primarily derived from the interest income earned by our fixed maturity securities and includes interest income from short-term and cash equivalent investments, dividend income from equity securities, earnings from limited partnerships, increases in the cash surrender value of business owned executive life insurance contracts, and rental income earned by our commercial real estate holdings. Investment fees and expenses and real estate expenses are deducted from investment income.
The increase in net investment income is principally due to higher average invested funds during 2005. The positive cash flow generated by our insurance operations significantly increased our average invested funds. Rising market interest rates also contributed to the improvement in net investment income. Rates began to increase in mid-2004, allowing new and maturing funds to be invested at higher rates. Our average income yield, on a consolidated basis, excluding NCRIC, was 4.2% for 2005 as compared to 4.0% for 2004. Our average tax equivalent income yield on a consolidated basis, excluding NCRIC, was 4.8% for the year ended December 31, 2005 as compared to 4.4% for the year ended December 31, 2004. We increased the proportion of the portfolio that is invested in tax-exempt securities because of the higher after-tax yields available on these securities; therefore, our average after-tax equivalent income yield improved more than our average income yield.
Interest expense increased in 2005 as compared to 2004 primarily because the average amount of debt outstanding was higher in 2005 and because interest rates increased in 2005. In the early part of 2004, our only outstanding debt was our Convertible Debentures. In April and May of 2004 we issued our 2034 Subordinated Debentures of $46.4 million; we added the 2032 Debentures of $15.5 million in August 2005 as a part of the NCRIC transaction. Our Convertible Debentures have a fixed interest rate; our Subordinated Debentures have variable rates.
Under the “modified prospective” method stock-based compensation is recognized under the requirements of SFAS 123(R) for all share-based payments granted after the effective date of SFAS 123(R) and for the non-vested portion of share-based payments granted prior to the adoption of SFAS 123(R). Under SFAS 123(R) compensation for non-vested share-based payments granted prior to adoption shall continue to be calculated as disclosed under SFAS 123, except that the effect of forfeitures is required to be estimated rather than considered as forfeitures occur.
As permitted by SFAS 123, we currently value employee stock-based payments using APB 25’s intrinsic value method. Accordingly, we generally recognize no compensation cost related to such payments but do provide pro forma disclosure of the effect on net income and earnings per share of applying the fair value provisions of SFAS 123 to such payments granted.
Had our SFAS 123 pro forma disclosures been prepared in accordance with the provisions of SFAS 123(R) the effect would have been different; however, the effect that SFAS 123(R) would have had on prior periods is not readily determinable. SFAS 123(R) provides more extensive guidance than does SFAS 123 with regard to factors that should be considered in valuing share-based payments. Under SFAS 123, we utilized a single set of valuation assumptions for all employees. Under SFAS 123(R), entities are required to “aggregate individual awards into relatively homogeneous groups with respect to exercise and post-vesting employment termination behaviors.” In order to appropriately reflect differing exercise and post-vesting employee termination behaviors, we anticipate aggregating prospective awards into groups consisting of senior executives, likely to exercise shortly after vesting, other senior executives and other employees. Additionally, under SFAS 123(R), fully vested awards granted to directors and awards that vest upon retirement granted to employees who are eligible for retirement will be expensed on the date of grant. Under SFAS 123, we calculated compensation expense (for pro forma disclosure) without consideration of expected forfeitures. Unlike SFAS 123, which permitted companies to reflect forfeitures as they occurred, SFAS 123(R) requires companies to estimate forfeitures in determining the amount of compensation cost to recognize each period. As a result, we will develop estimates of forfeitures during the requisite service periods and revise previous SFAS 123 calculations for known and expected forfeitures related to grants prior to the adoption of SFAS 123(R). Our own history with regard to the expected terms of employee stock awards is not sufficient to allow such assumptions to be developed statistically for most employee groups. Accordingly, for such groups, through December 31, 2007, we will apply the “simplified” method consistent with the guidance of SEC Staff Accounting Bulletin 107, i.e., expected term = (vesting term + original contractual term) / 2). We are in the process of finalizing these assumptions; however, the selection of all assumptions is not complete.
Presently, we estimate that the recognition of compensation cost, net of tax effects, for the non-vested portion of share-based payments granted prior to the adoption of SFAS 123(R) will approximate $1.3 million, net of related tax effects, during fiscal 2006. The further effect of adoption of SFAS 123(R) on future operating results will depend on the levels of share-based payments granted in the future, the groups of employees to whom the awards are granted, the number of awards granted to employees who are eligible for retirement, the terms of any future awards, as well as the final methods and assumptions used to determine the fair value of those share-based payments.
The FASB issued SFAS 154, Accounting Changes and Error Corrections, in May 2005 as a replacement of APB 20, Accounting Changes, and SFAS 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 applies to voluntary changes in accounting principle and changes the
requirements for accounting for and reporting of a change in accounting principle and is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. ProAssurance expects to adopt SFAS 154 on its effective date.
Virtually all of the growth that we experienced in 2004 was related to physician coverages. This growth included an increase of approximately $5.0 million related to physician tail policies. Premiums written for this coverage can vary significantly from year to year.
The following table summarizes net losses and net loss ratios for the years ended December 31, 2004 and 2003 by separating losses between the current accident year and all prior accident years. The net loss ratios shown are calculated by dividing the applicable net losses by calendar year net premiums earned.
During 2004, we continued to see an increase in loss severity, which increased loss costs. Current accident year net loss ratios are lower in 2004 than in 2003 primarily because loss costs increased at a slower pace than premium rates. Loss ratios have also improved because we converted our occurrence policies to claims-made coverage. Generally, loss ratios associated with claims-made coverage are initially lower than those associated with occurrence coverage.
The following table reflects our losses on both a gross and a net basis.
Assumptions used in establishing our reserves are regularly reviewed and updated by management as new data becomes available. Any adjustments necessary are reflected in current operations. Due to the size of our reserves, even a small percentage adjustment to the assumptions can have a material effect on our results of operations for the period in which the change is made.
Underwriting, acquisition and insurance expenses are comprised of variable costs, such as commissions and premium taxes that are directly related to premiums earned, and fixed costs that have an indirect relationship to premium volume, such as salaries, benefits, and facility costs assessments. Underwriting, acquisition and insurance expenses increased in 2004 principally due to additional commission expense incurred as a result of premium growth. Changes in the mix of premiums by state and coverage type also increased commission expense. We also experienced increases in costs for salaries, benefits and professional fees, most significantly those fees related to Sarbanes-Oxley compliance.
The expense ratio (underwriting, acquisition and insurance expenses divided by net premiums earned) increased slightly in 2004 to 16.2% as compared to 15.9% in 2003. The increase is principally attributable to higher commission costs.
Guaranty fund assessments were approximately $396,000 for the year ended December 31, 2004 as compared to approximately $100,000 for the year ended December 31, 2003.
Interest expense increased in 2004 as compared to 2003 primarily because the average amount of debt outstanding was higher in 2004 but also because interest was paid at a higher rate in the first half of 2004 as compared to the first half of 2003. In the first half of 2003 our only debt was an outstanding bank term loan. In July 2003 we issued $107.6 million of Convertible Debentures at a fixed rate of 3.9% and repaid a $67.5 million bank term loan which carried a variable rate. We increased our debt again in April and May of 2004, when we issued Subordinated Debentures of $46.5 million.