Our Consolidated Financial Statements include estimated reserves for unpaid losses and loss adjustment expenses related to our various insurance lines of business. Our actuaries utilize standard actuarial techniques to project ultimate losses. These projections are prepared using the Company’s data, including the number of claims reported and paid, and the average severity of reported and paid claims, as well as industry data. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Based on these quantitative as well as other qualitative factors, such as a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and the current reserving practices of the Company’s claims department, we select a “best estimate” of ultimate future losses, and then record this best estimate in the Company’s Consolidated Financial Statements. We receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves, as required by insurance regulatory authorities.
Loss frequency and severity trends are considered in the estimation of the ultimate liability of losses and loss adjustment expenses. Claim frequency is measured in various ways. The most common measure is the number of claims reported to us and is typically adjusted for the relative exposure, either in terms of the number of insureds or earned premiums. Claim frequency is also measured in terms of the number of claims reported to us on which we make loss payments, also known as indemnity payments, as opposed to claims on which we pay only expenses or close without any payment. Claim frequency impacts not only our projection of the number of IBNR claims associated with our occurrence business, but is also evaluated to determine the cause of changes in frequency. In periods where claims frequency is declining, we consider whether this means that non-meritorious claims are no longer being filed, which would have an impact on the percentage of claims that will ultimately have loss or indemnity payments and which could impact the projection of ultimate losses.
factors. One such factor considered by the actuaries with low-frequency, high-severity lines of business such as medical professional liability is a supposition that if fewer claims are reported to us, those claims are likely to have a higher average severity than the average severity of claims associated with a larger population of claims. Implicit in this supposition is an assumption that the claims that are still being reported to us are those of greater merit and potential severity, and the claims that are no longer being reported were the non-meritorious claims that were closed at little or no cost.
With long-tailed, low-frequency, high-severity lines of business such as medical professional liability, changes in the actuarially projected ultimate loss frequency and severity can have an even greater impact on the balance of recorded reserves than with most other property and casualty insurance lines. While we believe that our estimates of ultimate projected losses are adequate based on information known to us, there can be no assurance that additional significant reserve changes will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
The assumptions and methodologies used in estimating and establishing the reserve for unpaid losses and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded 8% of our recorded net reserves
assumptions and estimates about the operations of the issuer, and its future liquidity and earnings potential. Some of the factors considered in evaluating whether a decline in fair value is other than temporary are:
At December 31, 2008 we had approximately $1.4 million of unrealized losses on our available-for-sale investment security portfolio and $1.5 million of unrecognized losses on our held-to-maturity investment security portfolio. Approximately $0.2 million of the held-to-maturity unrecognized losses pertained to securities that had been in an unrecognized loss position for more than twelve months. All unrealized or unrecognized losses at December 31, 2008 were considered to be interest rate related and temporary in nature. For further information regarding the nature and amounts of these unrealized and unrecognized losses, see Note 3 of the Notes to Consolidated Financial Statements included elsewhere in this report.
Reinsurance premiums and losses related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded
to other companies are reported as a reduction of premium income. Reinsured losses incurred are reported as a reduction of gross losses incurred.
Our reinsurance treaties effective on or after January 1, 2006, although no longer swing-rated, do contain profit sharing provisions. In accordance with these provision, if the reinsurers’ experience under the treaties is favorable, that is the treaties are profitable from the reinsurers’ perspective, a percentage of the reinsurers’ profit would be due back to us. Recorded ceded loss experience as of December 31, 2008 does not indicate that any such profit sharing is due back to us.
We commuted our 2005 medical professional liability reinsurance treaty agreement effective December 31, 2008. The $16.6 million of consideration under the commutation, consisting of $8.5 million in cash and the reduction of swing-rated premiums payable of $8.1 million, were recorded as a reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) in the current year. In connection with the commutation we released the reinsurers from their obligations under the treaty of $16.0 million (thereby increasing losses and loss adjustment expenses incurred). The net effect of the commutation was a decrease in losses and loss adjustment expenses of $633,000.
We estimate our income tax expense based on the best information available to us at year end. This income tax expense includes a provision for those income taxes that are currently payable, as well as a provision for the deferred impact of certain deductible and taxable temporary differences. In the months subsequent to the calendar year end, we prepare and file our income tax returns and evaluate any differences between the provisions we recorded in the previous year and the actual amounts per the filed tax returns. These “return to provision” differences are recorded as adjustments to income tax expense in the period in which they are identified. Return to provision adjustments for each of the three years ended December 31, 2008 were less than $50,000.
We record any excess tax benefits related to employee share-based awards as a credit to additional paid in capital in the year that they are currently deductible in the Company’s consolidated tax return.
In addition, Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, Accounting for Income Taxes, requires management to identify, estimate and disclose positions they have taken where the income tax treatment of the position taken is not 100% certain. Our evaluation of the deductibility or taxability of items included in the Company’s tax returns has not resulted in the identification of any material, uncertain tax positions.
Investment Yield: Investment yield represents the average return on investments as determined by dividing investment income for the period by the average ending monthly investment balance for the period. As we use average month ending balances, the yield for certain individual asset classes that are subject to fluctuations in a given month, such as cash and cash equivalents, may be skewed slightly. However, we believe that when calculated for the cash and invested asset portfolio in its entirety, the overall investment yield is an accurate and reliable measure for evaluating investment performance. We calculate investment yields using pre-tax investment income, which excludes the tax savings benefits of certain tax-exempt securities. Our calculation of investment yields may differ from those employed by other companies.
policy is assigned a value of one doctor equivalent. When used in conjunction with the retention ratio, the insured physician count helps us to monitor the overall increase or decrease in insureds that comprise our premium base.
As a way of evaluating our capital management strategies we measure and monitor our return on equity, or ROE, in addition to our results of operations. We measure ROE as our net income for the period, annualized if necessary, divided by our total shareholders’ equity as of the beginning of the period. Other companies sometimes calculate ROE by dividing annualized net income by an average of beginning and ending shareholders’ equity. Accordingly, the ROE percentage we provide may not be comparable with those provided by other companies. We use a modified version of ROE as the basis for determining performance-based compensation.
The following table sets forth our results of operations for the years ended December 31, 2008, 2007 and 2006 on a consolidated basis. The discussion that follows should be read in connection with the Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.
2008 Compared to 2007. Net income decreased $7.6 million, or 14.4%, from 2007 to 2008, primarily as a result of decreases in our underwriting gain ($7.9 million) and investment income ($6.6 million), partially offset by a $6.6 million decrease in federal income tax expense. The underwriting gain decrease was largely the result of a 3.9% increase in our accident year loss ratio, $2.1 million less favorable prior year development and a slight increase in our underwriting expense ratio. Our investment income decreased due to the purchase of additional tax-exempt securities, which have a lower pre-tax yield than comparable quality corporate or mortgage-backed securities, and decreases in short-term interest rates throughout 2008. The $6.6 million decrease in federal income tax expense was largely attributable to the $14.2 million decrease in pre-tax investment income. However, the aforementioned purchase of additional tax-exempt investment securities produced additional tax savings as well.
The following table shows our direct premiums written by major geographical market as well as total net premiums written and earned for the years ended December 31, 2008 and 2007.
For the year ended December 31, 2008, direct premiums written were down $10.4 million, or 7.7% compared with 2007. The decrease in direct premiums written for 2008 was almost exclusively the result of premium rate reductions, which averaged 8.2% across all markets in 2008. This compares with a 7.8% decrease in 2007. Our retention ratio in 2008 was 87%, improving from 85% in 2007, and we ended 2008 with 9,068 insureds, down 1.6% from year end 2007.
Our average in-force premium decreased 6.1% to approximately $13,400 at December 31, 2008, from $14,300 at December 31, 2007. The decrease in the average in-force premium was primarily the result of the rate decreases discussed above, partially offset by the effect of new policies issued in 2008. New business production increased $2.4 million in 2008 to $10.7 million.
The rate decreases instituted over the last two to three years have been in response to favorable claim trends noted in virtually all markets of the medical professional liability industry. As these favorable claim trends appear to be industry wide, other medical professional liability insurers have lowered their rates as well, increasing the overall level of price competition in the industry. We anticipate that the medical professional liability insurance pricing environment will remain highly competitive in 2009, and that if current claim trends hold, additional premium rate decreases are likely. We plan to adhere to our philosophy of underwriting discipline and adequate pricing, and focusing on retaining our quality book of business. This strategy may result in the additional loss of premium volume. However, we remain focused on the overall underwriting results, and not merely top-line revenue growth.
Net incurred loss and loss adjustment expenses, which we refer to collectively as losses, decreased $4.1 million in 2008. Approximately $0.6 million of this decrease was the result of the commutation of our 2005 medical professional liability reinsurance treaty. As discussed in “-Critical Accounting Policies,” our reinsurance treaties for policy years 2005 and prior were swing-rated. As the swing-rated premiums under the 2005 treaty were accrued at the maximum, we recognized a gain on the commutation as the profit margin required by the reinsurers under the terms of the commutation was slightly less than additional accrued premiums.
Absent the gain on the commutation, incurred losses decreased $3.5 million. Of the $3.5 million decrease, $6.2 million pertained to the current accident year, while favorable development on prior accident years’ loss reserves decreased, resulting in a $2.7 million increase in net incurred losses. The decrease in current accident year losses was attributable to the decrease in net earned premium volume, partially offset by a 3.9% increase in the accident year loss ratio to 78.5% for 2008. The increase in the accident year loss ratio was due to the premium rate decreases taken in recent years, partially offset by the continued favorable development on prior years’ loss reserves.
As noted in the section “- Financial Condition, Reserves for Unpaid Loss and Loss Adjustment Expenses,” reserves are inherently uncertain and the ultimate cost to settle claims will likely be more or less than currently anticipated. Actual claim experience will dictate the magnitude and nature, whether favorable or unfavorable, of any future development. Our reserve estimate at December 31, 2008 reflects our best estimate of the future liability as of that date. However, if current trends continue, we believe that the actual claim experience is more likely to emerge favorably than unfavorably.
18 months. With the launch of certain aspects of this new system in the fourth quarter of 2008, and with the remaining portions of the system coming on-line in the first half of 2009, we have begun to amortize those costs that we have capitalized. In addition, salary and benefit costs associated with internal staff who have worked on the development project will no longer be capitalized, which will further increase the underwriting expense ratio. We believe that the new system will allow us to operate our business more efficiently, thus ultimately enabling us to reduce expenses in the future. For further discussion of the amortization expense relating to the system, see “- Property, Equipment and Depreciation” in Note 1 of the Notes to Consolidated Financial Statements.
Investment income decreased $6.6 million, or 15.3% in 2008. There were two primary factors driving the decrease in investment income. The first was the decline in short-term interest rates throughout 2008, which accounted for approximately $2.7 million of the decrease. The second factor was our continued purchase of tax-exempt securities in 2008. During 2008, we purchased additional tax exempt securities. These securities replaced higher-yielding, taxable corporate and government agency securities that matured, were called, sold or paid down during 2008. This shift from higher-yielding corporate and government agency securities to lower-yielding tax exempt securities accounted for approximately $3.8 million of the decrease in investment income. Overall our pre-tax investment yield for 2008 was 4.38%, a decrease of 62 basis points compared to a yield of 5.00% for 2007. On a net-of-tax basis, the decline in the investment yield was not as significant, dropping only 26 basis points to 3.31% for 2008, compared with 3.57% for 2007. While investment markets are likely to remain volatile in 2009, we believe our portfolio, with its emphasis on high-quality municipal, corporate and government agency mortgage-backed securities, is well positioned to provide solid returns in 2009.
Direct premiums written decreased 13.7% in 2007. Overall our retention rate in 2007 was good, with 85% of policies that expired renewing. As a result of our retention ratio, our insured physician count decreased only 2.5% to 9,217 at December 31, 2007 from 9,454 at December 31, 2006. However, premium rates decreased an average of 7.8%, and there were minor changes in the composition of our book of business, especially in Illinois where we saw a decrease in the number of insureds representing higher-risk, higher-premium specialties. Although these accounts were largely replaced, they were replaced with policies that had a lower annual premium.
Net premiums written did not decrease as significantly as direct premiums written in 2007 as a result of an increase in our loss retention to $1 million in 2007, from $750,000 in 2006. As a result of our increased retention, our ceded premiums written as a percentage of direct premiums written decreased to 3.4% in 2007, from 6.5% in 2006.
The favorable prior year development in 2007 was the result of continued positive trends in claim frequency and relative stability in average paid loss severity. Although we had experienced several consecutive years of declining claim frequency prior to 2007, we had been cautious with regard to recognizing its benefit on ultimate loss estimates. However, reported claims decreased an additional 18.5% in 2007 and we began to reflect the decline in claims frequency in our ultimate loss estimates as it appeared the decline was in fact a valid trend and not merely an anomaly.
The net realized losses of $111,000 in 2007 were the result of a few individually insignificant security sales. The net realized gain of $3.3 million reported for the year ended December 31, 2006 was the result of the sale of some of our investment real estate, which resulted in a realized gain of $1.4 million. In addition, the sale of ProAssurance common stock, which we received in exchange for Physicians Insurance Company of Wisconsin, or PICW, stock in connection with ProAssurance’s acquisition of PICW in 2006, resulted in a realized gain of $2.1 million. These realized gains in 2006 were partially offset by approximately $178,000 of impairment charges.
The effective tax rate for 2007 was 32.5% compared to 31.5% for 2006. The increase in the effective tax rate, despite an increase in our tax-exempt security interest, was a function of the release of $560,000 of reserves for uncertain tax positions in 2006, which created a tax benefit, as well as an increase in tax expense in 2007 due to an increase in non-deductible expenses. The reserve for uncertain tax positions was released in 2006 upon the realization of a refund related to an amendment of a prior years’ tax return. The increase in non-deductible expenses in 2007 pertains primarily to executive compensation in excess of tax deductible limits.
The primary sources of our liquidity, on both a short and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers, proceeds from the maturity or sale of invested assets and principal receipts from our mortgage-backed securities. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, the repayment of long-term debt, the payment of cash dividends on APCapital common stock and the repurchase of APCapital’s outstanding common stock.
In addition to our share repurchases, APCapital paid quarterly cash dividends of $0.10 per share in 2008, which totaled approximately $3.8 million for the year. On February 12, 2009, APCapital’s Board of Directors announced an increase in its quarterly cash dividend to $0.11 per share. The first quarter 2009 dividend is payable on March 31, 2009 to shareholders of record on March 13, 2009, and is expected to result in a total cash payout of approximately $0.9 million.
We made net federal income tax payments of approximately $15.2 million in 2008. Substantially all of our taxable income is generated by American Physicians. As such, in accordance with inter-company tax allocation agreements, it is primarily American Physicians responsibility to provide the cash resources to fund our tax obligations. APCapital generally has had a net positive cash flow from income taxes as it is reimbursed by its subsidiaries for the tax benefit of the loss it generates in accordance with inter-company tax allocation agreements.
At December 31, 2008 our statutory capital and surplus, which we refer to collectively as surplus, remained strong at approximately $205.0 million. This surplus level resulted in a net premiums written to surplus ratio of 0.59:1 based on $120.1 million of net premiums written. Surplus at December 31, 2007 was approximately $221.6 million, and our net premiums written to surplus ratio was also 0.59:1. The $16.6 million decrease in surplus in 2008 was due to $63.0 million of dividend payments made by American Physicians to APCapital, as well decreases in deferred income taxes and non-admitted assets totaling $3.5 million. Partially offsetting these decreases was an increase in surplus related to $49.1 million of net income and a $0.9 million increase in unrealized gains, net of tax. The Company’s Risk Based Capital and IRIS Ratios, other measures considered by regulators in evaluating the capital and surplus adequacy of our insurance subsidiaries are discussed under “Item 1. Business - Insurance Regulatory Matters.” Such cross referenced information is incorporated herein by reference.
Activity in the net liability for unpaid loss and loss adjustment expenses, including favorable development on prior accident years’ loss reserves and the reasons therefor, for the years ended December 31, 2008, 2007 and 2006 can be found in Note 8 of the Notes to Consolidated Financial Statements. Such cross-referenced information is included herein by reference.
Our tax-exempt municipal securities are all insured. However, when purchasing municipal and other tax-exempt securities, we do not rely on the insurance, but rather focus on the credit worthiness of the underlying issuing authority. In addition, we purchase only “essential purpose” tax-exempt bonds. Essential purpose bonds are used to fund projects such as schools, water and sewer, road improvements as well as other necessary services. These bonds are general obligations and are backed by the full taxing authority of the city, county or state, and have a very low historical rate of default. Our mortgage-backed securities are all issued by government sponsored enterprises, principally the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac. All of the Fannie Mae and Freddie Mac mortgage-backed securities consist
Accrued expenses and other liabilities at December 31, 2008 were $25.5 million, a decrease of $13.3 million compared to December 31, 2007. The decrease was principally due to a decrease in our reinsurance premiums payable balance of $8.6 million. Approximately $8.1 million of the decrease in the reinsurance premium payable balance was attributable to the elimination of the swing-plan premium payable associated with our 2005 reinsurance treaty, which we commuted effective December 31, 2008.
The long-term debt is more fully described in Note 9 of the Notes to Consolidated Financial Statements. Amounts included herein assume annual interest payments based on a 7% interest rate for the first four years and 8% thereafter. The principal is all assumed to be due at its original maturity date in 2033.
We have audited the accompanying consolidated balance sheets of American Physicians Capital, Inc. and Subsidiaries (the “Company”) as of December 31, 2008 and 2007 and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Share amounts have been retroactively adjusted to reflect a three-for-two stock split effective November 1, 2006. See Note 1.
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 (“APSpecialty”), Alpha Advisors, Inc. and American Physicians Assurance Corporation (“American Physicians”). APManagement Ltd. and APIndemnity (Bermuda) Ltd. were liquidated effective February 28, 2006 and May 10, 2006, respectively. APCapital and its consolidated subsidiaries are referred to collectively herein as the Company. All significant intercompany accounts and transactions are eliminated in consolidation.
Effective November 1, 2006, the Company paid a three-for-two stock split of its common shares to shareholders of record as of the close of business on October 11, 2006. All of the share and per-share data, as well as share-based award information included in these Consolidated Financial Statements and Notes thereto, has been retroactively adjusted to reflect the stock split.
Company’s medical professional liability direct premiums written represented claims-made policies. Occurrence basis policies and tail coverage accounted for the other 35% of premiums in those years.
The Company writes business throughout the United States of America, with an emphasis on markets in the Midwest, specifically the states of Illinois, Kentucky, Michigan and Ohio, as well as the state of New Mexico. These five states accounted for approximately 98% of the Company’s total medical professional liability direct premiums written for each of the years in the three year period ended December 31, 2008.
Write-downs for OTTI are recorded as realized losses in the period a security’s decline in market value is first considered other than temporary. The Company does not adjust the cost basis of an OTTI security for subsequent changes in market value unless a further decline in market value is deemed to also be an OTTI. Rather, subsequent changes in the fair value of OTTI securities are considered unrealized gains or losses and included as a component of other comprehensive income. However, in periods subsequent to the recognition of an OTTI on a fixed income security, the security is accounted for as if the security had been purchased on the measurement date of the OTTI. That is, the discount associated with the security, based on the new cost basis, will be accreted over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows. See Note 3 for details of charges for OTTI for the three years ended December 31, 2008.
Other investments on the accompanying Consolidated Balance Sheets consists of investment real estate, investment real estate limited partnerships, non-marketable and marketable equity securities. Investment real estate is carried at the lesser of historical cost or at estimated fair market value based on recent sales or offers for similar properties. Real estate limited partnerships are accounted for using the equity method. Non-marketable equity securities, which include the two business trusts described in Note 9, are also accounted for using the equity method. Marketable equity securities are classified as available-for-sale and carried at their fair value with any unrealized gains and losses reported net of any related tax effects, as a component of accumulated other comprehensive income.
The Company offers quarterly and monthly payment plans for policies with an annual term. Accordingly, premiums receivable include $32.5 million at December 31, 2008 and $33.9 million at December 31, 2007 of premium installments. Receivable balances consist principally of written premiums from physicians in the states of Michigan, Ohio, Illinois and New Mexico. Payment plans are designed so that credit risk associated with receivables is generally offset by the liability for unearned premiums. However, an allowance for doubtful accounts of approximately $50,000 at December 31, 2008 and December 31, 2007 has been established and is included in the premium receivable balance, primarily for receivable balances that may not be collectable and have no associated unearned premiums.
Claims-made policies provided by the Company include coverage for extended period reporting claims in the event of the death, disability or retirement (“DDR”) of the insured. This DDR coverage provides coverage to the physician for any prior incidents occurring during the coverage period that are reported after their death, disability or retirement. The loss exposure associated with this product is known as extended reporting period claims. The reserve for extended reporting period claims coverage is recognized during the term of the original claims-made policy and is based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of future premiums associated with this coverage. The amount of this reserve is $13.0 million and $15.0 million at December 31, 2008 and 2007, respectively, which includes a discount of approximately $3.6 million and $4.5 million at December 31, 2008 and 2007, respectively, related to the present value calculation. The reserve for DD&R benefits is included in unpaid loss and loss adjustment expenses in the accompanying Consolidated Balance Sheets. Changes in this reserve are charged or credited to income in the period in which the changes first become known.
The Company’s reinsurers are reviewed for financial solvency, at least quarterly. This review includes, among other quantitative and qualitative factors, a ratings analysis of each reinsurer participating in a reinsurance contract. At December 31, 2008 and 2007, there were no disputes with reinsurers regarding the recoverability of payment of amounts. See Note 10 for recoverable amounts from individually significant reinsurers.
The Company assesses the likelihood that deferred tax assets will be realized based on the availability of future taxable income in the periods when the deferred tax assets are expected to be deducted in the Company’s tax return. If it is deemed more likely than not that all, or a portion, of the Company’s deferred tax assets will not be realized, then a valuation allowance is established for the portion of the deferred tax assets that are deemed not likely to realized. Following this assessment methodology, the Company has determined that a valuation allowance is not necessary as of December 31, 2008 and 2007.
On January 12, 2009, The FASB issued FASB Staff Position (“FSP”) EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. FSP 99-20-1 amends the impairment guidance in EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, to achieve a more consistent determination of whether an other-than-temporary impairment has occurred. Prior to the issuance of EITF 99-20-1 two models for evaluating other-than-temporary impairments existed. The EITF 99-20 model required the use of market participant assumptions exclusively regarding future cash flows used in fair value estimates, whereas SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, allowed management to use its reasonable judgment regarding the probability of future cash flows. The FSP also retains and emphasizes the objective of an other-than-temporary impairment assessment and the related disclosure requirements in SFAS No. 115. FSP EITF 99-20-1 is effective for interim and annual reporting periods ending after December 15, 2008 on a prospective basis. The adoption of FSP EITF99-20-1 did not have a material effect on its consolidated results of operations, financial position or liquidity as the Company did not hold any of the type of securities to which the EITF 99-20 guidance applied.
Equity securities are included in other investments in the accompanying consolidated balance sheets.
The following tables show the Company’s gross, unrealized in the case of available-for-sale securities, or unrecognized for held-to-maturity securities, investment losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008 and 2007, respectively.
The carrying amount of bonds that were on deposit with various state regulatory authorities as of December 31, 2008 and 2007 was $8.3 million and $8.5 million, respectively.
Proceeds on the sales of investments in bonds totaled $11.1 million in 2008, $9.3 million in 2007, and $11.9 million in 2006. Gross gains of $23,000, $118,000, and $0 were realized on the sales of investments in bonds for the years ended December 31, 2008, 2007 and 2006, respectively. Gross losses of $60,000 and $133,000 were realized on the sales of investments in bonds for the years ended December 31, 2007 and 2006, respectively. There were no gross losses realized on the sale of investment in bonds for the year ended December 31, 2008. However, as noted previously, the Company recognized an impairment charge of $858,000 in 2008 on bonds as a result of a decision to sell the securities shortly after a reporting date. A gain of $10,000 was ultimately recognized upon the eventual sale of these securities.
Available-for-sale equity securities - are recorded at fair value on a recurring basis. Our available-for-sale equity security portfolio consists of publicly traded common stocks. As such quoted market prices in active markets are available for these investments, and they are therefore included in the amounts disclosed in Level 1.
Our financial assets with changes in fair value measured on a recurring basis at December 31, 2008 were as follows:
The Company had no financial liabilities that it measured at fair value at December 31, 2008.
The changes in the balances of Level 3 financial assets for the year ended December 31, 2008, were as follows:
Other Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
SFAS No. 130, “Reporting Comprehensive Income,” requires unrealized gains or losses on the Company’s available-for-sale investment securities arising during the period and the amortization of unrealized gains and losses on the Company’s held-to-maturity securities at the date of transfer to be included in other comprehensive income, net of tax.
The following table shows the components of net unrealized gains on investments, net of deferred federal income taxes included in accumulated other comprehensive income in the shareholders’ equity section of the accompanying Consolidated Balance Sheets at December 31, 2008 and 2007:
At December 31, 2008 and 2007, property and equipment consisted of the following:
In each of the last three years, claims frequency has declined and has been much lower than originally assumed in the Company’s actuarial projections. At the same time, paid claims severity has remained relatively stable,
contrary to previous actuarial estimates which anticipated increases in the paid loss severity. This trend of declining claim frequency, combined with the stable severity, has resulted in actual loss development that is significantly less than previous estimates of required reserves. As a result the Company has experienced favorable development in each of the last three years in the liability for unpaid loss and loss adjustment expenses relating to prior years.
Management believes that the estimate of the ultimate liability for unpaid losses and loss adjustment expenses at December 31, 2008, is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Company’s actual incurred loss and loss adjustment expenses will not conform to the assumptions inherent in the estimation of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying Consolidated Balance Sheets.
The Company owns two business trusts (the “Trusts”), which were formed for the purpose of issuing, in private placement transactions, $30.0 million of mandatorily redeemable trust preferred securities (“TPS”) and using the proceeds thereof, together with the equity proceeds received from APCapital in the initial formation of the Trusts, to purchase $30.9 million of floating rate junior subordinated deferrable interest debentures (the “Debentures”) from APCapital.
The Company had reinsurance recoverables from the following reinsurers at December 31, 2008 and 2007:
The Company commuted its 2005 medical professional liability reinsurance treaty agreement during 2008. The Company recognized the $16.6 million consideration under the commutation as a reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) in the current year. In connection with the commutation the Company released the reinsurers from their obligations under the treaty of $16.0 million (thereby increasing losses and loss adjustment expenses incurred). The net effect of the commutation was a decrease in losses and loss adjustment expenses of $633,000.
The Company’s income tax reconciliation for the years ended December 31, 2008, 2007 and 2006, is as follows:
At December 31, 2008 and 2007, the components of the net deferred federal income tax asset were as follows:
At December 31, 2008, the Company had approximately $1.0 million and $600,000 of net operating loss carryforwards that expire in 2011 and 2010, and are limited to $340,000 and $575,000 annually, respectively. The Company fully utilized its alternative minimum tax credits during 2007.
The Board of Directors has authorized the Company to purchase shares of its outstanding common stock under two separate plans. The Board of Directors has approved a series of authorizations to purchase shares of the
Company’s outstanding common stock at the discretion of management (referred to as the “discretionary plan”). At December 31, 2008, approximately $21.4 million of the $25 million authorization made on February 7, 2008 remained available for repurchase under the discretionary plan, subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Global Select Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital resources and requirements. Shares repurchased under these discretionary authorizations during the years ended December 31, 2008, 2007 and 2006, as well as the total number of shares repurchased pursuant to prior authorizations under the discretionary plan are shown in the table below.
The Company’s Board has also authorized the repurchase of the Company’s common shares pursuant to a Rule 10b5-1 plan. On October 29, 2007, the Board authorized the repurchase of an additional $20 million of the Company’s common shares pursuant to a Rule 10b5-1 plan in 2008, as well as the rollover of any remaining unused dollars allocated to the 2007 plan. At December 31, 2007, $19.4 million of the 2007 Rule 10b5-1 authorization remained unused, which means there is a total of $39.4 million available for repurchase under the 2008 Rule 10b5-1 plan. On December 4 and 11, 2008, the Board authorized the repurchase of an additional $10 million and $20 million of the Company’s common shares pursuant to the Rule 10b5-1 plan in 2008, as well as the rollover of any unused authorization into 2009. At December 31, 2008, the Company had $26.8 million of its 2008 Rule 10b5-1 plan authorizations remaining that could be carried over into 2009. The Rule 10b5-1 plan share repurchases are expected to continue until the authorizations are fully utilized, subject to conditions specified in the Rule 10b5-1 plan. However, the Company may terminate the plan at any time.
SFAS No. 107, “Disclosures About Fair Value of Financial Instruments”, requires disclosure 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 non-financial instruments from its disclosure requirements.
The Company has subleased approximately 13,000 square feet of office space in Chicago, Illinois to an unrelated third party. The difference in the cash flows between the Company’s obligations for the subleased space, in accordance with the original lease terms, and the rent the Company will receive from the sublessor over the next five years has been discounted using an interest rate of approximately six-percent to approximate the fair value of the liability incurred in connection with the contract termination. Other costs incurred in connection with the subleased space, such as broker commissions, were also included in the calculation of the original liability.
Activity in the liability for contract termination costs for the years ended December 31, 2008, 2007 and 2006, was as follows:
Holders of options under the Plan may exercise their outstanding options and pay the exercise price pursuant to a net share settlement feature. This feature allows the option holder to elect to have shares of stock withheld upon exercise to pay the option exercise price and the payment of taxes attributable to the option exercise.
The following table summarizes activity in the Company’s equity compensation plans for stock options awards for the year ended December 31, 2008:
The total fair value, at the date of vesting, of stock options and other share awards vested during the years ended December 31, 2008, 2007 and 2006 was $1.0 million, $2.0 million and $3.5 million, respectively.
In 2008 and 2007, the Company recognized pre-tax compensation cost of $44,000 and $160,000, respectively, related to share-based payment arrangements. Such costs are included in the accompanying Consolidated Statements of Income as either underwriting expense or loss adjustment expense. As of December 31, 2008, the Company had no unrecognized compensation costs related to non-vested share-based payment awards.
There were no stock options or other share-based awards granted during any of the three years ended December 31, 2008.
The Company is obligated under operating leases, which have various expiration dates through October 2013. Minimum future lease payments are as follows: 2009 - $876,000; 2010 - $852,000; 2011 - $759,000; 2012 - $746,000 and 2013 and thereafter - $510,000. Rental expense was $244,000 in 2008, $342,000 in 2007, and $546,000 in 2006. Note that rent expense is consistently less than the reported lease commitments as the lease commitment amounts do not anticipate the payments we receive for subleased office space related to our Chicago, Illinois lease. Sublease rentals under non-cancelable subleases are estimated to be $395,000 in 2009; $406,000 - 2010; $417,000 - 2011; and $794,000 in 2012 and thereafter.
In addition to obligations for operating leases, the Company is also obligated to fund certain infrastructure improvement assessments imposed by the City of East Lansing, Michigan in connection with the development of the area surrounding investment real estate owned by the Company. These assessments are due annually in the following amounts: 2009 - $110,000, 2010 - $105,000; and 2011 - $100,000. These, and other assessments, have also been imposed on a real estate LLC that the Company has a 50% ownership stake in. In the event that the cash resources of the LLC are not sufficient to fund the assessment payments, the Company may be called upon to make a capital contribution to the LLC to cover 50% of the assessment payments. In such an event, the amounts that the Company may be required to fund are as follows: 2009 - $262,000; 2010 - $252,000 2011 - $242,000; 2012 - $143,000; and 2013 and thereafter - $517,000.
Bonds and U.S. government securities are generally carried at amortized cost for statutory accounting purposes.
The following table sets forth the reported combined statutory surplus levels at December 31, 2008, 2007, and 2006 and the combined statutory net income for the years then ended for the Company’s American Physicians, APSpecialty and ICA insurance subsidiaries. Note that because of the parent/subsidiary relationship between American Physicians and APSpecialty, APSpecialty’s surplus has been eliminated from the combined results to avoid double counting its effect.
In our opinion such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
American Physicians Assurance Corporation - a stock insurance company incorporated under Michigan law (American Physicians).
At December 31, 2008 and 2007, APCapital’s investment in subsidiaries is stated at the initial consolidation value plus any additional capital contribution made to the subsidiaries by APCapital, adjusted for the equity in undistributed earnings of subsidiaries since the date of acquisition, less any dividends received from the subsidiaries.
APCapital has issued $30.9 million of floating rate junior subordinated deferrable interest debentures (“Debentures”) to subsidiary trusts. The trusts have issued mandatorily redeemable trust preferred securities that have terms that are essentially the same as the Debentures issued by APCapital, which are the only assets of the trusts. See Note 9 of the Notes to Consolidated Financial Statements for a description of the Debentures and the transactions in which they were issued. As of December 31, 2008, the outstanding balance of the debentures was $25.9 million.
APCapital received the following dividends payment from its American Physicians insurance subsidiary during 2007: $13 million in March, $13 million in May, $6 million in July and $46.2 million in August. In addition, APCapital received a $3.8 million dividend payment from ICA in August 2007. Of the $46.2 million and $3.8 million paid by American Physicians and ICA, respectively, in August 2007, $40 million and $2.3 million, respectively, required prior regulatory approval as they exceeded ordinary dividend limits imposed by the State of Michigan.