Net loss for the year ended December 31, 2002 includes a $9.1 million charge, net of tax, for the write-off of goodwill related to the adoption of Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.” In accordance with the transitional guidance given in SFAS No. 142, this write-off, related to the adoption of the standard, was treated as a cumulative effect of a change in accounting principle.
As the Company was in a net loss position for the years ended December 31, 2003, 2002 and 2001, no effect of awards or options were calculated as the impact would have been anti-dilutive.
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. The discussion that follows contains certain forward-looking statements relating to our anticipated future financial condition, operating results, cash flows and our current business plans. When we use words such as “will,” “should,” “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward looking-statements. These forward-looking statements represent our outlook only as of the date of this report. While we believe any forward-looking statements we have made are reasonable, actual results could differ materially since the statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are detailed under “Item 1A - Risk Factors” and elsewhere in this report and from time to time in other reports we have filed with the Securities and Exchange Commission. The cross-referenced information is incorporated herein by reference.
In 2003, we had determined that there was not sufficient positive evidence to support the realization of the future tax benefit and established a valuation allowance for the entire $49.9 million net deferred tax asset as of September 30, 2003. However, during 2005 we generated pre-tax income of $44.9 million. This combined with the $19.8 million of pre-tax income from 2004 led to management’s conclusion that it was more likely than not that sufficient taxable income would exist in future periods to support the realization of deferred tax assets. Accordingly, during 2005, we reversed the entire deferred tax valuation allowance.
In the analysis of our operating results that follows, we refer to various financial ratios that management uses to analyze and compare the underwriting results of our insurance operations. These ratios are calculated on a GAAP basis and include:
The increase in interest expense was the result of an increase in short-term interest rates. Our long-term debt of $30.9 million pays an average variable rate of interest of 4.15% plus the three-month London Inter Bank Offered Rate, or LIBOR. If the three-month LIBOR continues to increase, our interest expense will also increase; however, the annual rate of interest on the debentures is capped at 12.5% through May 2008.
Amortization expense in 2005 consists of $625,000 of amortization related to a two-year covenant not to compete and $181,000 of amortization for debt issue costs. The covenant not to compete was fully amortized as of December 31, 2005. Amortization expense in future periods should consist of only the amortization of debt issue costs, which should approximately $181,000 annually through 2007 and approximately $70,000 in 2008.
The decrease in federal income tax expense in 2004 was the result of the establishment of the deferred tax valuation allowance in 2003. Because of the impact of the valuation allowance neither the federal income tax benefit for 2004 or the tax expense for 2003 are representative of the expense anticipated in future periods.
At December 31, 2005, we had no material planned expenditures for the acquisition of assets, or other expenditures, other than expenses incurred in the normal course of operations.
As of September 17, 2004, American Physicians entered into a stock purchase agreement with various shareholders of Physicians Insurance Company of Wisconsin, Inc., or PICW, to acquire a substantial minority interest in PICW. The stock purchase agreement, as amended in November 2004, stated that American Physicians will purchase 4,782 shares of PICW common stock at a purchase price of $3,800 per share in cash, or approximately $18.1 million. On August 31, 2005, American Physicians terminated the stock purchase agreement. Concurrently with the termination, American Physicians withdrew its Form A application pending before the Office of the Commissioner of Insurance of Wisconsin (“OCI”) to acquire the interest in PICW.
The favorable development reflected for the medical professional liability segment is the result of positive trends in both the frequency and severity of reported and paid losses related primarily to the 2004 and 2003 accident years, especially in our Ohio and Michigan markets. These positive trends are the result of the more stringent underwriting standards we have put in place over the last few years, and our efforts to discontinue writing higher-risk specialties and in higher-risk geographic markets. Although these underwriting changes have taken place over the last few years, management has been cautiously optimistic in reflecting their impact in our actuarial analyses of the original reserve estimates at December 31, 2004 and 2003. However, more recent data suggests that the changes in our underwriting practices have reduced both the number of reported claims and the severity of paid claims, which has caused us to revise our original reserve estimates downward for the 2004 and 2003 accident years.
Net unrealized appreciation (depreciation) on available-for-sale investment securities arising during the period, as well as the amortization of unrealized gains related to held-to-maturity securities and related tax effects included in other comprehensive income were as follows for the years ended December 31, 2005, 2004 and 2003.
The carrying amount of bonds that were on deposit with various state regulatory authorities as of December 31, 2005 and 2004 was $8.6 million and $8.3 million, respectively.
The provision (benefit) for income taxes for the years ended December 31, 2005, 2004 and 2003 consists of:
At December 31, 2005 and 2004, the components of the net deferred federal income tax asset were as follows:
Under SFAS No. 107, the Company’s investment securities, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, and long-term debt constitute financial instruments. With the exception of fixed-income securities classified as held-to-maturity, the carrying amounts of all financial instruments approximated their fair values at December 31, 2005 and 2004. The fair value of fixed-income held-to-maturity securities is disclosed in Note 4.
All costs associated with termination benefits and contract terminations are included in the other expenses line item in the accompanying Consolidated Statements of Income, and have been allocated to the various segments in proportion to their estimated anticipated use prior to the sublease of the subleased space.
The Company offers benefits under certain defined contribution plans. In 2005, 2004 and 2003, the defined contribution plans provide for Company contributions of 5% of employee compensation, as defined in the plan, and a 100% match of employee contributions on the first 3% of contributions and 50% match on the next 2% of contributions. Employer contributions to the plans were approximately $937,000, $1,001,000, and $986,000, for 2005, 2004, and 2003, respectively.
In addition to the aforementioned 30,000 shares of restricted stock granted to certain employees in 2004, the Company also granted 1,000 shares of unrestricted stock to newly appointed directors of the Company’s Board. The market value of the Company’s stock at the date of grant for these unrestricted shares was $27.21, resulting in compensation expense of approximately $27,000 during 2004.
For pro forma disclosure purposes (see Note 1), the fair value of stock options was estimated at the date of grant using a binomial lattice model for 2005 grants. Prior to January 1, 2005, the Company used a Black-Scholes option pricing model to estimate the fair value of option grants at the date of grant. The following table indicates the assumptions used, or in the case of the binomial lattice model the range of assumptions, in estimating fair value for the years ended December 31, 2005, 2004 and 2003.
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