UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2008
o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 001-31434
AMERICAN PHYSICIANS SERVICE GROUP, INC.
(Exact name of registrant as specified in its charter)
Texas | 75-1458323 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. employer Identification No.) |
1301 Capital of Texas Highway, Suite C-300, Austin Texas | 78746 |
(Address of principal executive offices) | (Zip Code) |
Registrants telephone number, including area code: (512) 328-0888
Securities registered pursuant to Section 12(b) of the Act:
Title of each class |
| Name of each exchange on which registered |
None |
| None |
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.10 par value |
(Title of Class) |
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act Yes ¨ No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ | Accelerated filer þ | Non-accelerated filer ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No þ
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrants most recently completed second fiscal quarter.
Aggregate Market Value at June 30, 2008: $157,238,972
Indicate the number of shares outstanding of each of the registrants class of common stock, as of the latest practicable date.
Title of Each Class Common Stock, $.10 par value | Number of Shares Outstanding At February 25, 2009 6,987,904 |
Documents Incorporated By Reference
None
2
AMERICAN PHYSICIANS SERVICE GROUP, INC.
2008 Annual Report on Form 10-K
Table of Contents
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| Part I |
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Item 1. | 5 | |
Item 1A. | 17 | |
Item 1B. | 28 | |
Item 2. | 28 | |
Item 3. | 28 | |
Item 4. | 28 | |
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| Part II |
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Item 5. | 29 | |
Item 6. | 33 | |
Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 35 |
Item 7A. | 88 | |
Item 8. | 92 | |
Item 9. | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure | 92 |
Item 9A. | 93 | |
Item 9B. | 95 | |
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| Part III |
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Item 10. | 95 | |
Item 11. | 95 | |
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 95 |
Item 13. | 95 | |
Item 14. | 95 | |
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| Part IV |
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Item 15. | 96 | |
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| 99 |
3
AMERICAN PHYSICIANS SERVICE GROUP, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008
Cautionary Statement Regarding Forward-Looking Statements
This Annual Report on Form 10-K, including Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not materialize or prove correct, could cause our results to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including statements: of our plans, strategies and objectives for future operations; concerning new products, services, or developments; regarding future economic conditions, performance, or outlook; as to the outcome of contingencies; of beliefs or expectations; and of assumptions underlying any of the foregoing.
Forward-looking statements may be identified by their use of forward-looking terminology, such as believes, expects, may, should, would, intends, plans, estimates, anticipates, projects and similar words or expressions. You should not place undue reliance on these forward-looking statements, which reflect our managements opinions only as of the date of the filing of this Annual Report on Form 10-K. Factors that might cause our results to differ materially from those expressed or implied by these forward-looking statements include, but are not limited to, those discussed in Item 1. Business, Item 1A. Risk Factors, and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, below. Forward-looking statements are made in reliance upon the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and we undertake no obligation, other than that imposed by law, to update forward-looking statements to reflect further developments or information obtained after the date of filing of this Annual Report on Form 10-K or, in the case of any document incorporated by reference, the date of that document.
The following important factors, in addition to those referenced under Risk Factors in Item 1A, could affect the future results of our operations and could cause those results to differ materially from those expressed in or implied by such forward-looking statements:
general economic conditions, either nationally or in our market area, that are worse than expected;
changes in the healthcare industry;
regulatory and legislative actions or decisions that adversely affect our business plans or operations;
inflation and changes in the interest rate environment, and/or changes in the securities markets including the performance of financial markets affecting the fair value of our investments or making it difficult to determine the value of our investments;
uncertainties inherent in the estimate of loss and loss adjustment expense reserves and reinsurance;
significantly increased competition among insurance providers;
changes in the availability or cost of reinsurance including our ability to renew our existing reinsurance treaty or obtain new reinsurance;
failure or inability of our reinsurers to pay claims or amounts due us in a timely manner;
loss of key executives, personnel, accounts or customers; and
potential losses and litigation risk associated with our Financial Services businesses.
The foregoing factors should not be construed as exhaustive and we caution you not to place undue reliance on forward-looking statements, which speak only as of the date of this report. In addition to any risks and uncertainties specifically identified in the text surrounding forward-looking statements, you should consult our other filings under the Securities Act of 1933 and the Securities Act of 1934 for factors that could cause our actual results to differ materially from those presented.
4
PART 1
ITEM 1. Business.
General
We were organized in October 1974 under the laws of the State of Texas. Our principal executive office is at 1301 Capital of Texas Highway, Suite C-300, Austin, Texas 78746, and our telephone number is (512) 328-0888. Our website is www.amph.com. We make available free of charge on our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission, or the SEC. We also show details about stock trading by corporate insiders by providing access to SEC Forms 3, 4, and 5. Our stock trades on the NASDAQ Stock Market under the symbol AMPH.
We provide (1) insurance services, specifically medical professional liability insurance, and (2) financial services, including brokerage and other investment services to individuals and institutions.
Recent Transactions
Acquisition
On April 1, 2007, we acquired all of the issued and outstanding stock of American Physicians Insurance Company (API). The business combination was accounted for using the purchase method of accounting and, accordingly, the purchase price was allocated to assets acquired and liabilities assumed based on fair values at the date of acquisition. The total purchase price was $45,167,000 and consisted of consideration of 1,982,499 shares of the Companys common stock, valued at a per share price of $17.635, or $34,961,000 in the aggregate, $35,000 in cash paid in lieu of fractional shares of common stock, 10,197.95 shares of preferred stock valued at $9,179,000, plus costs to complete the acquisition of $992,000. We are required to redeem at least $1 million of the preferred stock each calendar year beginning in 2007, until December 31, 2016, at which time all of the preferred stock must have been redeemed. The preferred stock has a cumulative dividend equal to 3% of the outstanding redemption value per year. In June 2007, 1,019 shares of our Series A redeemable preferred stock were redeemed for $1,058,000, which included accrued dividends of $40,000. In June 2008, 1,004 shares of our Series A redeemable preferred stock were redeemed for $1,302,000, which included accrued dividends of $297,000. In the event of any liquidation, the holders of our Series A redeemable preferred stock receive an amount equal to the remaining redemption value before any distribution is made to the holders of our common stock.
Secondary Stock Offering
On June 19, 2007, we announced that our public offering of 2,100,000 shares of common stock had priced at $16.50 per share. Of the shares offered, 2,000,000 were sold by us, and Kenneth S. Shifrin, our Chairman of the Board and Chief Executive Officer, sold 100,000 of the 582,554 shares he owned as of that date.
The underwriters of the offering were granted a 30-day period to exercise an option to purchase up to 315,000 additional common shares from us. On July 12, 2007, we announced that the underwriters had exercised their over-allotment option to purchase all of these additional shares of common stock at the public offering price of $16.50 per share. Total common shares outstanding rose from approximately 4,819,000 to approximately 7,134,000 after the public offering.
Net proceeds received by the Company from the secondary offering, including the over-allotment, were approximately $35,000,000 after subtracting underwriting, legal, accounting and printing costs. Of this total, we contributed $10,000,000 to API to strengthen its capacity to underwrite insurance risks. The balance of the proceeds has been invested primarily in U.S. government and U.S. government agency securities and is available for general corporate purposes including possible acquisitions.
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Insurance Services Operations
Corporate Overview
We provide medical professional liability insurance primarily in Texas, where our insurance subsidiary, API has written business for over 30 years. API is authorized to do business in the States of Texas, Arkansas and Oklahoma and specializes in writing medical professional liability insurance for physicians and other healthcare providers. We became authorized to do business in Oklahoma in August 2007. We currently insure approximately 5,330 physicians and other healthcare providers, the vast majority of which are in Texas. Approximately 95% of our premiums are written through purchasing groups, which in Texas currently subjects us to less stringent state regulation of premium rates and policy forms. Historically, we operated as the attorney-in-fact manager for API since 1975. In April 2007 we acquired API, thus combining our insurance management experience with an insurance underwriting entity to allow for the increased capacity for continued growth in existing markets and for expansion into new markets.
Prior to our acquisition, API had been organized as a reciprocal insurance exchange under the laws of the State of Texas since 1975. A reciprocal insurance exchange is an entity, similar to a mutual insurance company, which sells insurance to its subscribers and other eligible healthcare providers, who may pay, at the election of the company, in addition to their annual insurance premiums, a contribution to the exchange's surplus. These exchanges generally enter into a contract with an attorney-in-fact that provides for all management and administrative services for the reciprocal exchange. The Company, through a wholly owned subsidiary, was the attorney-in fact for API from its inception until the acquisition.
The management agreement with the Company provided for full management of APIs affairs under the direction of its board of directors. Subject to the direction of the API board, as the attorney-in-fact, our responsibilities were largely ministerial, i.e., to solicit and receive applications, collect premiums, underwrite, handle claims and provide required accounting and reporting services to API. Additionally, the management agreement specifically identified expenses/liabilities to be borne by each entity. We paid certain salaries and personnel related expenses, rent, office operations costs and information technology costs, as provided in the management agreement. API was responsible for the payment of all claims, claims expenses, peer review expenses, directors fees and expenses, legal, actuarial and auditing expenses, its taxes, outside agent commissions and certain other specific expenses. We did not have authority to set premium rates, which were determined by the API board. Furthermore, any sale of API was not at the our discretion, but rather required Texas Department of Insurance approval along with API board approval and the concurring approval of two-thirds of all subscribers of API.
In consideration for performing services as the attorney-in-fact, API paid management fees to us equal to 13.5% of APIs earned premiums before payment of reinsurance premiums. In addition, any pre tax profits of API would be shared equally with us (profit sharing) so long as the total amount of profit sharing did not exceed 3% of APIs earned premiums. The management fees paid to us were $2,729,000 and $10,965,000 for the quarter ended March 31, 2007 and the year ended December 31, 2006, respectively. Revenues from our Insurance Services segment contributed approximately 41% for the first quarter of 2007 and 46% of our total revenue in 2006, respectively. As a result of our acquisition of API, the attorney-in-fact relationship ended and, after the first quarter of 2007, these management fees no longer affect our consolidated results of operations.
Since the acquisition of API, our results of operations are now directly affected by premiums we earn from the sale of medical professional liability insurance, investment income earned on assets we hold, insurance losses and loss adjustment expenses relating to the insurance policies we write as well as commissions and other insurance underwriting and policy acquisition expenses we incur. For the year ended December 31, 2008, revenues and pre-tax earnings from our Insurance Services segment, represents approximately 88% of our total revenues and substantially all of pre-tax earnings. For the year ended December 31, 2007, revenues and pre-tax earnings from our Insurance Services segment, represents approximately 74% of our total revenues and 94% of pre-tax earnings. On a pro forma basis, as if the acquisition had occurred on January 1, 2006, revenues and pre-tax earnings from our Insurance Services segment would have contributed approximately 82% and 93% of total revenues and pre-tax earnings, respectively, for the year ended December 31, 2006 and approximately 79% and 96% of our total revenues and pre-tax earnings, respectively, for the year ended December 31, 2007.
6
At the effective time of the merger, API entered into an Advisory Services Agreement with API Advisory, LLC, or API Advisor, an entity formed by the former members of API's board of directors. Under the terms of the Advisory Services Agreement, API Advisor would provide advisory and consulting services as an independent contractor.
Effective November 19, 2008, upon approval by the Texas Department of Insurance, API and API Advisor mutually agreed to terminate the Advisory Services Agreement. In consideration for terminating the agreement, API agreed to pay a total sum of $1,000,000 to the members of API Advisor. Each member of API Advisor in turn signed a non-competition agreement. The non-competition agreements are for a term of five years with the costs associated with the agreements expensed evenly over this period.
Products and Services
We offer medical professional liability insurance coverage, which is designed to protect our policyholders from losses and legal costs associated with medical professional liability claims. Our policies are written for one-year terms. Generally, medical professional liability insurance is offered on either a claims made basis or an occurrence basis. Claims made policies insure physicians only against claims that are reported during the period covered by the policy. Occurrence policies insure physicians against claims based on occurrences during the policy period regardless of when they are reported. We primarily offer claims made policies. We also provide for an extended reporting option, or tail policy, which is written on an occurrence basis to policyholders who meet certain requirements upon the non-renewal or cancellation of their policy, or upon their death, disability or retirement from practice.
Revenues and Industry Overview
The information required by Regulation S-K Items 101(b) and 101(d) related to financial information about segments and financial information about sales is contained in Note 21 of our accompanying audited consolidated financial statements included in Item 15 of this Form 10-K.
We derive the majority of our revenues from earned premiums that result from issuing policies written on a claims-made basis to physicians, physician groups and other healthcare providers as well as income generated from our investment portfolio. In Texas, we charge both a base premium and a premium maintenance fee on our claims made policies, which partially offset the costs incurred by us to issue and maintain policies. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro-rata basis over the term of the policy. Upon termination of coverage, policyholders may purchase an extended reporting period (tail) policy for additional periods of time. These extended period coverage policy premiums are immediately earned when the policy is issued.
Our results from operations are primarily driven by underwriting results, which is measured by subtracting incurred loss and loss adjustment expenses and other underwriting expenses from net earned premiums and maintenance fees. Net earned premiums exclude premiums ceded to reinsurers. Premiums ceded to reinsurers (ceded premiums) represent amounts paid to the reinsurance companies in return for the reinsurance company assuming a portion of the risk. Substantial underwriting losses could result in a curtailment or cessation of our operations. To limit possible underwriting losses, we reinsured our coverage risk between $250,000 and $1,000,000 per medical incident and for the 2008, 2007 and 2006 treaty years we share in 40%, 20% and 10%, respectively, of the profits and losses generated in this reinsurance layer. We utilize reinsurance to provide us with increased capacity to write additional risk and the ability to write specific risks within our capital resources and underwriting guidelines
Investment income is a result of the performance of our assets invested in fixed income securities and dividends received in equity securities. Investment income is impacted by the size of the portfolio and the rate of return, or yield, on the fixed income portfolio and is in addition to realized gains or losses on the sale of equity or fixed income securities.
The medical professional liability insurance industry tends to be cyclical in nature and the financial results of medical professional liability insurers are influenced by many factors including changes in severity and frequency of claims, changes in applicable laws and regulatory reform, changes in judicial attitudes towards liability claims, and changes in inflation, interest rates and general economic conditions.
7
The availability of medical professional liability insurance, or the industrys underwriting capacity, is determined principally by the industrys level of capitalization, historical underwriting results, returns on investment and perceived premium rate adequacy. Historically, the financial performance of the medical professional liability insurance industry has fluctuated between soft insurance markets and hard insurance markets. In a soft insurance market, increased competitive conditions drive unfavorable premium rates and underwriting terms that can result in losses for insurance carriers. In a hard insurance market, competitive conditions provide for more favorable premium rates and underwriting terms that can result in increased profitability for insurance carriers. Beginning in the early 1990s, the medical professional liability insurance industry in Texas and Arkansas operated in a soft market. Similarly, the industry experienced soft markets at the national level. However, beginning in 2001 and continuing throughout 2003, the medical professional liability insurance market hardened, with a number of carriers withdrawing from the Texas market. Prices for coverage rose substantially as insurers raised premium rates in reaction to increasing losses suffered in the industry.
Tort reform, enacted in Texas in 2003, has generally benefited medical professional liability insurers in the state by limiting certain damages that could be awarded in a medical professional liability claim. In September 2003, Texas voters approved a state constitutional amendment which gives the Texas legislature authority to set limits on damages in medical malpractice and other lawsuits. This coincided with the passage of state legislation which became effective on September 1, 2003 and which places a cap on non-economic damages in medical malpractice cases. Texas law now places a $250,000 cap for all physicians on a per case basis and a $250,000 cap for each health care institution, which collectively cannot exceed $500,000, resulting in an overall stacked cap of $750,000 for non-economic damages. It limits damages awarded for a plaintiffs non-economic damages such as damages for mental anguish, pain and suffering, and loss of companionship. However, there is no limit on the amount of economic or actual damages that could be received in a claim or suit. The tort reform legislation also limits liability of physicians in cases involving product liability or mass action cases.
As a result of tort reform, new competitors entered the Texas market while existing insurers grew their capital due to generally favorable underwriting results for policies covering post-tort reform periods. We believe these factors resulted in softening market conditions in Texas beginning in 2005. We continue to experience increased price competition from both new entrants and existing competitors in the Texas market.
Competition
Our primary competitors in Texas are Medical Protective Insurance Services Inc. (MedPro), Texas Medical Liability Trust (TMLT), ProAssurance Corporation, The Doctors Company, Advocate MD RPG, Inc., and Texas Medical Liability Insurance Underwriting Association, which is the state-sponsored insurer of last resort. We consider these companies to be our competitors because they are the companies to which policyholders typically move when cancelling policies with us. In Arkansas, our primary competitors are State Volunteer Mutual Insurance Company (SVMIC) and First Professionals Insurance Company (FPIC) and in Oklahoma, our primary competitors are Physicians Liability Insurance Company of Oklahoma (PLICO) and MedPro. We consider these companies competitors because they are the dominant insurance providers in Arkansas and Oklahoma. We compete with these companies on a variety of factors including price, customer service, expertise in claims handling, policy coverage, risk management services and financial strength. Many of our competitors have greater financial strength and broader resources than us. In premiums written and asset size, MedPro, TMLT, ProAssurance Corporation, SVMIC, FPIC and The Doctors Company are significantly larger than us. We believe that our long-term presence in the medical professional liability market, the physician involvement in our claims management process, our innovation in policy customization and our strong focus on customer relationship management allow us to successfully attract and retain insurance customers.
We believe an emerging competitive threat to the medical professional liability insurance industry is alternative risk transfer structures such as risk retention groups, captive insurers and other self-insurance vehicles. We believe larger physician groups and other healthcare providers may consider alternative risk transfer products as they grow in both size and the insurance premiums they pay. We believe that we have been successful at retaining many of our large physician groups due to our relationship-focused model and our willingness to tailor coverage terms that meet our clients needs and our underwriting objectives.
8
Marketing and Distribution
We market our insurance products through an established network of independent insurance agents who have specialized knowledge in our markets. We have a long-standing relationship with one agency through which we wrote approximately 44% of our 2008 written premium. In addition to utilizing independent agents, we generated approximately 19% of our 2008 written premiums from policies sold directly to policyholders. Over 95% of our written premiums are generated in Texas with the remainder in Arkansas and Oklahoma. Our business is composed of both solo practitioners and physicians in group practices, which we define as three or more physicians in practice together. No single customer represented more than 4% of premiums and maintenance fees written in 2008.
Over 95% of our sole practitioner and physician group premiums are written through purchasing groups, which can be any group of individuals with similar or related liability risks who form an organization, one of whose purposes is to purchase liability insurance coverage on a group basis. In some states, such as Texas, state insurance departments have less stringent regulation of premium rates and policy forms for insurance written through purchasing groups. However, the policies must contain the same legislatively mandated provisions included in the policies that the insurer must submit for approval on a regulated basis. Arkansas and Oklahoma are not exempt states and insurers selling to purchasing groups are subject to regulation on policy forms and insurance rates.
We employ comprehensive customer relationship practices in our marketing process where we maintain regular contact directly with our larger insurance customers and track the interaction we have with all of our policyholders. We believe this helps ensure that we maintain a strong, direct customer relationship with policyholders that come through our direct distribution as well as those from our independent agent distribution. We visit the majority of our physician group clients on an annual basis in order to provide face-to-face interaction with their key insurance decision makers. We also seek regular feedback from our insurance customers to help strengthen our customer relationships and improve the quality of our insurance operations.
Underwriting
Our underwriting process begins with our efforts to understand the specific risks and needs of an applicant. We conduct a comprehensive review on every new application and new group submission, in addition to an on-site visit to each new group considering applying with us for insurance coverage. Our underwriting process for new accounts incorporates our underwriting team, which includes our medical director. During this process, among other pertinent information, we review every application and submission to determine the applicants specific risks, such as:
the nature of the physicians practice;
claims history, including the frequency and severity of claims reported;
medical specialty;
training;
board certification;
practice territory;
disciplinary actions; and
hospital privileges.
Based on our evaluation of this information and on-site visits for group applicants, we determine the policy terms and pricing utilizing a rating model that applies specific factors for these risks. We then customize and tailor coverage and policy terms to address the specific needs of an applicant and insurance risks.
9
We utilize a consistent evaluation process for the approval of renewal policies that involves multiple levels of review before a policy is approved and issued. Every individual physician renewed is reviewed by our underwriting staff and medical director. Any physician group of three or more physicians applying for renewal undergoes this same underwriting review and is further reviewed by the president of API. Renewal policies are subject to a rating model that considers similar factors as those used for underwriting new policies.
Throughout the underwriting process, we leverage our management reporting technology and our management teams expertise to tailor policy and coverage terms. Our exclusive focus on medical professional liability insurance, supported by over 30 years of experience, allows us to design new product offerings and modify existing policy provisions, such as coverage limits, prior acts coverage, deductibles and experience renewal incentives, to service the unique needs of our policyholders while managing the risks we insure.
Claims Management
Our claims department manages claims arising from insurance policies we have underwritten. Our claims management team is comprised of nine claims managers who average 17 years of claims management experience. We meet regularly with our claims committee which includes qualified physicians in various medical specialties to assess the medical standard of care and various strategies of defense and resolution for claims made against our policyholders. We utilize external defense counsel with experience in medical professional liability cases to consult with us on claims and to defend lawsuits based on claims. Our claims staff oversees external defense counsels defense strategy and execution.
All potential claims go through a process by which coverage is verified prior to the vice president of claims accepting and approving the opening of a claim file. Once a claim is opened, our claims specialists will review the medical information, type of injury, amount of damages, venue, other defendant exposure and other available information to recommend an initial claim reserve amount. The initial reserve is an estimate until more information is developed and is commonly set based on our experience with similar cases. Our goal is to have the appropriate case reserve set on the claim no later than 18 months from the date the claim is first reported to us. As additional information is received, claims reserves are adjusted and any adjustment in excess of $100,000 must be approved by the vice president of claims. On an as needed basis, the vice president of claims and the medical director determine which claims reserved at $200,000 or greater or any other claims as deemed necessary are presented to the physicians on the claims committee to assess the medical standard of care and the defensibility of the case. The vice president of claims has authority to settle claims up to $175,000, with approval of the president of API also required for settlements above that amount.
Loss Prevention Services
We provide our policyholders with risk management and patient safety services designed to help reduce the risk of incidence and severity of claims and improve defensibility in the event our insured is named in a lawsuit. These services also enhance our underwriting process by allowing us to better understand the risk management and patient safety practices utilized by our policyholders. These products and services include:
On-site practice assessmentsWe require on-site assessments of all physicians in which there are concerns with practice and other loss performance issues. We also provide proactive on-site assessments at the request of any of our policyholders.
Peer-to-peer trainingWe provide training by medical specialists to address specific practice concerns, emerging risk issues, standards of care, patient/physician communication, and other medical practice oriented topics.
On-line continuing medical education trainingWe provide online courses that allow our policyholders to meet annual continuing medical education requirements. Our on-line educational services include various medical/legal courses aimed at reducing risk and enhancing patient safety.
In addition, we provide a quarterly risk management and patient safety newsletter and offer an around the clock hotline for policyholders to discuss practice issues or concerns.
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Investment Portfolio
As of December 31, 2008, total investments, at fair value, were $209,709,000 with $41,214,000 held at the holding company, $168,480,000 at API and $15,000 at APS Investment Services.
Our entire fixed-income portfolio consists of investment grade securities rated A or higher from any of Standard and Poors, Moodys or Fitch with the exception of one corporate bond and three collateralized mortgage obligations with a combined fair market value of approximately $1,874,000. The following table reflects the composition of our fixed-income portfolio by security rating category of the issuer, as of December 31, 2008. In cases where the rating agencies had different ratings assigned to a particular security, the classification in the table used the lower rating.
|
| (in thousands) | |||
Rating Category |
| Fair Value |
| Percentage | |
AAA / Aaa |
| $ | 170,313 |
| 86% |
AA / Aa |
|
| 8,676 |
| 4% |
A / A |
|
| 17,148 |
| 9% |
Non-investment grade |
|
| 1,874 |
| 1% |
Total |
| $ | 198,011 |
| 100% |
Our Insurance Services segment has an investment strategy that is reviewed and approved by the API board of directors annually. The primary goal of our investment strategy for our Insurance Services segment is to ensure that we have sufficient assets to meet our obligations to our policyholders and to provide investment income. The investment plan for our Insurance Services segment provides guidance on diversification, duration of the portfolio, sector allocation and specific restrictions, such as the size of investment in any one issue and limitations on the purchases of securities rated lower than investment grade by Moodys, Standard and Poors or a comparable rating institution.
Our Insurance Services segment employs an investment strategy that emphasizes asset quality to minimize the credit risk of our investment portfolio and also matches fixed-income maturities to anticipated claim payments and expenditures or other liabilities. The amounts and types of investments that may be made by our Insurance Services segment are regulated under the Texas Insurance Code. We utilize APS Asset Management, our investment advisor subsidiary, as our fixed-income advisor. We utilize two outside investment managers to manage our insurance segments equity portfolio.
Insurance Ratings
Insurance-specific ratings represent the opinion of rating agencies about the financial strength of a company and its capacity to meet its insurance obligations. Many large medical professional liability insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the company from which they purchase insurance. These ratings are based on factors most relevant to policyholders, agents and reinsurance intermediaries are not specifically directed towards the protection of investors. While these ratings may be of interest to investors, they are not recommendations to buy, sell or hold any security.
An insurance companys rating, and particularly its A.M. Best rating, is a potential source of competitive advantage or disadvantage in the marketplace. In addition, certain independent agents and brokers may establish a minimum A.M. Best rating for participation in a potential market. The significance of an A.M. Best rating to a given company varies depending upon the products involved, the customers and agents involved and the competition and market conditions. In addition, the significance of an A.M. Best rating may vary from state to state.
API currently has a financial strength rating from A.M. Best of "A" (Excellent) with a stable outlook, which is within the secure range of available ratings and represents the fourth highest of 16 rating levels. The rating process is dynamic and ratings can change. If you are seeking updated information about our rating, please visit the rating agency website at www.ambest.com.
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Regulation
General. We are regulated by insurance regulatory agencies in the states in which we conduct business, currently Texas, Arkansas and Oklahoma. State insurance laws and regulations generally are designed to protect the interests of policyholders, consumers or claimants rather than shareholders or other investors. The nature and extent of state regulation varies by jurisdiction, and state insurance regulators generally have broad administrative power relating to, among other matters, setting capital and surplus requirements, licensing of insurers and agents, establishing standards for reserve adequacy, protecting the disclosure of private consumer information, prescribing statutory accounting methods and the form and content of statutory financial reports, regulating certain transactions with affiliates, prescribing the types and amounts of investments, restricting payments of dividends and distributions and reviewing proposed acquisitions of control of domestic or licensed insurers.
Required Licensing. API is organized under the laws of Texas and is authorized in Texas, Arkansas and Oklahoma to transact certain lines of property and casualty insurance. We must apply for and obtain appropriate new licenses before we can expand into a new state on an admitted basis or offer new lines of insurance that require separate or additional licensing.
As an admitted insurer, in many cases, API must file premium rate schedules and policy or coverage forms for review and approval by the insurance regulators. In many states, rates and policy forms must be approved prior to use, and insurance regulators have broad discretion in judging whether an insurers rates are adequate, not excessive and not unfairly discriminatory. In some states, there has been deregulation, which may reduce or eliminate form and rate approval requirements in certain circumstances. The fact that our current business model involves sales through certain purchasing groups may lessen the rate filing and rate approval obligations of API in certain states.
Insurance Holding Company Laws. We operate as an insurance holding company and are subject to regulation in the State of Texas, where API is domiciled. These laws require us to register with the Texas Department of Insurance and furnish information about the operations of the companies held by us that may materially affect APIs operations, management or financial condition. These laws also provide that all transactions between API and us or any of our subsidiaries must be fair and reasonable. Transactions between insurance company subsidiaries and their parents and affiliates generally must be disclosed to the state regulators, and notice to and prior approval or absence of disapproval by the applicable state insurance regulator generally is required for any material transaction.
Payment of Dividends. State insurance laws restrict the ability of API to pay dividends or to make other payments to us. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurers surplus following payment of any dividends must be reasonable in relation to the insurers outstanding liabilities and adequate to meet its financial needs.
In connection with the acquisition of API, we entered into an agreement with the Texas Department of Insurance that prohibits API from paying dividends or other distributions to us with respect to APIs capital stock in any calendar year unless and until we have first complied with our redemption and dividend payment obligations to the holders of our Series A redeemable preferred stock for that year. Our agreement with the Texas Department of Insurance also provides that, until all of the Series A redeemable preferred stock has been fully redeemed and all dividends have been paid, API will not make aggregate annual dividends to us with respect to APIs common stock in excess of the lesser of 10% of APIs prior year-end policyholder statutory surplus or APIs prior year statutory net income, and in no event may such distributions exceed APIs statutory earned surplus.
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Following the redemption of all of the Series A redeemable preferred stock, APIs ability to pay dividends and distributions to us on its capital stock will continue to be subject to rules and regulations generally applicable to Texas insurance companies. Under those regulations, API may not pay an extraordinary dividend, which is defined as any dividend or distribution, the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year end or (ii) statutory net income for such prior year, until thirty days after the Insurance Commissioner of the State of Texas has received notice of such dividend and has either (i) not disapproved such dividend within such thirty day period or (ii) approved such dividends within such thirty day period. In addition, API must provide notice to the Insurance Commissioner of all ordinary dividends and other distributions to shareholders within two business days after declaration and at least ten days prior to the proposed payment.
The regulatory dividend and distribution limitations described above are based on the statutory financial results of API as determined in accordance with statutory accounting principles, which differ from GAAP in various ways. Key differences relate to, among other things, deferred policy acquisition costs, limitations on deferred income taxes, admitted versus non-admitted assets and differences in reserves. Insurance regulators can block payments to us from API that would otherwise be permitted without prior approval if the regulators determine that the payments (such as payments under our underwriting management agreements or payments for employee or other services) would be adverse to the interests of policyholders or creditors.
The Texas Department of Insurance also requires that, in addition to complying with all requirements relevant to its appointed actuary, we provide 30 days prior written notice to the department for any change in our appointed actuary until such time as we have complied with the redemption and dividend payment obligations to our preferred stockholders.
Finally, we must obtain prior approval from the Texas Department of Insurance of any material change in reserving practices or methodologies, including but not limited to any change in the level of our carried reserves in relation to the appointed actuarys range or point estimate until such time as we have complied with the redemption and dividend payments and obligations to our preferred stockholders.
Change in Control. Many state insurance laws contain provisions, intended primarily for the protection of policyholders, that require advance approval by the state insurance commissioner of any change in control of an insurance company that is domiciled, or, in some cases, has such substantial business that it is deemed to be commercially domiciled, in that state. Before granting approval of an application to acquire control of an insurer, the state insurance commissioner will typically consider such factors as the financial strength of the applicant, the integrity of the applicants board of directors and executive officers, the applicants plans for the future operations of the insurer and any anti-competitive results that may arise from the consummation of the change in control. Generally, state statutes provide that control of an insurer is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing, 10% or more of the voting shares of the insurer or of any company that controls the insurer, although this presumption of control may be rebutted. Any person who acquires 10% or more of our voting shares without the prior approval of the Texas Department of Insurance will be in violation of the laws of the State of Texas, and may be subject to remedies, penalties and sanctions, including the suspension and revocation of APIs certificate of authority to engage in business, and injunctive action requiring the disposition or seizure of the common stock or prohibiting the voting of the common stock and other actions determined by the Texas Department of Insurance.
These requirements may discourage, delay or prevent acquisition proposals, including unsolicited transactions, that some or all of our shareholders may consider desirable.
Guaranty Association Assessments. The states in which API is licensed to transact business require property and casualty insurers doing business within that state to participate in guaranty associations. These associations are organized to pay benefits owed to policyholders and claimants pursuant to insurance policies issued by insurers that have become impaired or insolvent. Typically, a state assesses each licensed insurer an amount related to the licensed insurers proportionate share of premiums written by all licensed insurers in the state in the particular line of business in which the impaired or insolvent insurer was engaged. The states in which API operates permit licensed insurers to recover a portion of these payments through full or partial premium tax credits.
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Although the amount and timing of future assessments are not predictable, such assessments under current state insurance regulations applicable to API are fully deductible from future premium taxes. As of December 31, 2008, API has $207,000 in guaranty fund assessment credits that are available to offset future premium taxes.
Risk-based Capital. In order to enhance the regulation of insurer solvency, the National Association of Insurance Commissioners ("NAIC") has adopted a formula and a model law to implement risk-based capital (RBC) requirements to assess the minimum amount of capital that an insurance company needs to support its overall business operations and to assure that it has an acceptably low likelihood of becoming financially impaired. The RBC formula takes into account various risk factors including asset risk, credit risk, underwriting risk and interest rate risk. As the ratio of an insurers total adjusted capital and surplus decreases relative to its risk-based capital, the RBC laws provide for increasing levels of regulatory intervention such as supervision and rehabilitation, and culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called authorized control level. As of December 31, 2008, the RBC ratios for API are in excess of the minimum requirements that would require any regulatory or corrective action. The NAIC has set a no action required level if a companys adjusted capital and surplus exceeds 200% of its RBC calculated surplus. Texas law requires certain trend testing if a companys adjusted capital and surplus is less than 300% of its RBC calculated surplus. We had RBC calculated at an authorized control level of $5,215,000 and statutory capital and surplus of $88,037,000, or over 17 times the minimum amount required as of December 31, 2008.
Statutory Accounting Principles. Statutory accounting principles (SAP) is a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. SAP is primarily concerned with measuring an insurers ability to pay all its current and future obligations to policyholders and creditors. SAP focuses on valuing the assets and liabilities of insurers in accordance with standards specified by the insurers domiciliary jurisdiction.
Generally Accepted Accounting Principles are designed to measure a business on a going-concern basis. It gives more consideration to the matching of revenue and expenses than SAP does and, as a result, certain expenses are capitalized when incurred and then amortized over the life of the associated policies. The valuation of assets and liabilities under GAAP is based in part upon best estimates made by the insurer, and shareholders equity represents both amounts currently available and amounts expected to become available over the life of the business. As a result, the values for assets, liabilities and equity reflected in financial statements prepared in accordance with GAAP may be different from those reflected in financial statements prepared under SAP.
The NAIC has established uniform statutory accounting principles. Regulators in Texas have adopted these principles, with certain modifications. SAP and related regulations determine the basis for measuring the amount of statutory surplus and statutory net income of API available to pay dividends when applying the dividend restrictions established by the Texas Department of Insurance.
Financial Services Operations
Corporate Overview
Through our Financial Services subsidiaries, we provide brokerage and investment services primarily to institutions and high net worth individuals, trading and analysis of syndicated bank loans and trade claims as well as management of fixed-income and equity assets for institutional and individual clients. We generally focus on niche markets within the financial industry where we can bring value to our customers by providing ideas, analysis and liquidity to under-followed or specialized investment situations. In our trading operations, we primarily act in a riskless principal or agent capacity, and carefully manage the limited amount of proprietary positions we assume.
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The impact of our Financial Services segment upon total revenues and earnings of the Company has declined precipitously since our acquisition of API in April, 2007, due primarily to the significance of the contribution of our acquired insurance operations and the decline in the financial services industry created by the global economic crisis. Prior to the acquisition, revenues generated from this segment represented 51% and 59% of our total revenues for the year ended December 31, 2006 and for the quarter ended March 31, 2007, respectively. Since the acquisition, revenues generated from the Financial Services segment declined to 25% for the year ended December 31, 2007 and to only 9% for the year ended December 31, 2008. Similarly, the percentage of total pre-tax earnings contributed by our Financial Services segment has declined from 37% to 7% for the years ended December 31, 2006 and 2007, respectively. The Financial Services segment had an overall net loss for the year ended December 31, 2008.
Through our broker-dealer subsidiary, APS Financial Corporation ("APS Financial"), we focus on providing fixed-income sales and trading services targeted to institutional customers such as hedge funds, mutual funds, insurance companies, other money managers and high net worth individuals. We have established a focus on high yield corporate bonds where our two research analysts provide proprietary research and our thirteen sales and trading personnel provide trading services to these and other clients. We also provide trading services for other types of debt instruments requiring specialized knowledge and analytics, including mortgage and asset backed debt, municipal debt, investment grade corporate bonds and structured debt. We clear trades through Southwest Securities, Inc. on a fully disclosed basis and we pay a fee based on the number and type of transactions executed. Our investment-banking group within our broker-dealer provides corporate finance and advisory services to our clients including arrangement of debt and equity financings, execution of sales, divestitures and acquisitions and other advisory services. APS Financial is a member of the Financial Industry Regulatory Authority (FINRA) and the Securities Investor Protection Corporation (SIPC), and, in addition, is licensed in forty-four states and the District of Columbia.
APS Asset Management, Inc. ("Asset Management"), our investment advisory subsidiary, provides management services of fixed-income and equity assets for institutional and individual clients on a fee basis. We can provide complete investment accounting, portfolio analytics, and performance measurement as well as trade execution for managed accounts. Asset Management is a registered investment adviser under the Investment Advisers Act of 1940.
APS Capital Corporation ("APS Capital") is our subsidiary dedicated to the trading of bank loans, trade claims and distressed private loan portfolios. APS Capital provides transaction services for trade claims and bank debt of institutions that are in distressed situations or have entered into bankruptcy. This subsidiary does not trade in securities and is not registered with FINRA or any other regulatory body. APS Capital typically locates and matches buyers and sellers of these instruments, rather than acquiring and re-selling the instruments directly for our own account.
We compete with other securities broker-dealers, financial advisory firms, investment banks and registered investment advisors, as well as commercial banks and thrift institutions. Competition in our Financial Services segment is principally based on the experience and relationships of our professionals, our ability to efficiently and effectively execute transactions, the price of our products and services, the quality and relevance of our research, our business reputation and the strength of our customer relationships. Many of the institutions we compete with are very well known firms in our markets with much greater financial resources than us.
In our investment banking activities, we compete with large, well-known investment banks as well as regional service providers who offer placement and advisory services to small- and middle-market companies. We compete for these investment banking assignments on the basis of our relationships with the issuers, potential investors, industry experience and transactional fees.
There is also significant competition in the financial services industry for qualified employees. We compete with other securities firms for investment bankers, sales representatives, securities traders, analysts and other professionals. Our ability to compete effectively depends on our ability to attract, retain and motivate qualified employees.
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Regulation
APS Financial and Asset Management are subject to extensive regulation under both federal and state laws. The SEC is the federal agency charged with administration of the federal securities and investment advisor laws. Much of the regulation of broker/dealers, however, has been delegated to self-regulatory organizations, principally FINRA and the national securities exchanges. These self-regulatory organizations adopt rules (subject to approval by the SEC) which govern the industry and conduct periodic examinations of member broker/dealers. Asset Management is an SEC registered advisor and subject to SEC examinations. APS Financial is also subject to regulation by state and District of Columbia securities commissions.
The regulations to which APS Financial is subject cover all aspects of the securities business, including sales methods, trade practices among broker/dealers, uses and safekeeping of customers funds and securities, capital structure of securities firms, record keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules, may directly affect the method of operation and profitability of APS Financial and Asset Management. The SEC, self-regulatory organizations and state securities commissions may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of APS Financial, Asset Management and/or our officers or employees. The principal purpose of regulation and discipline of broker/dealers and investment advisors is the protection of customers and the securities markets, rather than protection of creditors and shareholders.
APS Financial, as a registered broker/dealer and FINRA member organization, is required by federal law to belong to SIPC. When the SIPC fund falls below a certain minimum amount, members are required to pay annual assessments in varying amounts not to exceed 0.5% of their adjusted gross revenues to restore the fund. The SIPC fund provides protection for customer accounts up to $500,000 per customer, with a limitation of $100,000 on claims for cash balances. Customer Accounts managed by Asset Management are maintained with registered broker dealers who are members of SIPC. APS Financial maintains its customer assets with Southwest Securities, Inc. which provides SIPC and purchased supplemental coverage with protection of $20 million per account with an aggregate limit of $80 million.
Employees
As of December 31, 2008 we employed, on a full time basis, approximately 102 persons, including 60 in our Insurance Services segment, 29 in our Financial Services segment, and 13 at the holding company level. We consider our employee relations to be good. None of our employees is represented by a labor union and we have experienced no work stoppages.
Executive Officers
As of March 1, 2009, our executive officers were as follows:
Name | Age | Position(s) |
Kenneth S. Shifrin | 59 | Chairman of the Board and Chief Executive Officer, Director |
Timothy L. LaFrey | 53 | President and Chief Operating Officer, Director |
Marc J. Zimmermann | 39 | Vice President and Chief Financial Officer |
Maury L. Magids | 44 | Senior Vice President Insurance Services |
William H. Hayes | 61 | Secretary and Treasurer |
Thomas R. Solimine | 50 | Controller |
Our officers serve until the next annual meeting of our directors and until their successors are elected and qualified (or until their earlier death, resignation or removal).
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Mr. Shifrin has been our Chairman of the Board since March 1990. He has been our President and Chief Executive Officer from March 1989 until April 2007 and he was President and Chief Operating Officer from June 1987 to February 1989. He has been a director since February 1987. From February 1985 until June 1987, Mr. Shifrin served as our Senior Vice President - Finance and Treasurer. Mr. Shifrin also was Chairman of the Board of Prime Medical Services, Inc. from October 1989 until November 2004. With the merger of Prime Medical Services, Inc. and HealthTronics, Inc., or Healthtronics, Mr. Shifrin became Vice-chairman of the Board of HealthTronics in November 2004. In 2006, Mr. Shifrin resigned his vice-chairmanship but remains a member of the Board of Directors of HealthTronics. Mr. Shifrin is a member of the World Presidents Organization.
Mr. LaFrey has been our President and Chief Operating Officer as well as a director since April 2007. He previously served as a partner in the Austin office of Akin Gump Strauss Hauer & Feld LLP from April 1997 until April 2007, where his law practice focused on corporate governance, mergers and acquisitions, and debt and equity financings. Mr. LaFrey has extensive experience in the insurance, healthcare, technology and financial services industries. Prior to becoming an attorney, Mr. LaFrey, who also is a certified public accountant, was in the audit practice of KPMG Peat Marwick in Austin. He maintains memberships in the American Bar Association, The State Bar of Texas and the Travis County Bar Association. He also is a member of The American Institute of Certified Public Accountants, and the Texas Society of Certified Public Accountants, and is a member of the Board of Trustees of the Seton Healthcare System.
Mr. Zimmermann has been our Vice President and Chief Financial Officer since November 2007. He rejoined the Company in August 2003 as Chief Financial Officer of API. He had previously been with the Company from 1997 to 1998 as Director of Business Development of API. Prior to rejoining us, he was with Jefferson Wells, a financial and technology consulting firm. From January 1992 through February 1997, he was employed by Arthur Andersen LLP. Mr. Zimmermann is a certified public accountant.
Mr. Magids has been our Senior Vice President Insurance Services since June 2001 and has been President and Chief Operating Officer of API since January of 2000. From October 1996 until December 1999, Mr. Magids served as Senior Vice President of Business Development of API. Mr. Magids is a certified public accountant and was with Arthur Andersen LLP from August 1986 until September 1996.
Mr. Hayes has been our Secretary and Treasurer since November 2007. Mr. Hayes served as our Senior Vice President Finance from June 1995 until November 2007. Mr. Hayes was our Vice President -- Finance from June 1988 to June 1995 and was our Controller from June 1985 to June 1987. He has been our Secretary since February 1987 and was our Chief Financial Officer from June 1987 until November 2007. Mr. Hayes is a certified public accountant.
Mr. Solimine has been our Controller since June 1994. From July 1989 to June 1994, Mr. Solimine served as our Manager of Accounting.
There are no family relationships among any of our executive officers, and there is no arrangement or understanding between any of our executive officers and any other person pursuant to which he or she was selected as an officer. Each of our executive officers was elected by our board of directors to hold office until the next annual election of officers and until his or her successor is elected and qualified or until his or her earlier death, resignation or removal. Our board of directors elects our officers in conjunction with each annual meeting of our shareholders.
Item 1A. Risk Factors.
RISK FACTORS
There are a number of factors, many beyond our control, which may cause results to differ significantly from our expectations. There may also be a number of factors not described in this report that could also cause results to differ from our expectations. Any factor described in this report could by itself, or together with one or more other factors, have a negative effect on our business, results of operations and/or financial condition. The most significant of these risks and uncertainties are listed below. You should consider carefully these risks together with all of the other information included in this Form 10-K and the documents that we have incorporated by reference.
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Our reliance on key executives could affect our results of operations.
We believe that our success depends on the efforts and abilities of our relatively small group of executive officers personnel. The loss of services of one or more of these key executives could have a material adverse effect on our business. We do not maintain key man life insurance on any of our key executives. In 2000, Kenneth S. Shifrin, our Chairman and Chief Executive Officer, was diagnosed with chronic lymphocytic leukemia and he received chemotherapy treatment during 2007. Although he is currently in remission, a worsening of the effects of this condition could reduce our access to Mr. Shifrins services, which could adversely affect our business.
As a holding company, our financial condition and results of operations are dependent on our subsidiaries and our ability to pay expenses and dividends will be dependent on our ability to receive dividends from our subsidiaries, which may be restricted.
We are principally a holding company with assets consisting primarily of cash, investment securities and the capital stock of our subsidiaries. Consequently, our ability to pay our operating expenses, make redemption payments on our redeemable preferred stock and service our other indebtedness is dependent upon the earnings of our subsidiaries and our ability to receive funds from such subsidiaries through loans, dividends or otherwise. Our subsidiaries are legally distinct entities and have no obligation, contingent or otherwise, to make funds available to us for such obligations. In addition, our subsidiaries ability to make such payments is subject to applicable state laws and claims of our subsidiaries creditors will generally have priority as to the assets of such subsidiaries. Accordingly, our subsidiaries may not be able to pay funds to us sufficient to enable us to meet our obligations.
The ability of API to pay dividends to us or redeem any of the API preferred stock that we hold is subject to regulation by the Texas Department of Insurance. In addition to restrictions on dividends and distributions applicable to all Texas stock insurance companies, for so long as any Series A redeemable preferred stock is outstanding, the Texas Department of Insurance prohibits API from paying dividends or other distributions to us in respect of APIs capital stock that we hold in any calendar year unless and until we have complied with our redemption and dividend payment obligation to the holders of our Series A redeemable preferred stock for that year. Our agreement with the Texas Department of Insurance also provides that, until all of our Series A redeemable preferred stock has been fully redeemed and all dividends have paid, API will not make aggregate annual dividends to us with respect to APIs capital stock in excess of the lesser of 10% of APIs prior year-end policyholder statutory surplus or APIs prior year statutory net income, and in no event may such distributions exceed APIs statutory earned surplus. By way of illustration, if this dividend restriction had been in place in 2006 possible dividends paid by API to us for those years would have been limited to $4,555,000. For the calendar year 2007, the dividend restriction was $7,717,000 and through March 1, 2009 total dividends paid to us for 2007 was $7,377,000. For the calendar year 2008, the dividend restriction is $8,804,000 and no dividends have yet been paid to us. Accordingly our subsidiaries may not be able to pay funds to us and, even if paid such funds may not be sufficient to enable us to meet our obligations.
We are exposed to credit risk, interest rate risk and equity price risk and as a result, our revenues may fluctuate with interest rates, investment results and developments in the securities markets such as the recent economic crisis.
We are principally exposed to three types of market risk related to our investment portfolio, including credit risk, interest rate risk, and equity price risk. We have exposure to credit risk primarily as a holder of fixed-income securities. Equity securities are subject to equity price risk, which is defined as the potential for loss in market value due to a decline in equity prices. A decline in the value of equity securities, evidenced by lower prices traded for the common stock of these companies, might occur for several reasons, including poor financial performance, obsolescence of the service or product provided or any other news deemed to be negative by the investing public. A decline in the value of debt securities might occur for the same reasons above as well as due to an increase in interest rates. A material decline, other than temporary, in the value of any of our debt or equity securities or a going-concern problem regarding an issuer could have a material adverse effect on our financial condition and results of operations.
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The value of our fixed-income securities are also subject to interest rate and other risks. As interest rates decrease, the value of the portfolio increases with the opposite holding true in rising interest rate environments. All of our fixed-income securities are designated as available-for-sale and, accordingly, are presented at fair value on our balance sheet. Fixed-income securities may have their fair market value adversely affected due to a change in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates.
The financial environment globally and in the United States has recently experienced significant volatility. Our investment portfolio and the fair value of our investment holdings has been affected by these poor economic conditions and recent changes in the financial and credit markets, and we rely on the investment income produced by our investment portfolio to contribute to our profitability. Future changes in interest rates and credit quality caused by a continued market downturn may result in fluctuations in the income derived from, the valuation of, and in the case of declines in credit quality, payment defaults on, our fixed income securities, which could have a material adverse affect on our financial condition, liquidity or results of operations. Our investment portfolio is also subject to credit and cash flow risk, including risks associated with our investments in mortgage-backed securities. Because our investment portfolio is the largest component of our consolidated balance sheet, further deterioration of the economy and the financial and credit markets could result in additional other-than-temporary impairments that are material to our financial condition and operating results. For examples, such economic changes could arise from overall changes in the financial markets or specific changes to industries, companies or municipalities in which we maintain our investment holdings. For the years ended December 31, 2008 and 2007, we recorded $7,116,000 and $5,248,000 of other-than-temporary impairments, respectively.
Changes in interest rates as well as continued market instability due to a prolonged economic crisis could also have an impact at our broker-dealer subsidiary, APS Financial. Since revenues at APS Financial are primarily recorded as commissions earned on the trading of fixed-income securities, a rise in interest rates would cause a drop in the price of these securities and would generally result in customers being cautious about committing funds or selling their positions, thus negatively affecting commissions earned. The general level of interest rates may trend higher or lower in 2009 and this move may impact our level of business in different fixed-income sectors. A volatile interest rate environment or continued poor economic conditions in 2009 could also impact our financial services business as this type of market condition can lead to investor uncertainty and their corresponding willingness to commit funds. If a generally improving economy is the impetus behind higher rates, our investment grade business may decline.
In periods of market illiquidity and instability such as the current financial crisis, the fair value of our investments is more difficult to estimate, could result in assessments of fair value greater or less than amounts received in actual transactions and may have unforeseen consequences that we are currently unable to predict.
Investment securities traded in active markets are valued at quoted market prices. Other investment securities are valued through the use of various pricing models or based on broker indications that require the application of judgment in selecting the appropriate assumptions based on observable or unobservable market data. Volatile or illiquid markets increase the likelihood that such assumptions may not behave in historically predictable manners, resulting in fair value estimates that are overstated compared with actual amounts that could be realized upon disposition or maturity of the security.
In addition, the ultimate effects of the recent market volatility, credit crises, and overall economic downturn may have unforeseen consequences on the credit quality, liquidity and financial stability of the issuers of securities we hold or reinsurers with which we do business. As recent market experience indicates, such deteriorations in financial condition can occur rapidly, leaving us unable to react to such a scenario in a prudent manner consistent with orderly markets. This in turn could adversely and negatively affect our financial condition or results of operations.
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Anti-takeover provisions in our organizational documents, our shareholder rights plan and Texas law could prevent or delay a change in control.
Certain anti-takeover provisions applicable to our governance could prevent or delay an acquisition of our business at a premium price or at all. Some of these provisions are contained in our articles of incorporation as well as in our shareholder rights plan. Others are contained in the Texas statutory law governing corporations. These provisions may have the effect of delaying, making more difficult or preventing a change in control or acquisition of the Company by means of a tender offer, a proxy contest or otherwise. These provisions are expected to discourage certain types of coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of the Company first to negotiate with us.
Our articles of incorporation provide that we may not engage in certain business combinations with a corporation, subsidiary of a corporation, person, or other entity which is the beneficial owner, directly or indirectly, of twenty percent or more of our outstanding voting shares unless either certain requirements are first satisfied or the transaction is approved by the affirmative vote of no less than two-thirds of the shares of our common stock present in person or by proxy at a meeting where at least 80% of our common shares are represented (in person or by proxy).
Under our shareholder rights plan, each outstanding share of common stock has attached to it one purchase right. Each purchase right entitles its holder to purchase from us a unit consisting of one one-thousandth of a share of junior participating preferred stock at a price subject to adjustment. This could prevent or delay a change in control of the Company.
Articles 13.01 through 13.08 of the Texas Business Corporations Act provide that a Texas corporation may not engage in certain business combinations, including mergers, consolidations, and asset sales, with a person, or an affiliate or associate of such person, who is an affiliated shareholder (generally defined as the holder of twenty percent or more of the corporations voting shares) for a period of three years from the date such person became an affiliated shareholder unless (i) the business combination or purchase or acquisition of shares made by the affiliate shareholder was approved by the board of directors of the corporation before the affiliated shareholder became an affiliated shareholder; or (ii) the business combination was approved by the affirmative vote of the holders of at least 66 2/3% of the outstanding voting shares of the corporation not beneficially owned by the affiliated shareholder, at a meeting of shareholders called for that purpose , not less than six months after the affiliated shareholder became an affiliated shareholder. This anti-takeover statute may have the effect of inhibiting a non-negotiated merger or other business combination involving us, even if such event(s) would be beneficial to our shareholders.
Our geographic concentration means that our insurance business performance may be affected by economic, regulatory and demographic conditions of our operations within the State of Texas.
Our insurance business is concentrated in Texas, in which we generated 95% and 99% of premiums written by API for the years ended December 31, 2008 and 2007, respectively. Accordingly, unfavorable economic, regulatory and demographic conditions in Texas would negatively impact our business. We focus exclusively on medical professional liability insurance. In the event there is meaningful change in the existing legislation and claims environment, our financial condition and results of operations could be adversely affected. We may be exposed to greater risks than those faced by insurance companies that conduct business over a larger geographic area. For example, our geographic concentration could subject us to pricing pressure as a result of market or regulatory forces only applicable to Texas.
Our Insurance Services business is highly competitive and many of our competitors have greater financial, marketing, technological and other resources.
The insurance industry is highly competitive. Many of our competitors possess greater financial, marketing, technological and other resources. We may not be able to continue to compete successfully.
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All of our revenue from the Insurance Services segment is attributable to API. Our primary competitors in Texas are Medical Protective Insurance Services Inc. (MedPro), Texas Medical Liability Trust (TMLT), ProAssurance Corporation, The Doctors Company, Advocate MD RPG, Inc., and Texas Medical Liability Insurance Underwriting Association, which is the state-sponsored insurer of last resort. We consider these companies to be our competitors because they are the companies to which policyholders typically move when cancelling policies with us. In Arkansas, our primary competitors are State Volunteer Mutual Insurance Company (SVMIC) and First Professionals Insurance Company (FPIC) and in Oklahoma, our primary competitors are Physicians Liability Insurance Company of Oklahoma (PLICO) and MedPro. We consider these companies to be our competitors because they are the dominant insurance providers in Arkansas and Oklahoma. We compete with these companies on a variety of factors including price, customer service, expertise in claims handling, policy coverage, risk management services and financial strength. Many of our competitors have greater financial strength and broader resources than us. In premiums written and asset size, MedPro, TMLT, ProAssurance Corporation, SVMIC, FPIC and The Doctors Company are significantly larger than us. We do not have the capacity to write the volume of business equal to that of some of the other major carriers. With the implementation of tort reform in late 2003, additional companies have entered the Texas market, resulting in further increases in competition. As a result of this increased competition, we continue to face price pressure on both existing renewals and new business.
Our largest insurance competitor in Texas, TMLT was established under the provisions of a statute that authorized a statewide association of physicians or dentists to create a trust to self-insure its members. TMLT has certain competitive advantages as a result. TMLT is subject to limited government regulation in comparison to other insurance companies, such as API, in regards to statutory financial reporting and financial examinations by the Texas Department of Insurance. TMLT further benefits from not being required to pay premium taxes or participate in the Texas guaranty association.
The fact that we write only a single line of insurance may leave us at a competitive disadvantage and subjects our financial condition and results of operations to the cyclical nature of the medical professional liability insurance market.
We face a competitive disadvantage because we only offer a single line of insurance. Some of our competitors have additional competitive leverage because of the wide array of insurance products that they offer. For example, a business may find it more efficient or less expensive to purchase multiple lines of insurance coverage from a single carrier. Because we do not offer a range of insurance products and sell only medical professional liability insurance, we may lose potential customers to larger competitors who do offer a selection of insurance products.
Growth in premiums written in the medical professional liability insurance industry have fluctuated significantly over the past ten years as a result of, among other factors, changing premium rates. The cyclical pattern of such fluctuation has been generally consistent with similar patterns for the broader property and casualty insurance industry, due in part to the participation in the medical professional liability insurance industry of insurers and reinsurers that also participate in many other lines of property and casualty insurance and reinsurance. Historically, the financial performance of the property and casualty insurance industry has tended to fluctuate in cyclical patterns characterized by periods of greater competition in pricing and underwriting terms and conditions, otherwise referred to as a soft insurance market, followed by periods of capital shortage, lesser competition and increasing premium rates, otherwise referred to as a hard insurance market.
For the past four years, the medical professional liability insurance industry has faced a soft insurance market that has generally resulted in lower premium rates. During this four-year period, APIs rates have decreased by approximately 9% in 2005, 18% in 2006, 14% in 2007 and 6% in 2008. We cannot predict whether, or the extent to which, the recent decreases in premium rates will continue. However, any decrease in rates will reduce our revenues and cash flow from operations and may materially and adversely affect our liquidity and results of operations.
21
If we are unable to maintain a favorable financial strength rating or if it is lowered, it may be more difficult for our Insurance Services business to write new business or renew its existing business.
Third party rating agencies assess and rate the claims-paying ability of insurers based upon criteria established by the agencies. The financial strength ratings assigned by rating agencies to insurance companies represent independent opinions of financial strength and ability to meet policyholder obligations and are not directed toward the protection of investors. These ratings are not recommendations to buy, sell or hold any security.
Financial strength ratings are used by agents and clients as an important means of assessing the financial strength and quality of insurers. Our inability to maintain a favorable rating could adversely affect our ability to sell insurance policies. These results could have a material adverse effect on our results of operations and financial condition.
If we do not effectively price our insurance policies, then our financial results will be adversely affected.
Our premium rates are established when coverage is initiated and based on factors that include estimates of expected losses generated from the policies we underwrite. We analyze many factors when pricing a policy, including the policyholders prior loss history, medical specialty and practicing territory. If we underprice our insurance policies, actual costs for providing insurance coverage to policyholders may be significantly higher than associated premiums. We have limited experience in Oklahoma and Arkansas which further could impact our ability to effectively price our insurance policies in these states. When initiating coverage on a policyholder, we must rely on information provided by the policyholder or previous carriers to properly estimate future claims exposure. If any information is inaccurate, we could underprice our policies by using claims estimates that are too low. As a result, actual costs for providing insurance coverage to policyholders may be significantly higher than associated premiums. We assume the risk that policies in force were written at inadequate premium rates.
If our relationships with certain of our independent agencies, one of which accounts for a significant part of our business, were terminated, our financial condition and results of operations could be materially adversely affected.
We market and sell our insurance products through a group of approximately 41 active independent, non-exclusive insurance agents. In addition, for the year ended December 31, 2008, approximately 44% of our gross premiums written were produced by one agency.
We do not have exclusive arrangements with our agents, and either party can terminate the relationship at any time. These agents are not obligated to promote our products and may also sell our competitors products. We must offer medical professional liability insurance products and services that meet the requirements of these agents and their customers. We must also provide competitive commissions to these agents.
Thus, our relationships with our distribution partners may not continue or may continue under terms that are not as favorable to us as our current agreements. Also, if we do not maintain good relationships with the agents with whom we contract to sell our products, these agents may sell our competitors products instead of ours or may direct less desirable risks to us, and our revenues or profitability may decline. In addition, these agents may find it easier to promote the broader range of programs of some of our competitors than to promote our single-line medical professional liability insurance products. The loss of a number of our independent agents or the failure of these agents to successfully market our products could result in lower gross premiums written and have a material adverse effect on our financial condition and results of operations if we are unable to replace them with agents that produce comparable premiums.
22
Loss reserves in our Insurance Services business are based on estimates and may be inadequate to cover actual loss and loss adjustment expenses.
We must establish and maintain reserves for our estimated liability for losses and loss adjustment expenses in our Insurance Services business. We establish loss reserves in our financial statements that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have not yet been reported to us. Loss reserves are estimates of the ultimate cost of individual claims based on actuarial estimation techniques and are inherently uncertain. Judgment is required in applying actuarial techniques to determine the relevance of historical payment and claim closure patterns under current facts and circumstances. We periodically review our established reserves and may adjust reserves based on the results of these reviews. If we change our estimates, these changes are reflected in results of operations during the period in which they are made. These adjustments could be significant and could be inadequate to cover actual loss and loss adjustment expenses Reserve inadequacy could be more likely in Oklahoma and Arkansas as we have limited experience establishing loss reserves for business in these states.
If Texas tort reform is successfully challenged, it could materially affect our insurance operations.
Tort reforms generally restrict the ability of a plaintiff to recover damages by imposing one or more limitations, including, among other limitations, eliminating certain claims that may be heard in a court, limiting the amount or types of damages, changing statutes of limitation or the period of time to make a claim and/or limiting venue or court selection. Texas enacted legislation in 2003 specifically directed at medical professional liability reform. Among the more significant aspects of the legislation were caps on non-economic damages and caps on non-economic damages against a single institution and against all healthcare institutions combined.
The effects of tort reform have been generally beneficial to our insurance business. However, such reforms may not remain effective or ultimately be upheld by the courts. In the event that we begin experiencing an increase in claims frequency and/or severity, we will have to respond with corresponding increases to premium rate levels. These changes in rates may prevent us from having the ability to expand our Insurance Services business in the Texas marketplace. In addition, the benefits of tort reform may be accompanied by regulatory actions by state insurance authorities that may be detrimental to our insurance business, such as expanded coverage requirements and premium rate limitations or rollbacks.
Prior-year favorable experiences on our variable premium reinsurance contracts may not continue to result in favorable adjustments to ceded premiums.
Our annual reinsurance contracts for 2002 through 2008 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contract is subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
Since April 1, 2007, the date of acquisition of API, through December 31, 2007 we have recorded favorable development to ceded premiums of $10,888,000 primarily related to prior variable premium reinsurance treaties as a result of lower estimated loss and loss adjustment expenses for treaty years 2002 through 2006. For the year ended December 31, 2008, we have recorded favorable development to ceded premiums of $6,802,000 primarily related to prior variable premium reinsurance treaties as a result of lower estimated loss and loss adjustment expenses for treaty years 2002 through 2007. Prior-year favorable experiences on our variable premium reinsurance contracts may not continue to result in favorable adjustments to ceded premiums.
In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis give rise to a balance sheet asset classified as Other Amounts Receivable Under Reinsurance Contracts or a balance sheet liability classified as Funds Held Under Reinsurance Treaties. Furthermore, each variable premium reinsurance contract requires a 24- or 36-month holding period before any premium adjustments or cash can be returned or paid. The ultimate settlement amount will not be determined until all losses have been settled under the respective treaties.
23
As of December 31, 2008, we had recorded a balance sheet asset, Other Amounts Receivable Under Reinsurance Contracts of $1,497,000 and a balance sheet liability, Funds held under reinsurance treaties of $3,978,000, which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2008 treaty years as compared to the amounts paid on a provisional basis. A decline in the financial condition of any of our reinsurers could result in a default of their obligations to reimburse us amounts due on our variable premium reinsurance contracts.
Market conditions could cause reinsurance to be more costly or unavailable for our Insurance Services business.
As part of our overall risk management strategy, we currently purchase reinsurance for amounts of risk from $250,000 up to $1,000,000. If we are unable to maintain our current reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates we may be adversely affected by losses or have to reduce the amount of risk we underwrite.
We bear credit risk with respect to our reinsurers, and if any reinsurer fails to pay us, or fails to pay us on a timely basis, we could experience a shortage of liquidity or unexpected losses.
We transfer some of our risks to reinsurance companies in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, it does not relieve us of our liability to our policyholders. If reinsurers fail to pay us or fail to pay on a timely basis, our financial results will be adversely affected. The ultimate effects of the recent financial and market crisis and overall economic downturn may have negative consequences on the credit quality, liquidity and financial stability of the reinsurers with which we do business. As recent market experience indicates, such deteriorations in financial condition can occur rapidly, leaving us unable to react to such a scenario in a prudent manner consistent with orderly markets. This in turn could adversely and negatively affect our financial condition or results of operations.
Our Insurance Services business is subject to extensive government regulation.
Insurance businesses are subject to extensive regulation by state insurance authorities in each state in which they operate. Regulation is intended for the benefit of policyholders rather than shareholders. In addition to control over the amount of dividends and other payments that can be made by API, these regulatory authorities have broad administrative and supervisory power relating to licensing requirements, trade practices, capital and surplus requirements, investment practices and rates charged to insurance customers.
These regulations may impede or impose burdensome conditions on rate increases or other actions that we may want to take to enhance our operating results. In addition, we incur significant costs in the course of complying with regulatory requirements. Also, our ability to grow API through premiums and additional capacity could be limited due to surplus and risk-based capital requirements under the financial regulatory guidelines of the Texas Department of Insurance.
Currently, pursuant to an order of the Texas Department of Insurance, we must redeem at least $1 million of our Series A redeemable preferred stock each calendar year beginning in 2007, until December 31, 2016, at which time all of the Series A redeemable preferred stock must have been redeemed. We also must pay a cumulative dividend to holders of our Series A redeemable preferred stock equal to 3% of the outstanding redemption value per year. In addition, the Texas Department of Insurance has required us to place $2.5 million into an escrow account with a bank, to remain in escrow until the aggregate remaining redemption and dividend obligation with respect to our Series A redeemable preferred stock is less than the amount of such escrow balance. We have agreed that no withdrawals will be made from this escrow account without prior approval from the Texas Department of Insurance.
24
Changes in the healthcare industry could have a material impact on the results of operations of our Insurance Services business.
Our Insurance Services business derives substantially all of its medical professional liability insurance premiums from physicians and other individual healthcare providers, physician groups and smaller healthcare facilities. Significant attention has recently been focused on reforming the healthcare industry at both the federal and state levels. In recent years, a number of factors related to the emergence of managed care have negatively affected or threatened to affect the practice of medicine and economic independence of medical professionals. Medical professionals have found it more difficult to conduct a traditional fee-for-service practice and many have been driven to join or contractually affiliate with provider-supported organizations. Such change and consolidation may result in the elimination of, or a significant decrease in, the role of the physician in the medical professional liability insurance purchasing decision and could reduce our medical professional liability insurance premiums, as groups of insurance purchasers may be able to retain more risk.
If we are unable to successfully write policies in new states, we may not be able to grow and our financial condition and results of operations could be adversely affected.
One of our strategies is to write medical professional liability insurance in new states, either through internal growth initiatives or selective acquisitions. However, our lack of experience in a new state means that this strategy is subject to various risks, including risks associated with our ability to:
comply with applicable laws and regulations in those new states;
obtain accurate data relating to the medical professional liability industry and competitive environment in those new states;
attract and retain qualified personnel for expanded operations;
identify and attract acquisition targets;
identify, recruit and integrate new independent agents;
augment our internal monitoring and control systems as we expand our business; and
integrate an acquired business into our operations.
Any of these risks, as well as risks that are currently unknown to us or adverse developments in the regulatory or market conditions in any of the new states that we enter, could cause us to fail to grow and could adversely affect our financial condition and results of operations.
The unpredictability of court decisions in our Insurance Services business could have a material impact on our results of operations.
Our results of operations may be adversely affected by court decisions that expand the liability on our insurance policies after they have been issued and priced. Additionally, a significant jury award, or series of awards, against one or more of our insureds could require us to pay large sums of money in excess of our reserved amounts. Our policy to litigate claims against our insureds that we consider unwarranted or claims where settlement resolution cannot be achieved may increase the risk that we may be required to make such payments.
We could become subject to claims for extra-contractual obligations or losses in excess of policy limits in connection with our policyholders insurance claims. These claims are sometimes referred to as bad faith actions as it is alleged that the insurance company failed to negotiate a settlement of a claim in good faith within the insureds policy limit. Such claims could have a material adverse effect on our results of operations and financial condition.
25
Our Financial Services subsidiaries operate in highly competitive businesses against competitors with greater financial, marketing, technological and other resources.
Our Financial Services businesses are engaged in a highly competitive industry. We compete with numerous other broker-dealers, many of which are well known national or large regional firms with substantially greater financial and personnel resources. We also compete with a number of smaller regional brokerage firms in Texas and the southwestern United States.
In many instances APS Financial Corporation (APS Financial), our broker-dealer subsidiary, competes directly with these organizations. In addition, there is competition for investment funds from the real estate, insurance, banking and thrift industries. APS Financial competes for brokerage transactions principally on the basis of our research, our reputation in particular markets, and the strength of our client relationships. In our investment banking activities, we compete with large, well-known investment banks as well as regional service providers who offer placement and advisory services to small-and middle market companies. We compete for these investment banking assignments on the basis of our relationships with the issuers, potential investors, industry experience and transactional fees.
There is also significant competition in the financial services industry for qualified employees. We compete with other securities firms for investment bankers, sales representatives, securities traders, analysts and other professionals. Our ability to compete effectively depends on our ability to attract, retain and motivate qualified employees.
Our Financial Services businesses are subject to market forces beyond our control, which could affect us more severely than our competitors.
Our Financial Services businesses, like other securities firms, are directly affected by economic and political conditions, broad trends in business and finance and changes in volume and price levels of securities transactions. Over the last several years, The U.S. securities markets have experienced significant volatility, most recently with the current economic crisis. As we saw in 2008, a prolonged economic crisis and continued market downturn, could have a negative impact at our broker-dealer subsidiary, APS Financial, if customers are cautious about committing funds or selling their existing market positions. Since revenues at APS Financial are primarily recorded as commissions earned on the trading of fixed-income securities, a decrease in our trading volume will result in a revenue decline. Also, when trading volume is low, our profitability is adversely affected because our overhead remains relatively fixed, despite lower compensation costs associated with commission revenues. Severe market fluctuations in the future could have a material adverse effect on our business, financial condition and operating results. Certain of our competitors with more diverse product and service offerings might withstand such a downturn in the securities industry better than we would.
Our Financial Services business is subject to extensive government regulation.
The securities industry is subject to extensive governmental supervision, regulation and control by the Securities and Exchange Commission ("SEC"), state securities commissions and self-regulatory organizations, which may conduct administrative proceedings that can result in censure, fine, suspension or expulsion of APS Financial or any of its officers or employees. Financial Industry Regulatory Authority (FINRA) regulates our Financial Services business marketing activities. FINRA can impose certain penalties for violations of its advertising regulations, including censures or fines, suspension of all advertising, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer or any of its officers or employees.
Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of a system to ensure compliance with these laws and rules, as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions due to claimed noncompliance in the future, which could have a material adverse effect on our business, financial condition and operating results.
26
The federal or state governments or self-regulatory organizations having jurisdiction over our Financial Services business could adopt regulations or take other actions, such as the failure to renew or the revocation of required licenses that would have a material adverse effect on our business, financial condition and results of operations. In addition, our operations and profitability may be affected by additional legislation, changes in rules promulgated by the SEC, FINRA, the Board of Governors of the Federal Reserve System, the various stock exchanges and other self-regulatory organizations and state securities commissions or changes in the interpretation or enforcement of existing laws or rules.
The SEC, FINRA and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the SEC and suspension or expulsion by the FINRA and could ultimately lead to the firms liquidation. If such net capital rules are changed or expanded or if there is an unusually large charge against net capital, operations that require the intensive use of capital would be limited. Such operations may include trading activities and the financing of customer account balances. Also, our ability to pay dividends, repay debt and redeem or purchase shares of our outstanding stock could be severely restricted. A significant operating loss or an extraordinary charge against net capital could adversely affect the ability of APS Financial to expand or even maintain its present levels of business, which could have a material adverse effect on our business, financial condition and operating results.
Customers of our Financial Services business may default on their margin accounts, effectively passing their losses on to us.
Our Financial Services customers sometimes purchase securities on margin through our clearing organization, Southwest Securities, Inc. therefore, we are subject to risks inherent in extending credit. These risks are especially great when the market is rapidly declining. In such a decline, the value of the collateral securing the margin loans could fall below the amount of a customers indebtedness. Specific regulatory guidelines mandate the amount that can be loaned against various security types. Independent of our review, our corresponding clearing organization independently maintains a credit review of our customer accounts. If customers fail to honor their commitments, the clearing organization would sell the securities held as collateral. If the value of the collateral were insufficient to repay the loan, a loss would occur, which we may be required to fund. Any such losses could have a material adverse effect on our business, financial condition and operating results.
We are exposed to litigation in our Financial Services business.
From time to time, we are subject to lawsuits and other claims arising out of our Financial Services business. The outcome of these actions cannot be predicted and such litigation or actions could have a material adverse effect on our results of operations and financial condition. We cannot predict the effect of any current or future litigation, regulatory activity or investigations on our business. Given the current regulatory environment it is possible that we will become subject to further governmental inquiries and have lawsuits filed against us. Our involvement in any investigations and lawsuits would cause us to incur additional legal and other costs and, if we were found to have violated any laws, rules or regulations, we could be required to pay material fines, damages and other costs. We could also be materially adversely affected by the negative publicity related to these proceedings, and by any new industry-wide regulations or practices that may result from these proceedings.
One of our Financial Services subsidiaries trades bank debt and trade claims which subjects us to potential losses and litigation risk.
APS Capital Corporation (APS Capital), one of our subsidiaries in the Financial Services portion of our business, trades bank debt and trade claims. In that capacity, APS Capital potentially is liable for losses related to the impairment of the traded claims and for disputes that may arise during the trading process from either the holders of, or investors in, bank debt or trade claims.
27
For losses due to impairment, APS Capital may be liable for the portion of its potential profit on a trade that is proportional to any part of a traded claim that is subsequently impaired, offset, disallowed, subordinated, or subject to disgorgement (animpairment). Trade claims are private debt instruments representing claims by creditors against a debtor in bankruptcy. On rare occasions, when a trade claim has been allowed by a final, non-appealable court order, APS Capital may provide impairment protection for the full amount of a traded claim. In this case, it is possible that (1) a claim is impaired and (2) APS Capital may be unable to recover the impairment from any prior assignor of the claim.
In the process of trading or negotiating bank debt and trade claims, APS Capital is also subject to general litigation risk, which may result from disputes that arise during its trading process or from trades.APS Capital is currently party to -litigation related to a disputed bankruptcy trade claim. As a result, in 2008 we recorded an amount we believe to be sufficient to cover any future settlement regarding this disputed trade claim.
We rely on our information technology and telecommunication systems, and the failure of these systems could materially and adversely affect our business.
Our businesses are highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems in our Insurance Services business to process and invoice for new and renewal business, facilitate collections, provide customer service, administer claims and make payments on those claims; and, in our Financial Services business to receive and process trade orders. These systems also enable us to perform actuarial and other modeling functions necessary for underwriting and rate development.
We are currently implementing and undergoing an information and technology system conversion from our legacy system. The failure of our current system or failure to successfully implement and roll-out our new policy and claims system, could interrupt our operations or materially affect our ability to evaluate and write new and renewal business; accurately and timely invoice policyholders and/or compromise our ability to pay claims in a timely manner. In our Financial Services business, if our systems or any other systems provided by third-parties result in the trading process slowing down significantly or failing even for a short time, our Financial Services customers would suffer delays in trading, potentially causing substantial losses and possibly subjecting us to claims for such losses or to litigation claiming fraud or negligence. Any systems failure that interrupts our operations could negatively impact our business, financial condition and operating results.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We lease approximately 23,000 square feet of office space in an office project at 1301 Capital of Texas Highway., Suite C-300, Austin, Texas as our principal executive offices.
We also lease approximately 1,200 square feet of office space for our Insurance Services business at 5401 North Central Expressway, Suite 316, LB #B4, Dallas, Texas.
Item 3. Legal Proceedings
We are involved in various claims and legal actions that have arisen in the ordinary course of business. We believe that any liabilities arising from these actions will not have an adverse effect on our financial condition, or results of operations. See Note 19 to the consolidated financial statements included herein.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to vote of shareholders during the three months ended December 31, 2008.
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PART II
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for the Companys Common Equity and Related Stockholder Matters
Our common stock is currently listed on the NASDAQ Capital Markets under the symbol AMPH. The following table sets forth the range of the quarterly high and low bid prices for the last two fiscal years.
| 2008 |
| 2007 | ||||||||
| High |
| Low |
| High |
| Low | ||||
First Quarter | $ | 20.97 |
| $ | 16.48 |
| $ | 18.00 |
| $ | 14.39 |
Second Quarter | $ | 23.92 |
| $ | 19.17 |
| $ | 19.02 |
| $ | 15.83 |
Third Quarter | $ | 23.31 |
| $ | 18.50 |
| $ | 20.00 |
| $ | 16.51 |
Fourth Quarter | $ | 22.00 |
| $ | 16.42 |
| $ | 21.10 |
| $ | 17.50 |
In each of the years 2008, 2007 and 2006, we declared cash dividends of $0.30 per share of common stock amounting to total cash outlays of approximately $2,096,000, $1,416,000 and $820,000, respectively. Prior to 2004, we had never declared or paid any cash dividends on our common stock. The declaration and payment of any future dividends on our common stock would be at the sole discretion of our Board of Directors, subject to our financial condition, capital requirements, future prospects and other factors deemed relevant. Also, under the terms of our mandatorially redeemable preferred stock, we cannot pay any common dividends in any year until we have redeemed at least $1 million of our preferred shares and paid the 3% dividend thereon.
Performance Graph
The graph below compares, assuming $100 was invested on December 31, 2003 and assuming the reinvestment of any dividends, our cumulative total shareholder return with the total shareholder returns of all NASDAQ stocks (the NASDAQ Total) and of all stocks (the Peer Index) contained in the NASDAQ Financial and Insurance indexes, with each index being given equal weight.
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Authorized Capital Stock
Our authorized capital stock consists of 20,000,000 shares of common stock, par value $0.10 per share, and 1,000,000 shares of preferred stock, par value $1.00 per share.
Common Stock
As of March 1, 2009, there were approximately 6,986,000 shares of common stock outstanding that were held of record by approximately 3,500 shareholders.
The holders of our common stock are entitled to receive ratably, from funds legally available for the payment thereof, dividends when and as declared by resolution of our board of directors, subject to the preferential dividend and redemption rights of holders of our Series A mandatorily redeemable preferred stock and any other preferential rights which may be granted to holders of any preferred stock subsequently authorized and issued by us. In the event of liquidation, each share of common stock is entitled to share pro rata in any distribution of our assets after payment or providing for the payment of liabilities and any liquidation preference of any outstanding preferred stock. Each holder of our common stock is entitled to one vote for each share of common stock held of record on the applicable record date on all matters submitted to a vote of shareholders, including the election of directors.
Holders of our common stock have no preemptive rights and have no right to convert their common stock into any other securities. The outstanding shares of our common stock are duly authorized, validly issued, fully paid and non-assessable.
Series A Redeemable Preferred Stock
Our board of directors has established and provided for the issuance of a series of preferred stock, designated as the Series A redeemable preferred stock, which consists initially of 10,500 authorized shares. The shares of Series A redeemable preferred stock were authorized and issued in connection with our acquisition of API. As of March 1, 2009, there were approximately 8,060 shares of our Series A redeemable preferred stock, par value $1.00 per share, outstanding, that were held of record by approximately 2,300 shareholders.
Holders of Series A redeemable preferred stock are entitled to cumulative dividends thereon at the rate of 3% per annum payable on the remaining redemption value per share, in priority to the payments of dividends on the common shares. Holders of Series A redeemable preferred stock have no preemptive rights and have the same voting rights as the holders of our common stock. The shares are non-certificated and mandatorily redeemable. They must be redeemed ratably at not less than $1 million per year, with all outstanding shares being redeemed by December 31, 2016. In the event of any liquidation, the holders of Series A redeemable preferred stock receive an amount equal to the remaining redemption value plus accrued dividends before any distribution is made to the holders of our common stock. In June 2007, 1,019 shares of our Series A redeemable preferred stock were redeemed for $1,058,000, which included accrued dividends of $40,000. In June 2008, 1,004 shares of our Series A redeemable preferred stock were redeemed for $1,302,000, which included accrued dividends of $297,000. Additional redemptions totaling 102 shares were made during 2008 for $66,000.
Furthermore, in connection with the API acquisition, pursuant to its regulatory authority, the Texas Department of Insurance has required us to place $2.5 million into an escrow account with a bank, to remain in escrow until the aggregate remaining redemption and dividend obligation is less than the amount of such escrow balance. We have agreed that no early withdrawals will be made from this escrow account without prior approval from the Texas Department of Insurance.
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Pursuant to its regulatory authority, the Texas Department of Insurance will prohibit API from paying dividends to us on our common stock, or redeeming any of our preferred stock that is held by us, in any calendar year unless and until we have complied with the redemption and dividend payment obligation to the holders of our Series A redeemable preferred stock for that year. Furthermore, our agreement with the Texas Department of Insurance also provides that, until all of the Series A redeemable preferred stock has been fully redeemed and all dividends thereon have been paid, API will not make aggregate annual dividends to us with respect to APIs capital stock in excess of the lesser of 10% of APIs prior year-end policyholder statutory surplus or APIs prior year statutory net income, and in no event may such distributions exceed APIs statutory earned surplus.
Equity Compensation Plans
We have adopted, with shareholder approval, a Stock Option Plan pursuant to which we grant stock options to our directors, key employees and consultants and advisors. In addition, we have also adopted a Deferred Compensation Plan allowing for additional ownership of our common stock by our directors, key employees and consultants.
The following table represents securities authorized for issuance under those equity compensation plans, as further described in Note 16 and Note 17 to the consolidated financial statements included in Item 15. of this Form 10-K.
Equity Compensation Plan Information | |||
| |||
Plan Category | Number of securities to be issued upon exercise of outstanding options, warrants and rights. | Weighted-average exercise price of outstanding options, warrants and rights. | Number of securities remaining available for future issuance under equity compensation plans. Excluding securities reflected in column (a) |
| (a) | (b) | (c) |
Equity compensation plans approved by security holders | 904,000 | $16.21 Note 1 | 576,000 Note 2 |
|
|
|
|
Equity compensation plans not approved by security holders | none | none | none |
|
|
|
|
Total | 904,000 | $16.21 | 576,000 |
Note 1: Average price is for the 755,000 shares under the Stock Option Plan only, as 149,000 shares in the Deferred Compensation Plan ("deferred shares") are outright grants. Deferred shares are reflected in the financial statements at the grant date.
Note 2: As of December 31, 2008 there are 488,000, shares remaining in the Stock Option Plan and 88,000 shares remaining in the Deferred Compensation Plan.
Share Repurchase Program
We may from time to time repurchase shares of our outstanding common stock. Our open market stock repurchases are made in reliance upon Rule 10b-18 of the Exchange Act safe harbor from certain market manipulation claims for purchases by an issuer of its own common stock. Under this rule, we may not open trading in our shares, may not trade in the last thirty minutes of the trading session, may bid no more than the higher of the current bid or last trade, and may purchase no more in a single day than 25% of the average daily trading volume for the last four calendar weeks, unless certain rules for larger block trades are followed. Our stock option plan allows us to accept shares owned by an optionee immediately prior to the exercise of an option in payment for the option exercise. Additionally, we consider unsolicited offers to sell shares back to us and make a decision on purchasing them based on the price and our business needs at the time of the offer. We give priority in our repurchases to shares offered in option exercises, followed by open market purchases and finally unsolicited offers from shareholders. We do not reissue any shares acquired in repurchases, instead canceling them upon acquisition.
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Our original $2,000,000 share repurchase program was announced August 17, 2004 and was increased in $2,000,000 increments on December 12, 2005 and on June 30, 2006, by $1,000,000 on September 7, 2007 and by $4,000,000 on March 5, 2008 and on October 1, 2008. As of February 25, 2009, we had a maximum dollar value of $2,371,000 remaining for the future purchase of shares under the Share Repurchase Plan.
The following table reflects stock repurchases under the share repurchase program during the fourth quarter of 2008:
Period |
| (a) Total Number of Shares Purchased (Note 1) |
| (b) Average Price Paid per Share |
| (c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs |
| (d) Maximum Number of Shares (or approximate Dollar Value of Shares) that May Yet be Purchased Under the Plans or Programs | ||
Oct. 1, 2008 - Oct. 31, 2008 |
| 88,072 |
| $ | 18.43 |
| 88,072 |
| $ | 3,887,000 |
Nov. 1, 2008 - Nov. 30, 2008 |
| 37,680 |
| $ | 19.23 |
| 37,680 |
| $ | 3,163,000 |
Dec. 1, 2008 - Dec. 31, 2008 |
| 11,700 |
| $ | 21.85 |
| 11,700 |
| $ | 2,907,000 |
Note (1): All of the 137,452 shares purchased during the fourth quarter were acquired in open market transactions.
For the period January 1, 2009 through February 25, 2009, 26,482 shares were repurchased in open market transactions at an average price of $20.23 per share leaving a maximum dollar value of $2,371,000 remaining for the future purchase of shares under the Share Repurchase Plan.
Item 6. Selected Financial Data
The following table sets forth selected historical financial and operating data for the Company and is derived from our consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods in accordance with GAAP. The data should be read in conjunction with the consolidated financial statements, related notes and other financial information included elsewhere in this report, but may not be comparable as data for periods 2006 and later was impacted by the implementation of SFAS No. 123(R). Actual financial results through December 31, 2007 may not be indicative of future financial performance. Equity compensation expense of approximately $1,200,000 related to our acquisition of API is included in the 2007 results from operations.
There have been significant changes in the type of information reported and the presentation format as a result of the acquisition of API effective April 1, 2007 since we effectively became an insurance company as a result of the transaction. With the acquisition of API, our consolidated revenue and earnings are predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on APIs earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of APIs earned premiums. In addition, any pre-tax profits of API were shared equally with us (profit sharing) so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, our management agreement with API was terminated and our consolidated results of operations are no longer affected by management fees from API; but, rather our results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
32
Selected Consolidated Historical Financial and
Operating Data of American Physicians Service Group, Inc.
(in thousands except per share data) | Year ended December 31, | |||||||||||||
| 2008 |
| 2007 |
| 2006 |
| 2005 |
| 2004 | |||||
Income Statement Data: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross premiums and maintenance fees written direct and assumed | $ | 64,117 |
| $ | 50,120 |
| $ | - |
| $ | - |
| $ | - |
Premiums ceded |
| 1,543 |
|
| 4,813 |
|
| - |
|
| - |
|
| - |
Net premiums and maintenance fees written |
| 65,660 |
|
| 54,933 |
|
| - |
|
| - |
|
| - |
Net premiums and maintenance fees earned |
| 64,081 |
|
| 56,039 |
|
| - |
|
| - |
|
| - |
Investment income, net of investment expenses |
| 11,999 |
|
| 8,693 |
|
| 915 |
|
| 587 |
|
| 365 |
Realized capital gains (losses) - net |
| (7,749) |
|
| (5,256) |
|
| 155 |
|
| 3,103 |
|
| (2,322) |
Management services |
| 88 |
|
| 3,803 |
|
| 15,555 |
|
| 15,514 |
|
| 15,316 |
Financial services |
| 6,193 |
|
| 21,056 |
|
| 16,850 |
|
| 18,325 |
|
| 16,675 |
Other revenue |
| 137 |
|
| 68 |
|
| 89 |
|
| 122 |
|
| 45 |
Total revenues |
| 74,749 |
|
| 84,403 |
|
| 33,564 |
|
| 37,651 |
|
| 30,079 |
Losses and loss adjustment expenses |
| 18,569 |
|
| 13,695 |
|
| - |
|
| - |
|
| - |
Other underwriting expenses |
| 11,074 |
|
| 8,320 |
|
| - |
|
| - |
|
| - |
Change in deferred acquisition costs |
| 14 |
|
| (110) |
|
| - |
|
| - |
|
| - |
Management services expenses |
| - |
|
| 3,823 |
|
| 11,262 |
|
| 10,262 |
|
| 10,558 |
Financial services expenses |
| 9,749 |
|
| 19,030 |
|
| 15,157 |
|
| 16,273 |
|
| 14,545 |
General and administrative expenses |
| 5,752 |
|
| 5,459 |
|
| 2,106 |
|
| 2,603 |
|
| 1,506 |
Impairment of goodwill |
| - |
|
| 1,247 |
|
| - |
|
| - |
|
|
|
Total expenses |
| 45,158 |
|
| 51,464 |
|
| 28,525 |
|
| 29,138 |
|
| 26,609 |
Income from operations |
| 29,591 |
|
| 32,939 |
|
| 5,039 |
|
| 8,513 |
|
| 3,470 |
Income tax expense |
| 10,428 |
|
| 11,929 |
|
| 1,839 |
|
| 3,039 |
|
| 1,317 |
Minority Interests |
| - |
|
| 1 |
|
| 6 |
|
| 14 |
|
| 1 |
Net income before extraordinary gain |
| 19,163 |
|
| 21,009 |
|
| 3,194 |
|
| 5,460 |
|
| 2,152 |
Extraordinary gain, net of tax |
| - |
|
| 2,264 |
|
| - |
|
| - |
|
| - |
Net income | $ | 19,163 |
| $ | 23,273 |
| $ | 3,194 |
| $ | 5,460 |
| $ | 2,152 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Income per common share |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income before extraordinary gain | $ | 2.69 |
| $ | 3.80 |
| $ | 1.15 |
| $ | 2.03 |
| $ | 0.85 |
Extraordinary gain |
| - |
|
| 0.41 |
|
| - |
|
| - |
|
| - |
Net income | $ | 2.69 |
| $ | 4.21 |
| $ | 1.15 |
| $ | 2.03 |
| $ | 0.85 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Income before extraordinary gain | $ | 2.64 |
| $ | 3.69 |
| $ | 1.09 |
| $ | 1.86 |
| $ | 0.76 |
Extraordinary gain |
| - |
|
| 0.40 |
|
| - |
|
| - |
|
| - |
Net income | $ | 2.64 |
| $ | 4.09 |
| $ | 1.09 |
| $ | 1.86 |
| $ | 0.76 |
33
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements and notes thereto accompanying this report. Except for historical information contained here, the discussions in this Item 7 contain forward-looking information that involves risks and uncertainties. As discussed under Cautionary Statement Regarding Forward-Looking Statements, our actual financial condition and operating results could differ significantly from these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under Item 1A. Risk Factors.
General
We provide, through our wholly-owned subsidiaries, (1) insurance services, specifically medical professional liability insurance in Texas, Oklahoma and Arkansas and (2) financial services, including brokerage and investment services to institutions and high net worth individuals.
Insurance Services.
Effective April 1, 2007, American Physicians Insurance Exchange, or APIE, converted from a reciprocal insurance exchange to a Texas stock insurance company, pursuant to a plan of conversion, and changed its name to American Physicians Insurance Company, or API. Simultaneously, API merged with a wholly owned subsidiary of ours and became our wholly-owned subsidiary.
API provides medical professional liability insurance primarily in Texas, where it has written business for over 30 years. API is authorized to do business in the States of Texas, Arkansas and Oklahoma and specializes in writing medical professional liability insurance for physicians and other healthcare providers. API became authorized to do business in Oklahoma in August 2007. Historically, we operated as the attorney-in-fact manager for API since 1975. In April 2007, we acquired API, thus combining our insurance management experience with an insurance underwriting entity to allow for the increased possibility for expansion into new markets and for continued growth in existing markets.
34
Financial Services.
Through our subsidiaries, APS Financial Corporation, or APS Financial, APS Capital Corporation, or APS Capital, and APS Asset Management, Inc., or Asset Management, we provide our brokerage and investment services to institutions and high net worth individuals.
·
APS Financial.
APS Financial is a licensed broker/dealer that provides brokerage and investment services primarily to institutional and high net worth individual clients. APS Financial also provides portfolio accounting, analysis, and other services to insurance companies and banks. We recognize commission revenue, and the related compensation expense, on a trade date basis.
·
APS Capital.
APS Capital engages in the trading, clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios. Trade claims are private debt instruments representing a pre-petition claim on a debtors estate. We recognize commission revenue and the related compensation expense when the transaction is complete and fully funded.
·
Asset Management.
Asset Management manages fixed income and equity assets for institutional and individual clients on a fee basis. We recognize fee revenue monthly based on the amount of funds under management.
Other Investments.
In 2003, we acquired 385,000 shares of common stock of Financial Industries Corporation (FIC). The total purchase price was approximately $5,647,000. Our policy in regards to our investment in FIC had been that we would record pretax charges to earnings should the common stock price on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. From 2004 through 2007, we wrote down the carrying value of the FIC stock by $3,414,000. In 2008 FIC was acquired. The basis in our investment in FIC common stock at the closing of the merger was $5.80 per share and based on the sale price of $7.25 per share, we recognized a $558,000 gain in the third quarter of 2008.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES.
The accompanying financial statements have been prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). The preparation of our consolidated GAAP financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to: reserve for losses and loss adjustment expenses; death, disability and retirement reserves; reinsurance premiums recoverable/payable; premiums ceded; deferred policy acquisition costs, impairment of assets; bad debts; income taxes; and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies and estimates affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. We periodically review the carrying value of our assets to determine if events and circumstances exist indicating that assets might be impaired. If facts and circumstances support this possibility of impairment, our management will prepare undiscounted and discounted cash flow projections, which require judgments that are both subjective and complex. Management may also obtain independent valuations.
35
Revenue Recognition. Historically, our Insurance Services segment recognized revenues in accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Prior to April 1, 2007, our Insurance Services revenues were historically related to management fees based on the earned premiums of API and included a profit sharing component related to APIs annual earnings. Management fees equaled 13.5% of APIs earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of APIs pre-tax earnings up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Management fees were recorded, based upon the terms of the management agreement, in the period the related premiums are earned by API. API recognizes premiums as earned ratably over the terms of the related policy. The profit sharing component was historically recognized in the fourth quarter when it was certain API would have an annual profit. In 2007, however, since the management contract ended March 31, 2007, we recognized the quarters profit in March, based on our ability to fully determine the profit sharing base.
As a result of the acquisition, our Insurance Services segment recognizes revenue in accordance with SFAS No. 60, Accounting and Reporting of Insurance Enterprises. We issue policies written on a claims-made basis. A claims-made policy provides coverage for claims reported during the policy year. We charge both a base premium and a premium maintenance fee. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro rata basis over the term of the policy. Premium maintenance fees are charged to offset the costs incurred by API to issue and maintain policies. Unearned premiums and maintenance fees are determined on a monthly pro rata basis. Upon termination of coverage, policyholders may purchase an extended reporting period, or tail, endorsement for additional periods of time. These extended reporting period coverage endorsement premiums are earned when written.
Our Financial Services revenues are composed primarily of commissions on securities trades and clearing of trade claims and asset management fees. Revenues related to securities transactions are recognized on a trade date basis. Revenues from the clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios are recognized when the transaction is complete and fully funded. Asset management fees are recognized as a percentage of assets under management during the period based upon the terms of agreements with the applicable customers.
Fair Value Measurements. In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS 157, Fair Value Measurements. SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts its business. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.
Effective January 1, 2008, we adopted SFAS 157, Fair Value Measurements, for our financial assets and financial liabilities, but have not yet adopted SFAS 157 as it relates to nonfinancial assets and liabilities based on the February 2008 issuance of FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, which permits a one-year deferral of the application of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. The adoption of SFAS 157 as it pertains to financial assets and liabilities did not have a material impact on our results of operations, financial position or liquidity. We will adopt SFAS 157 for non-financial assets and non-financial liabilities on January 1, 2009 and do not expect the provisions to have a material effect on our results of operations, financial position or liquidity.
36
SFAS 157 describes three levels of inputs that may be used to measure fair value:
Level 1
Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2
Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3
Valuations are developed from unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
When determining the fair value measurements for assets and liabilities required or permitted to be recorded at and/or marked to fair value, we consider the principal or most advantageous market in which it would trade and consider assumptions that market participants would use when pricing the asset or liability. When possible, we look to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, we look to market observable data for similar assets and liabilities, independent industry-standard models such as matrix pricing and independent, third-party dealer quotes whose inputs may be less observable than Level 1 pricing. When market observable data is not as readily available, the valuation of financial instruments becomes more subjective and could involve substantial judgment. Certain assets and liabilities are not actively traded in observable markets and the Company must use alternative valuation techniques to derive a fair value measurement. For additional disclosures, see Note 23, Fair Value Disclosures, to the unaudited financial statements included herein.
In September 2008, the SEC and FASB issued joint guidance providing clarification of issues surrounding the determination of fair value measurements under the provisions of SFAS 157 in the current market environment. In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which amended SFAS 157 to provide an illustrative example of how to determine the fair value of a financial asset when the market for that asset is not active.
Fair value is used on a recurring basis for our equity and fixed maturity, available for sale securities in which fair value is the primary basis of accounting. Fair value for these securities is the market value based on quoted market prices, when available (Level 1) or quoted prices for similar assets or liabilities in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Certain assets and liabilities are not actively traded in observable markets with listed prices or quotes and we must use alternative valuation techniques based on independent dealer quotes on the security and our own assumptions and professional judgment to derive a fair value measurement (Level 3). In these instances when significant valuation assumptions are not readily observable in the market, instruments are valued based on the best available data to approximate fair value. This data would consider a risk premium that a market participant would require. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. Typically, during periods of market dislocation, the observability of prices and inputs may be reduced for the instruments we hold. This condition could cause an instrument to be reclassified to a lower level during any given period.
37
The following table presents the estimated fair value of our financial instruments on a recurring basis as of December 31, 2008:
(in thousands) |
|
|
|
| Fair Value Measurements at December 31, 2008 Using: | |||||||
|
| December 31, 2008 |
| Quoted prices in active markets for identical assets Level 1 |
| Significant other ob- servable inputs Level 2 |
| Significant other unob- servable inputs Level 3 | ||||
|
|
|
|
| ||||||||
|
|
|
|
| ||||||||
Description |
|
|
|
| ||||||||
Financial Assets: |
|
|
|
|
|
|
|
|
|
|
|
|
Fixed income securities, available for sale |
| $ | 198,011 |
| $ | 30,993 |
| $ | 164,359 |
| $ | 2,659 |
Equity securities, available for sale |
|
| 10,099 |
|
| 10,044 |
|
| 55 |
|
| - |
Total |
| $ | 208,110 |
| $ | 41,037 |
| $ | 164,414 |
| $ | 2,659 |
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage of Assets by Fair Value Hierarchy |
| 100% |
| 19.7% |
| 79.0% |
| 1.3% |
A reconciliation of the beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3) follows (in thousands):
| Fixed Maturity Securities, Available for Sale | |
Balance, January 1, 2008 | $ | 11,867 |
|
|
|
Total gains or losses realized/unrealized: |
|
|
Included in earnings (or changes in net assets) |
| (4,511) |
Included in other comprehensive income |
| 1,260 |
Purchases, issuances, and settlements |
| (2,297) |
Transfers in and/or out of Level 3 |
| (3,660) |
|
|
|
Balance, December 31, 2008 | $ | 2,659 |
|
|
|
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at December 31, 2008 | $ | (4,511) |
|
|
|
|
|
|
Gains and losses (realized and unrealized) included in earnings for the period are reported in net realized investment gains (losses) as follows: |
|
|
|
|
|
Total gains or losses included in earnings for the period (above) | $ | (4,519) |
|
|
|
Change in unrealized gains or losses related to assets held at December 31, 2008 | $ | (1,009) |
Level 1 consists of instruments whose values are based on quoted market prices in active markets. We receive quoted market prices from a third party, independent, nationally recognized pricing service (pricing service). The Company utilizes the pricing service, either for market values obtained based on quoted, actively traded market prices (Level 1) or quoted prices for similar assets in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Of our investment portfolio of $208,110,000 as of December 31, 2008 approximately 99% of our fixed-income securities are priced either as Level 1 or Level 2. The fair value estimate for our equity portfolio of $10,044,000 and our U.S. Treasury fixed income securities of $30,993,000 are based on Level 1 pricing provided by this pricing service since there is an active, readily tradable market value based on quoted prices, as of December 31, 2008, or the measurement date. Active markets are those in which transactions occur in significant frequency and volume to provide pricing information on an on-going basis. Valuation of Level 1 securities does not entail a significant degree of judgment since an active market exists and quoted prices are readily and regularly available.
38
With the exception of U.S. Treasury securities, very few of our fixed-income securities are actively traded. Most of our fixed-income securities, such as government or agency mortgage backed securities, tax-exempt municipal securities and corporate securities are valued using a pricing service and fall within Level 2. Level 2 pricing in our fair value hierarchy comprises $164,414,000 or 79.0% of our investment portfolio which as of December 31, 2008 includes our U.S. Government agency bonds/notes of $24,415,000; U.S Government agency mortgage backed bonds of $30,428,000; U.S. Government agency collateralized mortgage obligations (CMOs) of $50,531,000; Government tax-exempt bonds of $25,446,000; corporate bonds of $7,808,000 and non-agency CMOs of $25,730,000. Five Alt-A securities with a fair value estimate of $2,659,000 or 1.3% of our investment portfolio are classified as Level 3 since the securities are priced based on non-binding indications provided by dealers and the professional judgment of our investment professionals in our asset management subsidiary, APS Asset Management (Asset Manager) upon review of the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. Alt-A securities are CMOs generally considered to have underlying mortgages with underwriting characteristics that are stronger than Subprime mortgages but less stringent than Prime mortgages.
In regards to Level 2 pricing, fair values are used and are based on the market prices from the pricing service where valuations are based on quoted market prices for identical or similar assets and/or valuations using industry-standard models such as matrix pricing. The pricing service evaluates each asset based on relevant market information, credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation include, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets benchmark securities, bids and offers, quoted forward prices, time value, volatility factors, current market and contractual prices for the underlying instrument, and industry news and economic events. For mortgage related products, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. The pricing service we utilize has indicated that they will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation.
Through our Asset Manager, we review the estimates and assumptions of fair value of each security provided by the pricing service for Level 1 and Level 2 pricing and compare these estimates to our custodial bank statement, which also provides a fair market value for the securities we hold to determine if the estimates are representative of the prices in the market. Comparing our fair value pricing obtained from our custodial bank statement serves as a cross-check to the validity of the information provided from the pricing service. Valuations are reviewed for reasonableness based upon the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. We may adjust the valuation of securities from the independent pricing service when we believe its pricing does not fairly represent the market value of the investment. For example, when market observable data is not as readily available or if the security trades in an inactive market, the valuation of financial instruments becomes more subjective and could involve substantial judgment resulting in Level 3 pricing. We generally consider a market to be inactive if the following conditions exist: (1) there are very few transactions for the financial instrument; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly over time or among independent pricing services or dealers; and (4) there is a limited availability of public market information.
In the third quarter of 2007, the market for non-agency collateralized debt obligations, specifically the market for Alt-As, became increasingly inactive based on the limited number of transactions, varying market prices provided by dealers and the limited availability of market data for these securities. The inactivity was evidenced by a significant widening of the bid and ask spread in the dealer markets in which these securities trade and a significant decrease in the volume of trades relative to historical levels. As of December 31, 2008, our portfolio contained seven CMO securities classified as Alt-A of which five of these securities, or $2,659,000 representing 1.3% of our investment portfolio, are classified as Level 3 pricing. The remaining non-agency CMOs in our investment portfolio have underlying mortgages categorized as Prime quality loans with no adjustable features, and none of our CMOs have underlying mortgages classified as Subprime. All of our CMOs, including our Alt-A securities have underlying mortgages with fixed interest rates and all but one Alt-A security is investment grade, currently rated either AA or A. During the quarter ended December 31, 2008, one of the Alt-A securities with a fair market value of $27,000 at December 31, 2008 was downgraded to a C rating.
39
The deepening national housing crisis and its potential impact on the underlying collateral of our Alt-A securities has resulted in a significant and rapid decline of their fair market value, especially in relation to the market prices provided by the outside pricing service. Consistent with our approach to pricing our entire portfolio, we initially received market pricing on these securities from the pricing service. We then reviewed the pricing of our Alt-A securities based on the market environment and the specific characteristics including the overall structure of the instrument; default rates; demographic and geographic characteristics of the underlying mortgages; support levels; and loan to value ratios. As a result of this review, as of December 31, 2008, we have adjusted five of the seven Alt-A securities to lower fair market value from those indicated by the pricing service, (a market-corroborated observable input) based on non-binding indications received from dealers and the judgment of our Asset Manager (unobservable inputs). We obtain two to three indications from dealers who actively trade in these or similar securities, but are not binding offers. Because the approach to valuing these securities involves significant professional judgment and the expertise of our Asset Manager including the use of unobservable inputs from non-binding dealer indications, we classify securities valued in this manner as Level 3.
As noted in the table above (reconciliation of beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3)), $3,660,000 was transferred out of Level 3 to Level 2 during the twelve months ended December 31, 2008 as the pricing from dealer indications we received was comparable to the independent pricing service. We attempt to apply consistent methods and techniques utilized in previous evaluation periods to determine the appropriate level within the fair value hierarchy. Changes in pricing based on Level 3 pricing assumptions of our lowest rated Alt-A securities can have a material effect on our results of operations and financial position as evidenced by the recognition of realized losses of $1,220,100 and $5,818,600, respectively for the three and the twelve months ended December 31, 2008 on these Alt-A securities. If we would have selected pricing based on Level 2 assumptions provided by the pricing service, we would have recognized realized losses of only $693,900 and $3,194,400, respectively, or a $526,100 and $2,624,200 difference for the three and the twelve months ended December 31, 2008. Additionally, our financial position would have been higher since our fixed maturities, available for sale and accumulated, other comprehensive income would have been increased by $1,387,500 as of December 31, 2008 based on different pricing assumptions.
Investments. Our policy is to account for investments as available-for-sale securities which requires that we assess fluctuations in fair value and determine whether these fluctuations are temporary or other than temporary as defined in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, (SFAS 115).
In accordance with SFAS No. 115, we evaluate our investment securities on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other than temporary declines. A decline in the fair value of a security below cost judged to be other than temporary is recognized as a loss in the current period and its fair value becomes the new cost basis of the security. The following factors are considered in determining whether an investment decline is other than temporary:
·
The extent to which the market value of the security is less than its cost basis;
·
The length of time for which the market value of the security is less than its cost basis;
·
The financial condition and near-term prospects of the securitys issuer, taking into consideration the economic prospects of the issuers industry and geographical region, to the extent that information is publicly available;
·
Third party research and credit rating reports;
·
The extent to which the decline in fair value is attributable to credit risk specifically associated with an investment or its issuer;
·
The extent to which we believe market assessments of credit risk for a specific investment or category of investments are either well founded or are speculative;
40
·
Our internal assessments and those of our external portfolio managers regarding specific circumstances surrounding an investment, which can cause us to believe the investment is more or less likely to recover its value than other investments of similar characteristics;
·
For asset backed securities; the origination date of the underlying loans, the remaining average life, the probability that credit performance of the underlying loans will deteriorate in the future, and our assessment of the quality of the collateral underlying the loan; and,
·
Our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method for our available-for-sale investments acquired at other than par value. Amortization for loan-backed, or mortgage-backed, securities is adjusted prospectively for changes in pre-payment speed assumptions.
In November 2005, the Financial Accounting Standards Board (FASB) issued Staff Position No. FSP 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (FSP 115-1 and 124-1). FSP 115-1 and 124-1 supersedes Emerging issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments and amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations and Accounting Principles Board No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP 115-1 and 124-1 address the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary and the measurement of an impairment loss. FSP 115-1 and 124-1 also includes provision for accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 and 124-1 is effective for periods beginning after December 15, 2005, with earlier adoption permitted. We adopted FSP 115-1 and 124-1 during the fiscal quarter ended December 31, 2005. The adoption of FSP 115-1 and 124-1 did not have a material effect on our financial position, results of operations or cash flows.
Asset Impairment. We periodically review the carrying value of our assets to determine if events and circumstances exist indicating that assets might be impaired. If facts and circumstances support this possibility of impairment, our management will prepare undiscounted and discounted cash flow projections, which require judgments that are both subjective and complex. We may also obtain independent valuations. In accordance with SFAS No. 142, Goodwill and Other Intangibles intangible assets with indefinite lives are not amortized but are subject to annual tests for impairment or more often if events or circumstances indicate they may be impaired. Other identified intangible assets are amortized over their estimated useful lives and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount.
Business Combinations. We recorded all assets and liabilities acquired in the acquisition of API, including indefinite-lived intangibles, and other intangibles, at fair value as required by SFAS No. 141, Accounting for Business Combinations. The initial recording of other intangibles requires subjective judgments concerning estimates of the fair value of the acquired assets and liabilities.
The medical professional liability insurance policies we offer are written for only a one year period, Thus, the short term nature of the policy makes deferred policy acquisition costs (DAC) and unearned premium and maintenance fees (unearned premiums) short term items that are amortized over a one year period. This short time frame means that historical GAAP basis reflect fair value at the date of acquisition.
41
The fair values of the reserves for losses and loss adjustment expenses and related reinsurance recoverables (the net loss reserves) acquired in the API transaction were estimated as of the date of acquisition based on the present value of the expected underlying net cash flows, and includes a risk premium and a profit margin. In determining the fair value estimate, management discounted APIs historical undiscounted loss reserves, to present value assuming discounting patterns actuarially developed from the historical loss data of API. The discount rate used of 4.64% approximates the risk-free treasury rate on the acquisition date for maturities similar to the estimated duration of the reserves being valued. A risk premium was applied to the discounted net loss reserves to reflect managements estimate of the cost API would incur to reinsure the full amount of its net loss reserves with a third-party reinsurer. This risk premium is based upon managements assessment of the inherent uncertainty in reserving for net loss reserves and their knowledge of the reinsurance marketplace and was confirmed by a reinsurance intermediary. The calculation resulted in a fair value estimate which was not materially different than the historical loss reserves and therefore did not result in an adjustment to the historical reserve amount.
Based on our review of the fair value of assets acquired in the acquisition of API on April 1, 2007, there was no goodwill and we recorded an extraordinary gain of $2,264,000 during the three months ended June 30, 2007 for the excess of net assets received over cost to acquire.
In December 2007, the FASB issued Statement of Financial Accounting Standards, or SFAS No. 141 (Revised December 2007) Business Combinations (SFAS 141R). SFAS 141R replaces SFAS Statement No. 141, Business Combinations but retains the fundamental requirement in SFAS 141 that the acquisition method (referred to as the purchase method in SFAS 141) of accounting be used for all business combinations. SFAS 141R provides new and additional guidance with respect to business combinations including: defining the acquirer in a transaction, the valuation of assets and liabilities when non-controlling interests exist, the treatment of contingent consideration, the treatment of costs incurred to effect the acquisition, the treatment of reorganization costs, and the valuation of assets and liabilities when the purchase price is below the net fair value of assets acquired. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We have adopted the Statement on its effective date.
Reserve for Loss and Loss Adjustment Expense. These reserves represent our best estimate of the ultimate cost of all remaining reported and unreported claims for which we provide insurance coverage to our policyholders. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses (LAE) is an inherently uncertain process, does not represent an exact calculation of the liability and may not represent the ultimate cost of settling our claim obligations. For comparative purposes, we have included detailed claim and loss reserve data and analysis on a pro forma basis since we did not acquire API until April 1, 2007. This information is provided to highlight the development of claim and loss reserve data prior to our acquisition of API. Any reference in this Item 7 below to pro forma purports to show the impact to us had we acquired API as of January 1 of the year indicated.
The estimate of reserves for losses and LAE is reflective of the types of insurance policies written by us. We write our medical professional liability insurance policies predominantly on a claims-made basis. Claims-made insurance policies provide coverage for claims made and reported to the company during the period covered under the policy. We also write a small percentage of policies on an occurrence basis. Occurrence basis insurance policies provide coverage for losses that occur during the term of the policy, regardless of when the claim is reported. These occurrence policies also cover policyholders that purchase or earn, according to the terms of contract provisions, an extended reporting period, or tail endorsement, upon termination of coverage.
For both claims-made and occurrence policies, a significant amount of time can elapse between the occurrence or reporting of an insured event and the final settlement of the claim. The time period between the occurrence of a loss and its resolution by an insurer is referred to as the claims tail. Short tail claims are reported and settled quickly, resulting in less reserve estimation variability. The longer the tail or time before the final resolution of a claim, the greater the exposure to estimation risk and hence, greater estimation uncertainty. Although our predominance of claims-made policies has a positive impact in terms of reducing claim tails, most of our policies are nonetheless regarded as having a longer tail than other lines of property and casualty insurance. This is because medical professional liability claims frequently involve litigation which may take years before a judgment or settlement is reached. Medical liability claims are typically resolved over an extended period of time, often five years or more.
42
When a claim is reported to us, our claims adjusters establish a case reserve for the estimated amount of the ultimate payment including legal costs associated with defending the claim. The process of estimating case reserves reflects an informed judgment based upon the experience and knowledge of the claims adjuster regarding the nature and value of the specific claim, the severity of injury or damage, the judicial climate where the insured event occurred and the policy provisions relating to the type of loss. With lines of insurance like medical professional liability that often have claims with complex and technical facts and circumstances that take many years to investigate and close, the lack of information available to the claims adjusters when a claim is first reported often makes establishing case reserves difficult. As the discovery phase of the claim proceeds, better information regarding the nature and severity of the claim becomes available enabling us to establish a more appropriate case reserve for the claim. Case reserves on severe claims are also reviewed for adequacy at least quarterly by our claims committee, which includes our Medical Director, physicians with specific expertise in the specialty of the claims being reviewed, and senior management. This process of periodically evaluating and adjusting case reserves is one of the factors we consider when establishing our ultimate loss and LAE expenses. However, case reserves alone are insufficient in measuring our ultimate cost for losses and loss adjustment expenses.
In addition to case reserves, we also maintain reserves for claims incurred but not reported, commonly referred to as IBNR. IBNR is the estimated liability for (1) the ultimate cost of claims that have been reported but not yet settled, and (2) claims that have occurred but have not yet been reported. IBNR reserves are established to cover additional exposure on known and unknown claims using various actuarial loss projection models. Included in our IBNR loss reserve are estimates of the aggregate difference between our individual estimated case reserves and the amount for which they will ultimately be settled. This provision, which is included in our total IBNR reserves, comprises the majority of such reserves given our predominately claims-made coverage. Since each claim reported is settled individually based on its merits, and it is not unusual for a claim to take years after being reported to settle, an IBNR reserve is established for this uncertainty in ultimate claim cost. An additional provision in our IBNR loss reserves is included for our small percentage of occurrence policies where claims have occurred but have not yet been reported. While actuarial loss projection models vary, our general approach for calculating IBNR reserves involves calculating ultimate losses and LAE costs by each accident year and reducing that amount by the amount of cumulative claims paid and by the amount of our case reserves.
The two components, case reserves and the reserve for IBNR claims, constitute the liability for unpaid losses and loss adjustment expenses, and together represent our best estimate of the ultimate cost of settling our claim obligations as of the reporting date. The combination of changing conditions including, but not limited to, historical settlement patterns, trends in loss severity and frequency, legal theories of liability and legislative changes and other factors such as the time required for claim resolution makes the estimation of reserves inherently difficult and requires actuarial skill and judgment. We perform an in-depth review of reserves for unpaid losses and loss adjustment expenses on a semi-annual basis with assistance from our outside consulting actuary.
The independent review of reserves by our outside consulting actuary plays an important role in the overall assessment of the adequacy of reserves. We establish reserves for unpaid loss and loss adjustment expenses taking into account the results of multiple actuarial techniques applied as well as other assumptions and factors regarding our business. The actuarial techniques used that are material to the evaluation of reserves for unpaid loss and loss adjustment expense include the following:
Loss development methods (incurred and paid development);
Loss adjustment expense development methods (incurred and paid development);
Average hindsight outstanding projection;
Frequency/severity projection methods;
Bornhuetter-Ferguson expected loss projection methods; and
Trended pure premium method.
43
Each technique has inherent benefits and shortcomings (i.e., biases), particularly when applied to company-specific characteristics and trends. For example, certain methods (e.g., the Bornhuetter-Ferguson and pure premium methods) are more relevant to immature accident years, and other methods (e.g., the loss development methods) provide more meaningful information for years with a greater level of maturity. Because each method has its own set of attributes, we do not rely exclusively upon a single method. Rather, we evaluate each of the methods for the different perspectives that they provide. Each method is applied in a consistent manner from period to period and the methods encompass a review of selected claims data, including, but not limited to, claim and incident counts, average indemnity payments and loss adjustment expenses.
As part of its evaluation, our outside consulting actuary develops a point estimate and a range of reserves it believes is reasonable. The point estimate represents our actuaries' estimate of the most likely amount that will ultimately be paid to settle unpaid claims at a particular point in time. The upper end of the range reflects their higher estimates of future loss and loss adjustment expenses while the lower end of the range reflects their lower estimates of future loss and loss adjustment expenses. In general, the width of a range reflects the level of variability in the underlying projections. These range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimate.
We consider many factors, not just the actuarial point estimates, in determining ultimate expected losses and the level of reserves required and recorded. Recorded (carried) reserves are based upon the judgment of management and are not entirely driven by formulaic determinations produced by various actuarial methods. In addition to considering the point estimate and ranges calculated by the independent consulting actuaries, management also utilizes expected loss ratios in determining its best estimate, which it selects based on the following: (1) information used to price the applicable policies, (2) historical loss information, (3) any public data for medical professional liability insurance for the Texas, Arkansas and Oklahoma blocks of business, and (4) an assessment of the current market conditions. Additionally, we select a best estimate with due regard for the age, characteristics and volatility of medical professional liability insurance, the volume of data available for review and past experience with respect to the accuracy of estimates. Other external factors such as economic inflation, judicial trends and legislative and regulatory changes can also have a substantial impact on our reserve estimation assumptions. For example, when tort reform is passed in a state, as was the case in Texas, we will estimate the impact of reform on both frequency and severity of losses. In addition, we evaluate whether or not the legislation will stand if it is legally challenged in the courts. We also consider the effects of various reinsurance treaties and the varying retention levels and co-participations we have on any given year as these will have an impact on the loss reserves we cede to our reinsurers. We also consider input from our underwriting, claims, and senior management personnel and our claims committee.
Because of the nature and complexities of this line of insurance and expectations about future claim results and trends, our best estimate may differ from the selected reserve estimate of our independent actuary. Even minor changes in assumptions regarding these factors can have a substantial impact on the projection of the ultimate liability, especially with a long-tailed, low-frequency, high-severity line of business such as medical professional liability insurance. While our assessment may differ, our carried reserves remain within the actuarial range of the independent actuarys selected reserve estimate. The data and analysis performed by our independent actuarial firm serves as an objective confirmation of the adequacy of our carried reserves and we utilize the actuarial point estimate and reserve ranges to monitor the adequacy and reasonableness of recorded reserves. The reserve opinions of our independent actuary for the years ended December 31, 2008 and 2007 have been filed with state insurance regulators along with APIs statutory financial statements.
44
The reconciliation between our net reserve for loss and loss adjustment expenses filed with state insurance departments prepared in accordance with statutory accounting principles and those reported in our consolidated financial statements prepared in accordance with GAAP is shown below:
| Year Ended December 31, | |||||||
| Actual |
| Actual |
| Pro forma | |||
| 2008 |
| 2007 |
| 2006 | |||
| (Dollars in thousands) | |||||||
Net statutory reserves (1) | $ | 78,257 |
| $ | 81,513 |
| $ | 81,186 |
Less: Reinsurance Recoverables on paid loss and LAE |
| (131) |
|
| (349) |
|
| (97) |
Net adjusted statutory reserves |
| 78,126 |
|
| 81,164 |
|
| 81,089 |
Reinsurance recoverables on paid and unpaid loss and LAE |
| 13,796 |
|
| 20,019 |
|
| 28,491 |
Subrogation Recoverables |
| 219 |
|
| 423 |
|
| 509 |
GAAP reserves | $ | 92,141 |
| $ | 101,606 |
| $ | 110,089 |
(1) Net statutory reserves include an adjustment for reinsurance recoverables on paid loss and loss adjustment expenses. On a statutory basis reinsurance recoverables on paid loss and loss adjustment expenses are not included as a reduction of reserves but are recorded as a statutory asset.
We continually review and update the data underlying the estimation of the loss and loss adjustment expense reserves and make adjustments that we believe the emerging data supports. If reserves ultimately prove to be too high, then the excess amount will be recognized as a reduction to loss and loss adjustment expenses in the current period of operations that the change in estimate is made. If reserves prove to be inadequate in the future, we would have to increase such reserves and incur a charge to earnings in the period that such reserves are increased, which could have a material adverse affect on our results of operations and financial condition. These specific risks described above, combined with the variability that is inherent in any reserve estimate, could result in significant positive or negative deviation from our recorded net reserve amounts, and could positively or adversely impact our business, results of operations and cash flows.
We have established a net reserve for loss and LAE at $78,257,000 as of December 31, 2008 or what we believe to be the upper end of the reserve estimates, as projected by actuarial review; however, there is no assurance that such reserves will ultimately prove adequate. We have established a position of conservatively reserving to the upper-end of the reserve estimate due to the inherent judgments and uncertainties in estimating ultimate claims losses and managements philosophy that this is the appropriate approach to reserving at the current time.
We considered the following factors in establishing our best estimate as of December 31, 2008. First, as highlighted in the 10-year reserve development herein, APIs reserve estimates for the years 1999 through 2004 were significantly deficient. Not until recently, 2005 through 2008, have reserves trended favorably from the originally reported net liability. In addition, API has increased the number of policyholders it insures from 2,992 at January 1, 2004 to 5,336 at December 31, 2008 resulting in an approximately 78% increase in policyholder exposure over the last several years. We also recently began writing medical liability policies in Oklahoma. The significant adverse development patterns of API coupled with the uncertainty as to how our significant increase in policyholders and new business in Oklahoma will perform over time warrants a conservative position. Also, API began co-participating in the 2006, 2007, and 2008 reinsurance treaties on claims in excess of the retention of $250,000 on individual claims and $350,000 on multiple insured claims related to a single occurrence. The 2006, 2007, and 2008 reinsurance treaties provide for API retaining an additional 10% of the retention levels for 2006, 20% for 2007, and 40% for 2008. Uncertainty in regards to how these increased participation levels would impact our recorded reserves should API be exposed to considerable losses resulting from a significant liability event or the occurrence of an unusually high number of liability losses in one reporting period, were considered in determining our best estimate as of December 31, 2008.
45
In considering the potential sensitivity of the factors and assumptions underlying managements best estimate of recorded loss and loss adjustment reserves, as previously mentioned, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a relatively large average cost per claim. For example, at December 31, 2008, we had 5,336 policyholders and during the calendar year ended 2008 API paid a total of $ 10,815,000 in gross paid damages on 85 claims. Even a small change in the number of claims expected to be paid (i.e. frequency) or a small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, our financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, API has closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the high average cost per claim, any change in the trends of key assumptions used in estimating the ultimate values could result in a significant change in the reserve estimate.
Loss frequency and severity trends are important assumptions in the estimation of ultimate liability of losses and loss adjustment expenses. Claims frequency is measured in various ways. The most common measure is the number of claims reported, which is then typically adjusted for the relative exposure, either in terms of the number of insureds or earned premiums. Claims frequency is also measured in terms of the number of claims reported to us on which we make loss payments as opposed to claims on which we pay only expenses or those that we close with no payment to claimants. Claim frequency impacts not only our projection of the number of IBNR claims associated with our occurrence or tail business but is also evaluated to determine the cause of changes in frequency. In periods where claims frequency is declining, we determine the nature of the claims in decline. A drop in non-meritorious claims, for example, could have an impact on the percentage of claims that will ultimately have loss payments and could impact the projection of ultimate losses.
Claims severity is often measured on a paid, reported and ultimate basis. Paid severity represents the cost of payments associated with loss settlements and is typically measured as an average of paid losses per claim closed, per claim closed with no payment and per claim closed with an indemnity payment. Reported severity is usually measured as our average case reserve per open claim. Ultimate severity takes into account not only the severity of losses currently being paid and the losses in our open claims inventory, but also incurred but unreported claims and all remaining costs to settle these claims. One such factor we consider with low-frequency, high-severity lines of business like medical professional liability insurance is the premise that if fewer claims are reported to us, those claims are likely to have higher average severity than the average severity associated with a large population of claims. Implicit in this assumption is that claims that are still being reported are those of greater merit and potential severity while claims no longer being reported are assumed to be non-meritorious in nature and could be closed at little or no cost.
46
The following table shows net case, IBNR and total reserves and various claim statistics and reserve averages for the years ended December 31, 2008, 2007 and 2006.
| At and For the Year Ended December 31, |
|
|
|
| |||||||
| Actual |
| Pro forma |
| Pro forma |
| % Change |
| % Change | |||
| 2008 |
| 2007 |
| 2006 |
| 2008 vs. 2007 |
| 2007 vs. 2006 | |||
Medical professional liability: |
|
|
|
|
|
|
|
|
|
|
|
|
Number of open claims beginning of period |
| 740 |
|
| 809 |
|
| 702 |
| -8.5% |
| 15.2% |
Number of reported claims |
| 381 |
|
| 402 |
|
| 507 |
| -7.7% |
| -20.7% |
Number of claims settled with indemnity payment |
| (85) |
|
| (100) |
|
| (80) |
| -15.0% |
| 25.0% |
Number of claims settled without indemnity payment |
| (451) |
|
| (371) |
|
| (320) |
| 18.9% |
| 15.9% |
Number of open claims end of period |
| 585 |
|
| 740 |
|
| 809 |
| -20.9% |
| -8.5% |
Estimated number of IBNR claims (1) |
| 85 |
|
| 121 |
|
| 75 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net case reserves | $ | 43,784,174 |
| $ | 43,473,407 |
| $ | 45,973,937 |
| 0.7% |
| -5.4% |
Net IBNR reserves |
| 34,473,255 |
|
| 38,039,275 |
|
| 35,212,210 |
| -9.4% |
| 8.0% |
Statutory net reserve (net reserve) | $ | 78,257,429 |
| $ | 81,512,682 |
| $ | 81,186,147 |
| -4.0% |
| 0.4% |
|
|
|
|
|
|
|
|
|
|
|
|
|
Average net case reserve per open claims | $ | 74,845 |
| $ | 58,748 |
| $ | 56,828 |
| 27.4% |
| 3.4% |
Average net IBNR reserve per open and IBNR claims |
| 51,453 |
|
| 44,180 |
|
| 39,833 |
| 16.5% |
| 10.9% |
Average net reserve per open and IBNR claims |
| 116,802 |
|
| 94,672 |
|
| 91,840 |
| 23.4% |
| 3.1% |
|
|
|
|
|
|
|
|
|
|
|
|
|
Average net paid loss per claim closed with payment | $ | 122,602 |
| $ | 124,527 |
| $ | 92,555 |
| -1.5% |
| 34.5% |
(1) IBNR claim counts are estimates based on actuarial projections
Our open claim counts of 585 at December 31, 2008 decreased significantly by 21% from 740 open claims at December 31, 2007. In 2008, our claims settled (with and without indemnity) of 536 outpaced the number of reported claims of 381 which continued the claims trend that we saw in 2007 in which our open claim counts decreased by 8.5% from 809 at December 31, 2006 to 740 at December 31, 2007, the result of a relatively low 402 claims being reported in 2007 combined with total claims closed (with and without indemnity) of 471 outpacing reported claims. However, in 2006 our open claims increased by 15.2% from 702 at January 1, 2006 to 809 at December 31, 2006, the result of reported claim counts of 507 outpacing the number of closed claims (with and without indemnity) in 2006. Our assumption was that the increase in reported claim counts in 2006 was attributable to the significant increase in policyholder count beginning in 2004 through December 31, 2007. We also believed these elevated claim counts represented a more reasonable, normalized claim count in a post-tort reform environment in Texas as compared to the historically low reported claim counts of 335 and 385 in 2005 and 2004, respectively, after the passage of tort reform. From a historical perspective it is important to note that we had 1,372 open claims (the highest number of claims in the history of API) at December 31, 2003, the year in which tort reform legislation passed in Texas. Our open claim counts have declined dramatically since the end of 2003 as the number of reported claims has decreased and as we continue to settle or close claims at an accelerated pace.
47
Net case reserves were relatively flat in 2008 (up .7%) as compared to 2007; however, the average net case reserves continued to increase by 27.4% as the number of open cases continued to decrease. Net case reserves decreased by 5.4% from December 31, 2006 to December 31, 2007 as the number of open claims continued to decrease over this period. During 2008 our IBNR reserve decreased by 9.4% from $38,039,000 in 2007 to $34,473,000 in 2008. While our number of policyholders continues to increase from 4,930 in 2007 to 5,336 in 2008 the number of reported claims has dropped to 381 in 2008 from 402 in 2007, and the number of remaining open claims has decreased to 585 at December 31, 2008 from 740 at December 31, 2007. Furthermore, claim severity has stabilized and continues to emerge favorably for the post-tort reform years. The combination of declining reported claims and open claims resulted in the decrease in IBNR year over year. Reflected in our net IBNR reserve increase of 8.0% from $35,212,000 at December 31, 2006 to $38,039,000 December 31, 2007 is due to a significant increase in our total number of policyholders, which has risen from 3,919 at the beginning of 2006 to 4,930 at December 31, 2007. Our higher average paid loss per claim in 2008 of $122,602 as compared to $92,555 in 2006, respectively, supports the assumption previously mentioned above that if fewer claims are reported in a given year; those claims are likely to have higher severity than those claims associated with a larger population. Implicit in this assumption is that claims reported post-tort reform, while fewer in number, are of greater merit and potential severity and claims that are no longer reported were non-meritorious in nature and were closed at little or cost.
The following table reflects the activity in the liability for reserve for losses and loss adjustment expenses since January 1, 2006 through the year ended December 31, 2008 (in thousands):
| At and For the Year Ended December 31, | |||||||
| Actual |
| Pro Forma |
| Pro Forma | |||
| 2008 |
| 2007 |
| 2006 | |||
Reserve for loss and loss adjustment expensesJanuary 1 | $ | 101,606 |
| $ | 110,089 |
| $ | 95,628 |
Less: reinsurance recoverable on paid and unpaid loss and LAE including subrogation |
| (20,442) |
|
| (29,000) |
|
| (29,695) |
|
|
|
|
|
|
|
|
|
Net balanceJanuary 1 |
| 81,164 |
|
| 81,089 |
|
| 65,933 |
|
|
|
|
|
|
|
|
|
Incurrednet of reinsurancerelated to: |
|
|
|
|
|
|
|
|
Current year |
| 39,134 |
|
| 40,682 |
|
| 42,354 |
Prior periods |
| (20,565) |
|
| (16,023) |
|
| (4,786) |
|
|
|
|
|
|
|
|
|
Net incurred |
| 18,569 |
|
| 24,659 |
|
| 37,568 |
|
|
|
|
|
|
|
|
|
Paidnet of reinsurancerelated to: |
|
|
|
|
|
|
|
|
Current year |
| 3,379 |
|
| 3,591 |
|
| 3,743 |
Prior periods |
| 18,228 |
|
| 20,993 |
|
| 18,669 |
|
|
|
|
|
|
|
|
|
Net paid |
| 21,607 |
|
| 24,584 |
|
| 22,412 |
|
|
|
|
|
|
|
|
|
Net balanceDecember 31 |
| 78,126 |
|
| 81,164 |
|
| 81,089 |
|
|
|
|
|
|
|
|
|
Plus: reinsurance recoverable on paid and unpaid loss and LAE including subrogation |
| 14,015 |
|
| 20,442 |
|
| 29,000 |
|
|
|
|
|
|
|
|
|
Reserve for loss and loss adjustment expensesDecember 31 | $ | 92,141 |
| $ | 101,606 |
| $ | 110,089 |
Incurrednet of reinsurance depicts incurred loss and loss adjustment expense related to premium earned in that period, also referred to as accident year. Incurrednet of reinsurance for the prior years represents the net change in reserve estimates charged or credited to earnings in the current year with respect to liabilities that originated and were established in prior years.
Our incurred loss and loss adjustment expense for the most recent accident year of $39,134,000 in 2008 is reflective of the relative decreases in reported claim count as compared to prior accident years of $40,682,000 in 2007 and $42,354,000 in 2006. In 2008 and 2007, we decreased our incurred loss and loss adjustment expense for prior year development by $20,565,000 in 2008 and $16,023,000 in 2007, which was primarily the result of loss severity for the 2002 through 2006 report years developing favorably compared to prior period estimates.
48
During 2006, API recorded favorable prior year development of $4,786,000, the result of 2004 and 2005 report year loss severity falling below expectations. We continue to see beneficial trends in claims frequency and relative stability in average paid loss severity as compared to pre-tort reform years. For instance, the average number of claims reported and the average net claim paid with indemnity (net paid loss severity) over the last four years (2005-2008) since the passage of tort reform has averaged 406 and approximately $102,000 as compared to the previous four years (2000-2003) prior the passage of reform in which claims reported averaged 773 and paid loss severity averaged $144,000. The effect of significant changes in claim frequency introduces a great deal of variability into our reserve estimation process. We are traditionally cautious with our assumptions concerning emerging trends in claims frequency and severity loss trends and consequently we do not immediately place much weight on the impact that any short-term declines in frequency and severity may have on our ultimate losses. However, actual frequency and severity loss trends have developed more favorably than originally anticipated. We utilize historical claims data to project future expected results. As a result, the impact of recent claims trends is moderated by historical data. We have recently experienced favorable trends of declining frequency and stable paid loss severity and the results of these trends are reflected in our reserve estimations. The impact of recent favorable trends is the main reason for the increase in favorable development from $4,786,000 in 2006, $16,023,000 in 2007, and $20,565,000 in 2008.
We attempt to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherently uncertain process involving loss and loss adjustment expense reserve estimates, the final resolution of the ultimate liability may be different from that anticipated at the reporting date. Therefore, actual paid damages in the future may yield a materially different favorable or unfavorable amount than currently reserved. While we believe that the estimates for loss and loss adjustment expense reserves are adequate as of December 31, 2008, there can be no assurance that our estimates will not change 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 following tables, known as the reserve development tables, show the development of the net liability for unpaid loss and loss adjustment expenses. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year-ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. A (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years. The volatility of medical professional liability claim frequency and severity makes the prediction of the ultimate losses very difficult. Likewise, the long period of time necessary for medical professional liability claims to develop and be paid further complicates the reserving process.
49
The following summarizes our reserve development since our acquisition of API on April 1, 2007. Since we acquired API on April 1, 2007, reserve development data for API prior to that date is not directly applicable for us.
| 2007 |
| 2008 | ||
Original Net Liability end of year | $ | 81,164 |
| $ | 78,126 |
|
|
|
|
|
|
Cumulative net paid as of; |
|
|
|
|
|
One Year later |
| 18,228 |
|
| - |
Two Years later |
|
|
|
|
|
Three Years later |
|
|
|
|
|
Four Years later |
|
|
|
|
|
Five Years later |
|
|
|
|
|
Six Years later |
|
|
|
|
|
Seven Years later |
|
|
|
|
|
Eight Years later |
|
|
|
|
|
Nine Years later |
|
|
|
|
|
Ten Years later |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Re-estimated Net Liability as of: |
|
|
|
|
|
End of year |
| 81,164 |
|
| 78,126 |
One Year later |
| 60,955 |
|
|
|
Two Years later |
|
|
|
|
|
Three Years later |
|
|
|
|
|
Four Years later |
|
|
|
|
|
Five Years later |
|
|
|
|
|
Six Years later |
|
|
|
|
|
Seven Years later |
|
|
|
|
|
Eight Years later |
|
|
|
|
|
Nine Years later |
|
|
|
|
|
Ten Years later |
|
|
|
|
|
|
|
|
|
|
|
Net cumulative (deficiency) redundancy |
| 20,209 |
|
| - |
|
|
|
|
|
|
Original Gross liability- end of year | $ | 101,606 |
| $ | 92,141 |
Less: Reinsurance recoverables - end of year | $ | (20,442) |
| $ | (14,015) |
Original Net liability - end of year | $ | 81,164 |
| $ | 78,126 |
|
|
|
|
|
|
Gross re-estimated liability - latest | $ | 73,539 |
| $ | 92,141 |
Re-estimated reinsurance recoverables-latest | $ | (12,584) |
| $ | (14,015) |
Net re-estimated liability - latest | $ | 60,955 |
| $ | 78,126 |
|
|
|
|
|
|
Gross cumulative (deficiency) redundancy | $ | 28,067 |
| $ | - |
50
For comparative purposes, we have included detailed claim and loss reserve data and analysis on a pro forma basis since we did not acquire API until April 1, 2007. This information is provided to highlight the development of claim and loss reserve data prior to our acquisition of API on April 1, 2007.
| PRO FORMA | ||||||||||||||||||||||||||||
| 1998 |
| 1999 |
| 2000 |
| 2001 |
| 2002 |
| 2003 |
| 2004 |
| 2005 |
| 2006 |
| As of March 31, 2007 | ||||||||||
Original Net Liability end of year | $ | 42,177 |
| $ | 35,471 |
| $ | 37,593 |
| $ | 33,747 |
| $ | 35,030 |
| $ | 42,231 |
| $ | 56,349 |
| $ | 65,933 |
| $ | 81,089 |
| $ | 86,036 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cumulative net paid as of; |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
One Year later |
| 24,898 |
|
| 21,805 |
|
| 27,998 |
|
| 23,360 |
|
| 31,665 |
|
| 34,965 |
|
| 30,634 |
|
| 20,074 |
|
| 20,993 |
|
| - |
Two Years later |
| 36,796 |
|
| 40,156 |
|
| 41,575 |
|
| 40,278 |
|
| 48,023 |
|
| 55,034 |
|
| 43,409 |
|
| 29,939 |
|
| 33,157 |
|
|
|
Three Years later |
| 43,786 |
|
| 44,562 |
|
| 47,614 |
|
| 45,952 |
|
| 54,926 |
|
| 62,226 |
|
| 49,173 |
|
| 34,878 |
|
|
|
|
|
|
Four Years later |
| 44,904 |
|
| 46,015 |
|
| 50,520 |
|
| 48,503 |
|
| 57,390 |
|
| 66,613 |
|
| 51,622 |
|
|
|
|
|
|
|
|
|
Five Years later |
| 45,626 |
|
| 47,670 |
|
| 51,090 |
|
| 49,417 |
|
| 58,957 |
|
| 70,387 |
|
|
|
|
|
|
|
|
|
|
|
|
Six Years later |
| 46,786 |
|
| 47,905 |
|
| 51,674 |
|
| 50,090 |
|
| 60,942 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Seven Years later |
| 46,903 |
|
| 48,520 |
|
| 52,020 |
|
| 51,694 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Eight Years later |
| 47,487 |
|
| 48,655 |
|
| 53,454 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Years later |
| 47,585 |
|
| 48,752 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ten Years later |
| 47,682 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Re-estimated Net Liability as of: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
End of year |
| 42,177 |
|
| 35,471 |
|
| 37,593 |
|
| 33,747 |
|
| 35,030 |
|
| 42,231 |
|
| 56,349 |
|
| 65,933 |
|
| 81,089 |
|
| - |
One Year later |
| 42,837 |
|
| 37,248 |
|
| 39,708 |
|
| 42,155 |
|
| 46,955 |
|
| 68,083 |
|
| 73,957 |
|
| 63,061 |
|
| 65,939 |
|
|
|
Two Years later |
| 43,677 |
|
| 41,837 |
|
| 48,411 |
|
| 45,826 |
|
| 61,294 |
|
| 79,041 |
|
| 69,525 |
|
| 50,291 |
|
| 52,834 |
|
|
|
Three Years later |
| 44,636 |
|
| 47,540 |
|
| 50,926 |
|
| 54,212 |
|
| 64,379 |
|
| 81,888 |
|
| 61,154 |
|
| 45,330 |
|
|
|
|
|
|
Four Years later |
| 46,880 |
|
| 48,214 |
|
| 55,846 |
|
| 55,618 |
|
| 66,557 |
|
| 77,432 |
|
| 58,456 |
|
|
|
|
|
|
|
|
|
Five Years later |
| 47,420 |
|
| 51,101 |
|
| 56,163 |
|
| 54,762 |
|
| 63,760 |
|
| 76,522 |
|
|
|
|
|
|
|
|
|
|
|
|
Six Years later |
| 49,604 |
|
| 51,064 |
|
| 55,236 |
|
| 53,115 |
|
| 64,483 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Seven Years later |
| 49,626 |
|
| 50,551 |
|
| 54,220 |
|
| 53,768 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Eight Years later |
| 48,873 |
|
| 49,706 |
|
| 54,839 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Years later |
| 48,563 |
|
| 49,720 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ten Years later |
| 48,558 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net cumulative (deficiency) redundancy |
| (6,381) |
|
| (14,249) |
|
| (17,246) |
|
| (20,021) |
|
| (29,453) |
|
| (34,291) |
|
| (2,107) |
|
| 20,603 |
|
| 28,255 |
|
| - |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Original Gross liability- end of year | $ | 66,434 |
| $ | 54,132 |
| $ | 64,335 |
| $ | 61,701 |
| $ | 54,186 |
| $ | 61,313 |
| $ | 69,445 |
| $ | 95,628 |
| $ | 110,089 |
| $ | 116,226 |
Less: Reinsurance recoverables - end of year |
| (24,257) |
|
| (18,661) |
|
| (26,742) |
|
| (27,954) |
|
| (19,156) |
|
| (19,082) |
|
| (13,096) |
|
| (29,695) |
|
| (29,000) |
|
| (30,190) |
Original Net liability - end of year | $ | 42,177 |
| $ | 35,471 |
| $ | 37,593 |
| $ | 33,747 |
| $ | 35,030 |
| $ | 42,231 |
| $ | 56,349 |
| $ | 65,933 |
| $ | 81,089 |
| $ | 86,036 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross re-estimated liability - latest | $ | 62,791 |
| $ | 61,091 |
| $ | 68,144 |
| $ | 62,032 |
| $ | 71,960 |
| $ | 84,837 |
| $ | 65,486 |
| $ | 50,162 |
| $ | 62,511 |
|
|
|
Re-estimated reinsurance recoverables-latest |
| (14,233) |
|
| (11,371) |
|
| (13,305) |
|
| (8,264) |
|
| (7,477) |
|
| (8,315) |
|
| (7,030) |
|
| (4,832) |
|
| (9,677) |
|
|
|
Net re-estimated liability - latest | $ | 48,558 |
| $ | 49,720 |
| $ | 54,839 |
| $ | 53,768 |
| $ | 64,483 |
| $ | 76,522 |
| $ | 58,456 |
| $ | 45,330 |
| $ | 52,834 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross cumulative (deficiency) redundancy | $ | 3,643 |
| $ | (6,959) |
| $ | (3,809) |
| $ | (331) |
| $ | (17,774) |
| $ | (23,524) |
| $ | 3,959 |
| $ | 45,466 |
| $ | 47,578 |
|
|
|
The above tables do 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 these tables.
Prior to our acquisition on April 1, 2007, API had been organized as a Texas reciprocal insurance exchange since its formation in 1975. A reciprocal insurance exchange is an entity, similar to a mutual insurance company, which sells insurance to its subscribers and other eligible healthcare providers, who may pay, at the election of the company, a contribution to the companys surplus, in addition to their annual premiums.
51
As noted in the pro forma table above, APIs net reserve estimates for the years 1998 through 2003 were significantly deficient. During this period, API, as well as the medical professional liability industry as a whole, saw increased frequency and claims severity trends on its claims outstanding. API began to address these concerns beginning in 2000 through 2003 with rate increases averaging 22% per year. API also employed stricter underwriting standards including exiting certain specialties, limiting coverage in geographical areas and reducing the policy limits options offered to insureds.
In 2003, Texas voters approved a constitutional amendment which gave the Texas Legislature authority to set limits on damages in medical malpractice and other lawsuits. This coincided with the passage of state legislation which became effective on September 1, 2003 and which places a cap on non-economic damages in medical malpractice cases.
Prior to the passage of Texas tort reform in 2003, API saw a significant increase in the number claims reported as claimants were attempting to beat the filing deadline prior to tort reform going into effect. This has resulted in significant adverse development from the originally reported net liability for 2003.
Beginning in 2004, we have seen favorable decreases in the number of claims reported each year as compared to historical reported claim development patterns.
While Texas tort reform has generally benefited API due to a lower number of reported claims and stable severity trends, it has increased our exposure to estimation risk and hence, greater estimation uncertainty in regards to loss reserves. Historically deficient trends in our loss reserves may not be indicative of future loss trends in a post-tort reform environment.
During 2006, 2007 and 2008, due to improved underwriting practices coupled with tort reform in Texas, API has recognized favorable development related to previously established reserves for accident years 2004 through 2007. Ultimately, as actual results have proven better than suggested historical trends, redundancies have developed, as evident from the favorable trend in our loss reserves from the originally reported net liability in 2005 and 2006.
The table below shows our recorded net reserves at December 31, 2008 and December 31, 2007, the actuarial point estimates and the high and low ends of the actuarial reserve range, as determined by our independent actuaries:
|
| Actual as of December 31, 2008 | ||||||||||
|
| Recorded Net Reserves |
| Actuarial Point Estimate |
| Low End of Actuarial Range |
| High End of Actuarial Range | ||||
| (in thousands) | |||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |
Total net reserves | $ | 78,257 |
| $ | 64,396 |
| $ | 50,016 |
| $ | 78,257 | |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Actual as of December 31, 2007 | ||||||||||
|
| Recorded Net Reserves |
| Actuarial Point Estimate |
| Low End of Actuarial Range |
| High End of Actuarial Range | ||||
|
| (in thousands) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
Total net reserves | $ | 81,513 |
| $ | 67,269 |
| $ | 47,640 |
| $ | 81,513 |
There are several limitations to interpreting reserve ranges. The reserve range represents a statistical distribution of possible outcomes and while from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate. There are also many macroeconomic effects that may impact the development of reserves such as, tort reforms, changes in the tort common law or the litigiousness of jurisdictions in which we issue policies, the influence of legislative actions and changes in political philosophy. As a result of these factors, as well as the many other quantitative and qualitative factors described herein, there can be no assurance that reserves will develop within these ranges.
52
We have modeled a statistical distribution along various confidence levels to calculate the potential variability inherent in our loss reserves and the corresponding impact on pre-tax income. Due to the correlation between reserving variables and how they can inter-relate to one another, it is neither practical nor meaningful to isolate and demonstrate the impact of changes in a particular assumption such as claims frequency or severity or other specific parameters such as the effect of tort reform in calculating the reserve estimate. However, a statistical distribution shows the impact if actual claims experience were to emerge more favorably or unfavorably from our recorded reserves at the 78% confidence level to the actuarial point estimate, or approximately 18% or more than our recorded reserves. In regards to trending downward to the actuarial point estimate, we believe this reflects a more likely than not scenario as the confidence level is approximately 50%, represents the mean of the distribution and is the most likely amount to be paid. In regards to trending 12% higher than recorded reserves, the confidence level rises to 90% and shows the wide dispersion of possible outcomes given the inherent uncertainty of loss reserves in the medical professional liability line of insurance in relation to other shorter tail lines of insurance. We believe this scenario is reasonably conceivable due to a significant liability event, such as an unexpected adverse court decision that impacts many open claims or multiple insureds or the occurrence of an unusually high number of liability losses in one reporting period. The following table shows the effects on pre-tax income if the recorded reserves as of December 31, 2008 develop under these scenarios:
|
| Increase | |
|
| (Decrease) in | |
|
| Pre-tax Income | |
|
| (in thousands) | |
Actuarial Point Estimate | $ | 13,862 | |
15% Higher than Recorded Reserves | $ | (9,681) |
Reinsurance Premiums Ceded. We enter into reinsurance agreements whereby other insurance entities agree to assume a portion of the risk associated with the policies issued by API. In return, we agree to pay a premium to the reinsurers. We utilize reinsurance to control exposure to potential losses arising from large risks, and to have additional capacity for growth. We remain responsible for the ultimate risk on its policies and would be responsible for losses and loss adjustment expenses should a reinsurer fail to pay its obligations. Reinsurance agreements are also subject to risk transfer analysis in order to be recognized as traditional reinsurance for GAAP or statutory accounting purposes. Risk transfer standards require that (a) the reinsurer assumes significant insurance risk (underwriting and timing risk) under the reinsured portions of the underlying insurance agreements; and (b) it is reasonably possible that the reinsurer may realize a significant loss from the transaction. Whether a reinsurance agreement involves risk transfer is determined by management, with assistance from our outside consulting actuaries, utilizing a comprehensive set of standards. We believe that all of our reinsurance agreements contain the appropriate risk transfer requirements.
Under APIs primary medical professional liability reinsurance contract or excess of loss treaty, certain premiums are ceded to other insurance companies under the terms of the reinsurance agreement. The excess of loss treaty provides coverage for losses in excess of APIs retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The 2006 reinsurance contract provides for these same terms with API retaining 10% of the risk above the aforementioned $250,000 and $350,000 retention levels. The 2007 reinsurance contract provides for the same terms with API retaining 20% of the risk above the $250,000 and $350,000 retention levels. The 2008 reinsurance contract provides for the same terms with API retaining 40% of the risk above the $250,000 and $350,000 retention levels. The reinsurance contracts for 2002 through 2008 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contracts are subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
53
To the extent that estimates for unpaid losses and loss adjustment expenses change, the amount of variable reinsurance premiums may also change. The ceded premium estimates are based upon managements estimates of ultimate losses and loss adjustment expenses and the portion of those losses and loss adjustment expenses that are allocable to reinsurers under the terms of the related reinsurance agreements. Given the uncertainty of the ultimate amounts of losses and loss adjustment expenses, these estimates may vary significantly from the ultimate outcome. In addition to the in-depth review of reserves for unpaid losses and loss adjustment expenses, on a semi-annual basis, API also has its outside consulting actuary review development in the reinsurance layer or excess of $250,000 retention for each open variable premium treaty year. Management reviews these estimates and any adjustments necessary are reflected in the period in which the change in estimate is determined. Adjustment to the premiums ceded could have a material effect on APIs results of operations for the period in which the change is made.
In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis give rise to a balance sheet asset classified as Other amounts receivable under reinsurance contracts or a balance sheet liability classified as Funds held under reinsurance treaties. Furthermore, each retrospective treaty requires a 24- or 36-month holding period before any premium adjustments or cash can be returned or paid. The ultimate settlement amount will not be determined until all losses have been settled under the respective treaties. As of December 31, 2008, we had recorded a balance sheet asset, Other amounts receivable under reinsurance contracts of $1,497,000 and a balance sheet liability, Funds held under reinsurance treaties of $3,978,000, which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2007 treaty years as compared to the amounts paid on a provisional basis.
The effect of reinsurance on premiums written and earned for the year ended December 31, 2008 is as follows (in thousands):
| Written |
| Earned | ||
Direct premiums | $ | 64,117 |
| $ | 62,538 |
Ceded: |
|
|
|
|
|
Current year |
| (5,259) |
|
| (5,259) |
Prior years |
| 6,802 |
|
| 6,802 |
Total Ceded |
| 1,543 |
|
| 1,543 |
|
|
|
|
|
|
Net premiums | $ | 65,660 |
| $ | 64,081 |
The effect of reinsurance on premiums written and earned since the acquisition of API on April 1, 2007 through December 31, 2007 is as follows (in thousands):
| Written |
| Earned | ||
Direct premiums | $ | 50,120 |
| $ | 51,226 |
Ceded: |
|
|
|
|
|
Current year |
| (6,075) |
|
| (6,075) |
Prior years |
| 10,888 |
|
| 10,888 |
Total Ceded |
| 4,813 |
|
| 4,813 |
|
|
|
|
|
|
Net premiums | $ | 54,933 |
| $ | 56,039 |
For the twelve months ended December 31, 2008, we recorded favorable development to ceded premiums of $6,802,000 primarily related to prior year variable premium reinsurance treaties as a result of lower estimated ultimate loss and loss adjustment expenses for treaty years 2002 through 2007. Since the acquisition of API on April 1, 2007, for the year ended December 31, 2007, we recorded favorable development to ceded premiums of $10,888,000 primarily related to prior year variable premium reinsurance treaties as a result of lower estimated ultimate loss and loss adjustment expenses for treaty years 2002 through 2006.
54
Reinsurance Recoverables. Ceded reserves for loss and loss adjustment expenses are recorded as reinsurance recoverables. Reinsurance recoverables are the estimated amount of future loss payments that will be recovered from reinsurers, and represent the portion of losses incurred during the period that are estimated to be allocable to reinsurers.
There are several factors that can directly affect the ability to accurately forecast the reinsurance recoverables. Many of the factors discussed above related to the sensitivities of forecasting total loss and loss adjustment expense reserves also apply when analyzing reinsurance recoverables. Since we cede excess losses above $250,000 on individual claims and $350,000 on multiple insured claims plus additional retention levels above those amounts, the trends related to severity significantly affect this estimate. Current individual claims severity can be above or fall below our retention level over the period it takes to resolve a claim.
Similar to the estimate for reserves, due to the long-tailed nature of the medical professional liability line of insurance, relatively small changes in the actuarial assumptions for trends, inflation, severity, frequency for projected ultimate loss and loss adjustment expense reserves can have a greater impact on the recorded balance for reinsurance recoverables than with most other property and casualty insurance lines. While API believes that its estimate for ultimate projected losses related to loss and loss adjustment expense is adequate based on reported and open claim counts, there can be no assurance that additional significant reserve enhancements 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. Reinsurance contracts do not relieve us from our obligations to policyholders.
Unsecured reinsurance recoverables at December 31, 2008, that exceeded 10% of total reinsurance paid and unpaid loss and loss adjustment expenses are summarized as follows (in thousands):
Company Name |
| December 31, 2008 | |
Swiss Reinsurance |
| $ | 5,246 |
Transatlantic Reinsurance |
| $ | 3,687 |
ACE Tempest Re USA |
| $ | 2,718 |
Hannover Ruckversicherrungs |
| $ | 1,626 |
As of December 31, 2008, ACE Tempest Re USA and Swiss Reinsurance (Swiss Re) are A.M. Best rated A+ (Superior). However, subsequent to year-end, A.M. Best down rated the financial strength rating of Swiss Re to A (Excellent) with a stable outlook based on its quantitative and qualitative assessment of risk capital that Swiss Re does not have sufficient cushion to weather more negative effects of the continuing turmoil in the financial markets and other unexpected events. As of December 31, 2008, Transatlantic Reinsurance (Transatlantic) and Hannover Ruckversicherrungs are A.M. Best rated A (Excellent), but Transatlantic Reinsurances financial strength rating was down-rated from A+ (Superior) to its current rating of A (Excellent) in September 2008. This rating action was based on the rapid deterioration of the financial condition of American International Group (AIG). Transatlantic is an independently publicly traded company (NYSE) and, while AIG owns 59% of Transatlantic, the Transatlantic board of directors is not controlled by AIG. To date, both Swiss Re and Transatlantic, as well as our other reinsurers, have continued to reimburse us for paid claims in a manner consistent with past practices.
We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer defaults. Any amount found to be uncollectible would be written off in the period in which the uncollectible amount is identified. We require letters of credit from any reinsurance company that does not meet certain regulatory requirements, and/or credit ratings. As of December 31, 2008, our reinsurance contracts were with companies in adequate financial condition, and we believe there is not a need to establish an allowance for uncollectible reinsurance recoverable. We have not experienced any material problems collecting from our reinsurers. However, the ultimate effects of the recent financial and market crisis and overall economic downturn may have negative consequences on the credit quality, liquidity and financial stability of the reinsurers with which we do business. As recent market experience indicates, such deteriorations in financial condition can occur rapidly, leaving us unable to react to such a scenario in a manner consistent with orderly markets. This in turn could adversely and negatively affect our financial condition and results of operations.
55
Death, Disability and Retirement Reserves. API has established a death, disability and retirement reserve for policyholders, which is intended to set aside a portion of the policy premium to account for the coverage provided for the extended reporting period or tail coverage offered by API upon the death and/or disability and/or retirement of a policyholder which is provided at no additional cost to the policyholder. The death, disability and retirement reserve is included in unearned premiums.
Stock-Based Compensation. On January 1, 2006, we adopted SFAS No. 123 (revised 2004), Share-Based Payment, (SFAS 123R), which requires the measurement and recognition of compensation expense for all stock-based compensation awards made to employees and directors, including employee stock options and employee stock purchase plans. The Securities and Exchange Commission also issued Staff Accounting Bulletin No. 107 (SAB 107) which provides interpretative guidance in applying the provisions of SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.
SFAS 123R requires companies to estimate the fair value of stock-based awards on the date of grant using an option-pricing model. The portion of the value that is ultimately expected to vest is recognized as expense over the requisite service period. As stock-based compensation expense recognized in our consolidated statements of income for fiscal years 2008, 2007 and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
In addition, SFAS 123R requires that the benefits of realized tax deductions in excess of tax benefits on compensation expense be reported as a component of cash flows from financing activities rather than as an operating cash flow, as previously required. In accordance with SAB 107, we classify stock-based compensation within general and administrative expenses to correspond with the financial statement components in which cash compensation paid to employees and directors is recorded.
Deferred Policy Acquisition Costs. The costs of acquiring and renewing insurance business that vary with and are directly related to the production of such business are deferred and amortized ratably over the period the related unearned premiums and maintenance fees are earned. Such costs include commissions, premium taxes and certain underwriting and policy issuance costs. Deferred acquisition costs are recorded net of ceding commissions. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed in the period the determination is made.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believe it is more likely than not our deferred tax assets will be fully recovered. In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 ("FIN 48"), which we adopted on January 1, 2007. FIN 48 clarifies the accounting for income tax uncertainties. We have developed and implemented a process based on the guidelines of FIN 48 to ensure that uncertain tax positions are identified, analyzed and properly reported in the companys financial statements in accordance with SFAS 109. Based on all known facts and circumstances and current tax law, we believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2008, is not material to our results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2008, if recognized, would not have a material effect on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.
56
Unaudited Pro Forma Condensed Consolidated Financial Information
We are providing the following unaudited pro forma condensed consolidated financial statements to present a picture of the results of operations of the combined company after giving effect to our acquisition of API, absent any operational or other changes, had APIs and our businesses been combined for the periods and at the dates indicated. The pro forma condensed consolidated statements of operations for the years ended December 31, 2007 and 2006 are presented as if the API acquisition occurred on January 1, 2006. The unaudited pro forma condensed consolidated financial statements were prepared using the purchase method of accounting.
The pro forma adjustments are based upon available information and assumptions that each companys management believes are reasonable. The unaudited pro forma condensed consolidated financial statements are presented for illustrative purposes only and are based on the estimates and assumptions set forth in the notes accompanying these statements, which should be read in conjunction with these unaudited pro forma condensed consolidated financial statements. The companies may have performed differently had they always been combined. You should not rely on this information as being indicative of the historical results that would have been achieved had the companies always been combined or the future results that the combined company will experience. The unaudited pro forma condensed consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition. The unaudited pro forma condensed consolidated financial statements and the related notes thereto should be read in conjunction with the audited consolidated financial statements of the Company for the years ended December 31, 2007 and 2006, and the related notes thereto and other information in the Managements Discussion and Analysis of Financial Condition and Results of Operations and the unaudited financial statements of API for the quarter ended March 31, 2007 filed in our Form S-1 dated, June 19, 2007.
57
Unaudited Pro Forma Condensed Combined Statement of Operations |
For the Year Ended December 31, 2007 |
(In thousands, except per share data) |
| APSG Historical 12/31/07 |
| API Historical 1/1/07 to 3/31/07 |
| Pro Forma Adjustments "Merger" |
| Combined Pro Forma 12/31/07 | ||||
REVENUES |
|
|
|
|
|
|
|
|
|
|
|
Premiums and maintenance fees written | $ | 50,120 |
| $ | 15,466 |
| $ |
|
| $ | 65,586 |
Premiums ceded |
| 4,813 |
|
| (2,407) |
|
|
|
|
| 2,406 |
Change in unearned premiums & maintenance fees |
| 1,106 |
|
| 3,252 |
|
|
|
|
| 4,358 |
Net Premiums and maintenance fees earned |
| 56,039 |
|
| 16,311 |
|
|
|
|
| 72,350 |
|
|
|
|
|
|
|
|
|
|
|
|
Investment income, net of investment expense |
| 8,693 |
|
| 1,791 |
|
| 78 | (a) |
| 10,505 |
|
|
|
|
|
|
|
| (80) | (d) |
|
|
|
|
|
|
|
|
|
| 23 | (b) |
|
|
Realized capital gains (losses), net |
| (5,256) |
|
| 126 |
|
|
|
|
| (5,130) |
Management services |
| 3,803 |
|
|
|
|
| (3,718) | (a) |
| 179 |
|
|
|
|
|
|
|
| 94 | (c) |
|
|
Financial services |
| 21,056 |
|
|
|
|
| (307) | (b) |
| 20,749 |
Other revenue |
| 68 |
|
|
|
|
|
|
|
| 68 |
|
|
|
|
|
|
|
|
|
|
|
|
Total revenues |
| 84,403 |
|
| 18,228 |
|
| (3,910) |
|
| 98,721 |
|
|
|
|
|
|
|
|
|
|
|
|
EXPENSES |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment expenses |
| 13,695 |
|
| 10,934 |
|
| (1,154) | (a) |
| 24,659 |
|
|
|
|
|
|
|
| 1,184 | (d) |
|
|
Other underwriting expenses |
| 8,320 |
|
| 3,215 |
|
| 1,570 | (d) |
| 11,635 |
|
|
|
|
|
|
|
| (1,564) | (a) |
|
|
|
|
|
|
|
|
|
| 94 | (c) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortization of deferred policy acquisition costs |
| (110) |
|
| 141 |
|
|
|
|
| 31 |
Management services expenses |
| 3,823 |
|
|
|
|
| (989) | (a) |
| - |
|
|
|
|
|
|
|
| (2,834) | (d) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Financial services expenses |
| 19,030 |
|
|
|
|
|
|
|
| 19,030 |
General and administrative |
| 5,459 |
|
|
|
|
| 102 | (e) |
| 5,561 |
|
|
|
|
|
|
|
|
|
|
|
|
Impairment of goodwill |
| 1,247 |
|
|
|
|
|
|
|
| 1,247 |
Total expenses |
| 51,464 |
|
| 14,290 |
|
| (3,591) |
|
| 62,163 |
|
|
|
|
|
|
|
|
|
|
| - |
Income from operations |
| 32,939 |
|
| 3,938 |
|
| (319) |
|
| 36,558 |
|
|
|
|
|
|
|
|
|
|
|
|
Income tax expense |
| 11,929 |
|
| 1,326 |
|
| (35) | (e) |
| 13,121 |
|
|
|
|
|
|
|
| (99) | (b) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Minority interests |
| 1 |
|
|
|
|
|
|
|
| 1 |
|
|
|
|
|
|
|
|
|
|
|
|
Net income before extraordinary gain | $ | 21,009 |
| $ | 2,612 |
| $ | (185) |
| $ | 23,436 |
|
|
|
|
|
|
|
|
|
|
|
|
Net Income before extraordinary gain per Share: |
|
|
|
|
|
|
|
|
|
|
|
Basic: | $ | 3.80 |
|
|
|
|
|
|
| $ | 4.24 |
Diluted: | $ | 3.69 |
|
|
|
|
|
|
| $ | 4.12 |
|
|
|
|
|
|
|
|
|
|
|
|
Basic weighted average shares outstanding |
| 5,532 |
|
|
|
|
|
|
|
| 5,532 |
Diluted weighted average shares outstanding |
| 5,695 |
|
|
|
|
|
|
|
| 5,695 |
58
Unaudited Pro Forma Condensed Combined Statement of Operations |
For the Year Ended December 31, 2006 |
(In thousands, except per share data) |
| APSG Historical 12/31/06 |
| API Historical 12/31/06 |
| Pro Forma Adjustments "Merger" |
| Combined Pro Forma 12/31/06 | ||||
REVENUES |
|
|
|
|
|
|
|
|
|
|
|
Premiums and maintenance fees written | $ | - |
| $ | 74,833 |
| $ |
|
| $ | 74,833 |
Premiums ceded |
| - |
|
| (4,709) |
|
|
|
|
| (4,709) |
Change in unearned premiums & maintenance fees |
| - |
|
| 735 |
|
|
|
|
| 735 |
Net Premiums and maintenance fees earned |
| - |
|
| 70,859 |
|
|
|
|
| 70,859 |
|
|
|
|
|
|
|
|
|
|
|
|
Investment income, net of investment expense |
| 915 |
|
| 6,466 |
|
| 236 | (a) |
| 7,605 |
|
|
|
|
|
|
|
| (158) | (d) |
|
|
|
|
|
|
|
|
|
| 146 | (b) |
|
|
Realized capital gains (losses), net |
| 155 |
|
| 6 |
|
|
|
|
| 161 |
Management services |
| 15,555 |
|
|
|
|
| (15,610) | (a) |
| 320 |
|
|
|
|
|
|
|
| 375 | (c) |
|
|
Financial services |
| 16,850 |
|
| - |
|
| (755) | (b) |
| 16,095 |
Other revenue |
| 89 |
|
| - |
|
|
|
|
| 89 |
|
|
|
|
|
|
|
|
|
|
|
|
Total revenues |
| 33,564 |
|
| 77,331 |
|
| (15,766) |
|
| 95,129 |
|
|
|
|
|
|
|
|
|
|
|
|
EXPENSES |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment expenses |
| - |
|
| 38,970 |
|
| (4,278) | (a) |
| 37,568 |
|
|
|
|
|
|
|
| 2,876 | (d) |
|
|
Other underwriting expenses |
| - |
|
| 14,252 |
|
| 3,582 | (d) |
| 11,759 |
|
|
|
|
|
|
|
| (6,450) | (a) |
|
|
|
|
|
|
|
|
|
| 375 | (c) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortization of deferred policy acquisition costs |
| - |
|
| (39) |
|
|
|
|
| (39) |
Management services expenses |
| 11,262 |
|
| - |
|
| (4,646) | (a) |
| - |
|
|
|
|
|
|
|
| (6,616) | (d) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Financial services expenses |
| 15,157 |
|
| - |
|
|
|
|
| 15,157 |
General and administrative |
| 2,106 |
|
| - |
|
| 408 | (e) |
| 2,514 |
|
|
|
|
|
|
|
|
|
|
|
|
Total expenses |
| 28,525 |
|
| 53,183 |
|
| (14,749) |
|
| 66,959 |
|
|
|
|
|
|
|
|
|
|
| - |
Income from operations |
| 5,039 |
|
| 24,148 |
|
| (1,017) |
|
| 28,170 |
|
|
|
|
|
|
|
|
|
|
|
|
Income tax expense |
| 1,839 |
|
| 8,397 |
|
| (139) | (e) |
| 9,890 |
|
|
|
|
|
|
|
| (207) | (b) |
|
|
Minority interests |
| 6 |
|
|
|
|
|
|
|
| 6 |
|
|
|
|
|
|
|
|
|
|
|
|
Net income | $ | 3,194 |
| $ | 15,751 |
| $ | (671) |
| $ | 18,274 |
|
|
|
|
|
|
|
|
|
|
|
|
Net Income per Share: |
|
|
|
|
|
|
|
|
|
|
|
Basic | $ | 1.15 |
|
|
|
|
|
|
| $ | 3.84 |
Diluted | $ | 1.09 |
|
|
|
|
|
|
| $ | 3.72 |
|
|
|
|
|
|
|
|
|
|
|
|
Basic weighted average shares outstanding |
| 2,774 |
|
|
|
|
| 1,983 |
|
| 4,757 |
Diluted weighted average shares outstanding |
| 2,933 |
|
|
|
|
| 1,983 |
|
| 4,916 |
59
Notes to Unaudited Pro Forma Condensed
Consolidated Financial Statements for the years ended December 31, 2007 and December 31, 2006
1. Basis of Presentation
The accompanying unaudited pro forma statements of operations present the pro forma effects of our acquisition of API through the issuance of common and preferred shares of our stock. The statements of operations for the years ended December 31, 2007 and 2006 are presented as though the acquisition occurred on January 1, 2006.
2. Method of Accounting for the Acquisition
We accounted for the acquisition using the purchase method of accounting for business combinations. We were deemed to be the acquirer for accounting purposes based on a number of factors determined in accordance with GAAP. The purchase method of accounting requires that APIs assets acquired and liabilities assumed by us be recorded at their estimated fair values.
3. Adjustments to Historical Financial Statements for Comparability
Following the acquisition, we are primarily an insurance company and, accordingly, we have reclassified our statements of operations in the unaudited pro forma financial information to conform to GAAP as applied to insurance companies.
4. Pro Forma Adjustments Related to the Acquisition
Pursuant to our acquisition of API, API became a wholly owned subsidiary of the Company.
At the effective time of the acquisition, April 1, 2007, each share of common stock of API was converted into, and exchanged for, the right to receive the number of shares of our common stock based upon an exchange ratio equal to a purchase price of $39 million minus the $9,179,000 agreed-upon present value of the payments authorized by the Texas Department of Insurance that must be made by us to comply with the mandatory redemption features of the API Series A redeemable preferred stock in exchange for the API refundable deposit certificates, divided by $17.28, divided by the 10,000,000 shares of API common stock. The $17.28 price was the average closing price of our common shares for the twenty trading days immediately preceding the closing. According to the terms of the merger agreement for the acquisition, the value of our common stock issued in the acquisition was subject to adjustment upwards or downwards by up to 15% based on the closing price of our common shares for the twenty trading days immediately preceding the effective date of the acquisition.
Each share of Series A redeemable preferred stock of API was converted into the right to receive one share of our Series A redeemable preferred stock. The shares of our common stock and Series A redeemable preferred stock issued in the acquisition are subject to a 180-day lock-up period in which the holders of such shares are prohibited from transferring their shares. This lock-up period expired on September 28, 2007.
The purchase accounting and pro forma adjustments related to the unaudited pro forma statements of operations as a result of the acquisition are as follows:
(a)
Records the elimination of the revenue component of management fee and sub-producer commissions by the Company, the management fee expense by API and the sub-producer expenses by the Company for the three months ended March 31, 2007 and the year ended December 31, 2006.
(b)
Records the elimination of intercompany revenue by APS Investment Services for investment trading fees for managing APIs fixed income investment portfolio and records related other comprehensive income at API, change in amortization of bond premium and tax expense for the three months ended March 31, 2007 and the year ended December 31, 2006.
60
(c)
Records commissions expense incurred by API that is currently reimbursed by the Company. There is no reimbursement following the acquisition. The reimbursement was eliminated in our financial statements.
(d)
Reclassifies the salaries, marketing, professional fees and general administrative expenses of the attorney-in-fact supporting the functional areas of claims, underwriting and investments.
(e) Records the 3% per annum dividend on our Series A redeemable preferred stock and the imputed interest from recording the liability at fair value.
RESULTS OF OPERATIONS
Overview
With the acquisition of API on April 1, 2007, our consolidated revenue and earnings will be predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on APIs earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of APIs earned premiums. In addition, any pre-tax profits of API were shared equally with us so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, the management agreement was terminated and our consolidated results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
Despite continued lower premiums in our Insurance Services segment in 2008, improvements in the terms on our reinsurance contracts coupled with favorable reserve development allowed us to deliver strong results from our operations from this operating segment. As a result of favorable development in both claim counts and claim severity post-tort reform and increased competition, we lowered our rates on average approximately 6% in 2008. We have seen an increase in competition by both existing professional liability carriers as well as new entrants into the marketplace. As a result of this increased competition, we continue to be faced with price pressure on both existing renewals and new business. Many of the new entrants have been aggressive in seeking new business and are willing to compete on price. We will continue to monitor frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted. As a result of these market forces, we will face increased competition throughout 2009, but will continue to price insurance products at rates believed to be adequate for the risks assumed.
Our Financial Services segment suffered its first net operating loss since 1996 as a result of the 2008 collapse of the investment, mortgage and banking markets. This segment experienced significant declines in commission revenue from security trading in both investment grade and non-investment grade securities, along with similar revenue percentage declines in our investment banking and bank debt trade claim businesses. Though the size of monthly losses eased in the final months of the year as a result of continued efforts to cut costs, it is apparent that a return to profitability for this segment will be dependent to a great extent upon the recovery of the U.S. economy as a whole and the investment markets in particular
61
The following table sets forth selected historical financial and operating data. Our results of operations for the year ended December 31, 2007 include the historical financial and operating results prior to and subsequent to the acquisition of API on April 1, 2007. The selected historical financial and operating data is derived from our consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All information is presented in accordance with GAAP, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of SFAS No. 123(R). Actual financial results through December 31, 2008 may not be indicative of future financial performance. Equity compensation expense of approximately $1,200,000 related to our acquisition of API is included in the year ended December 31, 2007 results from operations.
For comparative purposes, we have also included the results of operations for the year ended December 31, 2007 and 2006 on a pro forma basis since we did not acquire API until April 1, 2007. This information is provided to highlight the results of operations prior to our acquisition of API and any reference in this Item 7 below to pro forma reflects the impact to us had we acquired API as of January 1 of the year indicated.
Selected Condensed Consolidated Historical and Proforma Financial and
Operating Data of American Physicians Service Group, Inc.
| Year ended December 31, | |||||||||||||
| 2008 |
| 2007 |
| 2007 |
| 2006 |
| 2006 | |||||
| Actual |
| Actual |
| Pro forma |
| Actual |
| Pro forma | |||||
Income Statement Data: |
|
|
|
|
|
|
|
|
| |||||
Gross premiums and maintenance fees written direct and assumed | $ | 64,117 |
| $ | 50,120 |
| $ | 65,586 |
| $ | - |
| $ | 74,833 |
Premiums ceded |
| 1,543 |
|
| 4,813 |
|
| 2,406 |
|
| - |
|
| (4,709) |
Net premiums and maintenance fees written |
| 65,660 |
|
| 54,933 |
|
| 67,992 |
|
| - |
|
| 70,124 |
Net premiums and maintenance fees earned |
| 64,081 |
|
| 56,039 |
|
| 72,350 |
|
| - |
|
| 70,859 |
Investment income, net of investment expenses |
| 11,999 |
|
| 8,693 |
|
| 10,505 |
|
| 915 |
|
| 7,605 |
Realized capital gains (losses) - net |
| (7,749) |
|
| (5,256) |
|
| (5,130) |
|
| 155 |
|
| 161 |
Management services |
| 88 |
|
| 3,803 |
|
| 179 |
|
| 15,555 |
|
| 320 |
Financial services |
| 6,193 |
|
| 21,056 |
|
| 20,749 |
|
| 16,850 |
|
| 16,095 |
Other revenue |
| 137 |
|
| 68 |
|
| 68 |
|
| 89 |
|
| 89 |
Total revenues |
| 74,749 |
|
| 84,403 |
|
| 98,721 |
|
| 33,564 |
|
| 95,129 |
Losses and loss adjustment expenses |
| 18,569 |
|
| 13,695 |
|
| 24,659 |
|
| - |
|
| 37,568 |
Other underwriting expenses |
| 11,074 |
|
| 8,320 |
|
| 11,635 |
|
| - |
|
| 11,759 |
Change in deferred acquisition costs |
| 14 |
|
| (110) |
|
| 31 |
|
| - |
|
| (39) |
Management services expenses |
| - |
|
| 3,823 |
|
| - |
|
| 11,262 |
|
| - |
Financial services expenses |
| 9,749 |
|
| 19,030 |
|
| 19,030 |
|
| 15,157 |
|
| 15,157 |
General and administrative expenses |
| 5,752 |
|
| 5,459 |
|
| 5,561 |
|
| 2,106 |
|
| 2,514 |
Impairment of goodwill |
| - |
|
| 1,247 |
|
| 1,247 |
|
| - |
|
| - |
Total expenses |
| 45,158 |
|
| 51,464 |
|
| 62,163 |
|
| 28,525 |
|
| 66,959 |
Income from operation |
| 29,591 |
|
| 32,939 |
|
| 36,558 |
|
| 5,039 |
|
| 28,170 |
Income tax expense |
| 10,428 |
|
| 11,929 |
|
| 13,121 |
|
| 1,839 |
|
| 9,890 |
Minority Interests |
| - |
|
| 1 |
|
| 1 |
|
| 6 |
|
| 6 |
Net income before extraordinary gain |
| 19,163 |
|
| 21,009 |
|
| 23,436 |
|
| 3,194 |
|
| 18,274 |
Extraordinary gain, net of tax |
| - |
|
| 2,264 |
|
| - |
|
| - |
|
| - |
Net income | $ | 19,163 |
| $ | 23,273 |
| $ | 23,436 |
| $ | 3,194 |
| $ | 18,274 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted weighted average shares outstanding |
| 7,248 |
|
| 5,695 |
|
| 5,695 |
|
| 2,933 |
|
| 4,916 |
Earnings per common share | $ | 2.64 |
| $ | 4.09 |
| $ | 4.12 |
| $ | 1.09 |
| $ | 3.72 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Underwriting Ratios |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio (1) (4) (5) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accident year |
| 61% |
|
| 53% |
|
| 56% |
|
| N/A |
|
| 61% |
Prior years |
| -32% |
|
| -29% |
|
| -22% |
|
| N/A |
|
| -7% |
Calendar year |
| 29% |
|
| 24% |
|
| 34% |
|
| N/A |
|
| 54% |
Expense ratio (2) (4) (5) |
| 17% |
|
| 15% |
|
| 16% |
|
| N/A |
|
| 17% |
Combined ratio (3) (4) (5) |
| 46% |
|
| 39% |
|
| 50% |
|
| N/A |
|
| 71% |
(1) Loss ratio is defined as the ratio of losses and loss adjustment expenses to net premiums and maintenance fees earned.
(2) Expense ratio is defined as the ratio of other underwriting expenses and net change in deferred acquisition costs to net premiums and maintenance fees earned
(3) Combined ratio is the sum of the loss ratio and the expense ratio.
(4) Ratios for the 2007 actual results reflect the results of operations for API from April 1, 2007 (the date of acquisition).
(5) Ratios for the 2006 actual results are not applicable as the acquisition of API occurred in 2007.
62
| Year ended December 31, | ||||
(in thousands) | 2008 |
| 2007 | ||
| Actual |
| Actual | ||
Balance Sheet Data: |
|
|
|
|
|
Cash and cash equivalents and investments | $ | 231,769 |
| $ | 223,193 |
Premiums and maintenance fees receivable |
| 17,186 |
|
| 15,946 |
Reinsurance recoverables |
| 15,293 |
|
| 24,554 |
All other assets |
| 19,306 |
|
| 19,105 |
Total Assets | $ | 283,554 |
| $ | 282,798 |
|
|
|
|
|
|
Reserve for losses and loss adjustment expenses |
| 92,141 |
|
| 101,606 |
Unearned premiums and maintenance fees |
| 36,785 |
|
| 35,417 |
Manditorily redeemable preferred stock |
| 7,568 |
|
| 8,554 |
All other liabilities |
| 10,595 |
|
| 13,241 |
Total Liabilities |
| 147,089 |
|
| 158,818 |
Total stockholders' equity |
| 136,465 |
|
| 123,980 |
Total Liabilities & Stockholders' Equity | $ | 283,554 |
| $ | 282,798 |
2008 Compared to 2007
Actual
Condensed income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands except per share data) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Revenues | $ | 74,749 |
| $ | 84,403 |
| $ | (9,654) |
| -11% |
Income from Operations |
| 29,591 |
|
| 32,939 |
|
| (3,348) |
| -10% |
Net Income |
| 19,163 |
|
| 23,273 |
|
| (4,110) |
| -18% |
Diluted Net Income Per Share | $ | 2.64 |
| $ | 4.09 |
| $ | (1.45) |
| -35% |
Pro forma
Condensed actual income statement data for the year ended December 31, 2008 and condensed pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands except per share data) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Revenues | $ | 74,749 |
| $ | 98,721 |
| $ | (23,972) |
| -24% |
Income from Operations |
| 29,591 |
|
| 36,558 |
|
| (6,967) |
| -19% |
Net Income |
| 19,163 |
|
| 23,436 |
|
| (4,273) |
| -18% |
Diluted Net Income Per Share | $ | 2.64 |
| $ | 4.12 |
| $ | (1.48) |
| -36% |
Further explanation for the year-to-year variances are described below throughout the remainder of Item 7 of this Form 10-K.
63
Premium related income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Gross premiums and maintenance fees written direct and assumed | $ | 64,117 |
| $ | 50,120 |
| $ | 13,997 |
| 28% |
|
|
|
|
|
|
|
|
|
|
|
Premium ceded: |
|
|
|
|
|
|
|
|
|
|
Current year |
| (5,259) |
|
| (6,075) |
|
| 816 |
| -13% |
Prior year |
| 6,802 |
|
| 10,888 |
|
| (4,086) |
| -38% |
Net premiums ceded |
| 1,543 |
|
| 4,813 |
|
| (3,270) |
| -68% |
Net premiums and maintenance fees earned | $ | 64,081 |
| $ | 56,039 |
| $ | 8,042 |
| 14% |
Premium related income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Gross premiums and maintenance fees written direct and assumed | $ | 64,117 |
| $ | 65,586 |
| $ | (1,469) |
| -2% |
|
|
|
|
|
|
|
|
|
|
|
Premium ceded: |
|
|
|
|
|
|
|
|
|
|
Current year |
| (5,259) |
|
| (8,482) |
|
| 3,223 |
| -38% |
Prior year |
| 6,802 |
|
| 10,888 |
|
| (4,086) |
| -38% |
Net premiums ceded |
| 1,543 |
|
| 2,406 |
|
| (863) |
| -36% |
Net premiums and maintenance fees earned | $ | 64,081 |
| $ | 72,350 |
| $ | (8,269) |
| -11% |
Gross premiums and maintenance fees written
Actual
Gross premiums and maintenance fees written increased $13,997,000 (28%) from $50,120,000 to $64,117,000 for year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
Pro forma
On a pro forma basis, gross premiums and maintenance fees written decreased $1,469,000 (2%) from $65,586,000 for the year ended December 31, 2007 to $64,117,000 for the year ended December 31, 2008. While API increased in the number of policyholders to approximately 5,330 at December 31, 2008 from 4,930 at December 31, 2007, gross premiums and maintenance fees written decreased due to rate decreases which averaged 6% for the year ended December 31, 2008 as compared to average rate decreases of 14% for 2007. We continue to experience growth in the number of policyholders; however, premium growth has decreased in 2008 as compared to 2007 as a result of pricing decreases.
Premiums Ceded
Actual
Premiums ceded expenses increased $3,270,000 (68%) from $4,813,000 to $1,543,000 for the year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
64
Pro forma
On a pro forma basis, premiums ceded expenses increased $863,000 from $2,406,000 to $1,543,000 for the year ending December 31, 2007 as compared to the same period in 2008. The reinsurance contracts beginning in 2002 through 2008 are variable premium treaties that have various minimum and maximum rates. The actual premium rate will depend upon the ultimate losses ceded to the reinsurer under the related treaty. We, supported periodically by outside consulting actuarial reviews, continually monitor the development of claims subject to reinsurance and adjust premiums ceded for estimated profit sharing provisions based on claims development in the reinsurance layers. The pro forma increase in premiums ceded of $863,000 is primarily the result of recognizing $6,802,000 of favorable prior reinsurance development for prior years reinsurance treaties during the year ended December 31, 2008 as compared to recognizing $10,888,000 of favorable development during the year ended December 31, 2007. The $4,086,000 variance in favorable development on prior year reinsurance treaties year over year was offset by lower 2008 accident year ceded premiums of $5,259,000 as compared to $8,482,000 for 2007 accident year ceded premiums. The lower ceded premiums for the 2008 accident year is primarily due to the Company retaining 40% of any claim in excess of $250,000 on individual claims and $350,000 on multiple insured claims for the 2008 reinsurance treaty. We retained only 20% of any excess on the 2007 treaty. We are retaining this additional risk in the reinsurance layer in order to lower our ceding costs based on decreases in claims and coverage limits since the passage of tort reform legislation in Texas in 2003. In addition, ceded premiums are lower for the current period due to lower earned premiums in 2008 as compared to 2007.
Net Premiums and Maintenance Fees Earned
Actual
Net premiums and maintenance fees earned increased to $64,081,000 from $56,039,000 for the year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
Pro forma
On a pro forma basis, net premiums and maintenance fees earned decreased by $8,269,000 (11%) to $64,081,000 from $72,350,000 for the year ended December 31, 2008 as compared to the same period in 2007. Written premiums and maintenance fees were down $1,469,000 year over year primarily due to rate decreases and we recognized $4,086,000 less in favorable development for the prior years reinsurance treaties during 2008 as compared to 2007.
65
Investment Income
Actual
Investment income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Investment income: |
|
|
|
|
|
|
|
|
|
|
Fixed Maturities | $ | 11,164 |
| $ | 7,850 |
| $ | 3,314 |
| 42% |
Equity Securities |
| 320 |
|
| 132 |
|
| 188 |
| 142% |
Short-term investments and other |
| 568 |
|
| 759 |
|
| (191) |
| -25% |
Finance charges on premiums receivable |
| 142 |
|
| 95 |
|
| 47 |
| 49% |
Structured annuity |
| 77 |
|
| 62 |
|
| 15 |
| 24% |
|
|
|
|
|
|
|
|
|
|
|
Total investment income | $ | 12,271 |
| $ | 8,898 |
| $ | 3,373 |
| 38% |
|
|
|
|
|
|
|
|
|
|
|
Investment expense |
| 272 |
|
| 205 |
|
| 67 |
| 33% |
|
|
|
|
|
|
|
|
|
|
|
Net investment income | $ | 11,999 |
| $ | 8,693 |
| $ | 3,306 |
| 38% |
Investment income, net of investment expenses increased by $3,306,000 (38%) to $11,999,000 from $8,693,000 for the year ended December 31, 2008 as compared to 2007 as a result of recording the benefit of investment income for a full twelve months on a substantially larger invested asset base in 2008 compared to only nine months in 2007 as the acquisition of API took place effective April 1, 2007 resulting in a much larger investment portfolio. In addition, cash received from 2008 operations increased the portfolio balance and consequently, increased investment income.
Pro forma
Investment income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Investment income: |
|
|
|
|
|
|
|
|
|
|
Fixed Maturities | $ | 11,164 |
| $ | 9,581 |
| $ | 1,583 |
| 17% |
Equity Securities |
| 320 |
|
| 158 |
|
| 162 |
| 103% |
Short-term investments and other |
| 568 |
|
| 842 |
|
| (274) |
| -33% |
Finance charges on premiums receivable |
| 142 |
|
| 132 |
|
| 10 |
| 8% |
Structured annuity |
| 77 |
|
| 85 |
|
| (8) |
| -9% |
|
|
|
|
|
|
|
|
|
|
|
Total investment income | $ | 12,271 |
| $ | 10,798 |
| $ | 1,473 |
| 14% |
|
|
|
|
|
|
|
|
|
|
|
Investment expense |
| 272 |
|
| 293 |
|
| (21) |
| -7% |
|
|
|
|
|
|
|
|
|
|
|
Net investment income | $ | 11,999 |
| $ | 10,505 |
| $ | 1,494 |
| 14% |
On a pro forma basis, investment income, net of investment expenses, increased by $1,494,000 (14%) to $11,999,000 from $10,505,000 for the year ended December 31, 2008 as compared to the same period for 2007. Cash and invested assets increased by $8,576,000 (4%) to $231,769,000 at December 31, 2008 from $223,193,000 at December 31, 2007 resulting in the increase in investment income. The increase in invested assets resulted primarily from positive net cash flow from operating activities. Partially offsetting these increases were lower rates earned on investments during the current period.
66
Realized Capital Gains (Loss)
Actual
Realized capital gains and losses income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Realized capital gains (losses) - net |
|
|
|
|
|
|
|
|
|
|
Net realized gains | $ | 1,354 |
| $ | 384 |
| $ | 970 |
| 253% |
Net realized (losses) |
| (1,987) |
|
| (392) |
|
| (1,595) |
| 407% |
Other -than-temporary impairment (losses) |
| (7,116) |
|
| (5,248) |
|
| (1,868) |
| 36% |
Net realized gains (losses) | $ | (7,749) |
| $ | (5,256) |
| $ | (2,493) |
| 47% |
Realized capital losses were $7,749,000 for the year ended December 31, 2008 as compared to a $5,256,000 for the year ended December 31, 2007 primarily as a result of other than temporary impairment losses incurred in our investment in Alt-A collateralized mortgage-backed securities of $5,819,000 in 2008 as compared to $4,566,000 in 2007, resulting from fair market value declines. In addition, we incurred additional other than temporary charges in 2008 on two other non-agency CMO securities in the amount of $1,070,000 for CMO securities as noted above and realized losses due to the selective sale of equity and fixed income securities of $1,679,000 to offset prior year capital gain carry forwards.
Of our entire invested assets, including unrestricted cash,
·
36% is comprised of agency-backed mortgage obligations, with underlying collateral consisting of GNMA, FHLMC, or FNMA loans;
·
11% is comprised of non-agency collateralized mortgage obligations (non-agency CMO's);
·
38% is comprised of U.S. Treasury, government agency bonds and notes, municipal tax exempt bonds and corporate bonds; and,
·
15% is comprised of cash, equities and other invested assets.
The majority of the non-agency CMOs in our portfolio have underlying mortgages categorized as Prime quality loans, and none of our CMOs have underlying mortgages classified as Subprime. Also, all CMOs have underlying mortgages with fixed rates. However, within our portfolio at December 31, 2008, there were seven CMO securities classified as Alternative-A or Alt-A. These Alt-A securities are generally considered to have underlying mortgages with underwriting characteristics that are stronger than Subprime mortgages but less stringent than Prime mortgages. All but one of our Alt-A securities are investment grade, have underlying fixed rate mortgage collateral and as of December 31, 2008 are rated either AA or A. The Alt-A security that is non-investment grade has a book value at December 31, 2008 of $27,000.
67
Beginning with the three months ended September 30, 2007, we saw a significant and rapid decline in the market value of our Alt-A securities. In evaluating this decline, we considered the deepening national housing crisis and its potential effects on the underlying collateral and concluded that the decreases in value of our Alt-A securities should be considered to be other than temporary as defined in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Prior to the three months ended December 31, 2008, we had previously determined that all but one of the Alt-A securities was other-than-temporarily impaired. As a result of the continued deterioration in the credit, housing and mortgage market and the erosion in the underlying collateral support for the Alt-A securities, we recorded additional write-downs of $1,220,000 for the three months ended December 31, 2008 primarily due to the remaining AA-rated security that had previously not been deemed other-than-temporarily impaired in prior quarters. The amount of the pretax charge to earnings associated with write-downs of our Alt-A securities for the twelve months ended December 31, 2008 and December 31, 2007 was $5,819,000 and $4,566,000, respectively. The aggregate write-down on Alt-A securities since the quarter ended September 30, 2007 is $10,385,000. While we have the ability to hold all of our Alt-A securities indefinitely, we continue to closely monitor and evaluate these securities and their underlying collateral.
The following table reflects the composition of our Alt-A securities as of December 31, 2008 after the other than temporary impairments (dollars in thousands):
Rating Category |
| Book Value |
| Fair Value |
| % of Portfolio (Fair Value) | ||
AA |
| $ | 1,654 |
| $ | 1,667 |
| 0.7% |
A |
| $ | 1,287 |
| $ | 1,320 |
| 0.6% |
C |
| $ | 27 |
| $ | 27 |
| 0.0% |
Total |
| $ | 2,968 |
| $ | 3,014 |
| 1.3% |
We also began to observe an increase in the market-reported delinquency rates for not only our Alt-A CMOs, but also our non-agency CMOs backed by prime loans. The delinquency data suggests that continuing home price declines and growth in unemployment are now affecting the behavior by a broader sector of mortgage borrowers, particularly those mortgages with vintage years subsequent to 2005. Rising unemployment, accelerating house price declines, tight credit conditions, volatility in interest rates and weakening consumer confidence not only contributed to rising delinquencies, but also significantly impacted our expectations regarding future performance, both of which are critical to assessing our other-than-temporary impairments. As a result of these factors and a significant decline in market value and the down-rating by outside rating agencies to below investment grade, we recorded write-downs during the three months ended December 31, 2008, on two other non-agency CMO securities in the amount of $1,070,000. We cannot be reasonably assured that the credit support will not continue to weaken for our non-agency CMOs including our Alt-A securities, particularly in light of the current economic forecasts regarding unemployment, further deterioration of the housing and mortgage markets and continued declines in the value of the collateral underlying these mortgages. While we have the ability to hold all of these securities indefinitely, we continue to closely monitor and evaluate these securities and their underlying collateral. Furthermore, we will continue to consider opportunities to reduce our position in non-agency CMOs including Alt-A securities if we determine that it prudently reduces our exposure to further declines that may be considered other-than-temporary.
In 2003, we acquired 385,000 shares of common stock of Financial Industries Corporation (FIC). The total purchase price was approximately $5,647,000. Our policy in regards to our investment in FIC had been that we would record pretax charges to earnings should the common stock price on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. From 2004 through 2007, we wrote down the carrying value of the FIC stock by $3,414,000. In 2008, FIC was acquired. The basis in our investment in FIC common stock at the closing of the merger was $5.80 per share and based on the sale price of $7.25 per share, we recognized a $558,000 realized gain in the third quarter of 2008.
68
Pro forma
Realized capital gains and losses income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Realized capital gains (losses) - net |
|
|
|
|
|
|
|
|
|
|
Net realized gains | $ | 1,354 |
| $ | 513 |
| $ | 841 |
| 164% |
Net realized (losses) |
| (1,987) |
|
| (395) |
|
| (1,592) |
| 403% |
Other -than-temporary impairment (losses) |
| (7,116) |
|
| (5,248) |
|
| (1,868) |
| 36% |
Net realized gains (losses) | $ | (7,749) |
| $ | (5,130) |
| $ | (2,619) |
| 51% |
On a pro forma basis, realized capital losses were $7,749,000 for the year ended December 31, 2008 compared to a loss of $5,130,000 for the year ended December 31, 2007. The increase in losses for the current year is primarily due to larger other than temporary impairment charges in our investment in Alt-A collateralized mortgage-backed securities of $5,819,000 in 2008 as compared to $4,566,000 in 2007, resulting from fair market value declines. In addition, we incurred additional other than temporary charges in 2008 on two other non-agency CMO securities in the amount of $1,070,000 for CMO securities as noted above.
Management Services Revenue
Actual
Prior to the acquisition of API, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations. In conjunction with the merger with API on April 1, 2007, our management agreement was terminated as of March 31, 2007 and as such is no longer included in our consolidated results of operations though management fee revenue, including the contingent management fee, were recorded through the quarter ended March 31, 2007. Consequently, management services revenue decreased by $3,715,000 to $88,000 from $3,803,000 for the year ended December 31, 2008 compared to 2007.
Financial Services Revenues
Actual
Financial services revenue for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Broker/Dealer Commissions | $ | 5,124 |
| $ | 15,655 |
| $ | (10,531) |
| -67% |
Investment Banking Fees |
| 175 |
|
| 2,506 |
|
| (2,331) |
| -93% |
Bank Debt Trade Claim Fees |
| 740 |
|
| 3,045 |
|
| (2,305) |
| -76% |
Management Fees and Other |
| 154 |
|
| (150) |
|
| 304 |
| -203% |
Total Financial Services Revenues | $ | 6,193 |
| $ | 21,056 |
| $ | (14,863) |
| -71% |
69
Our Financial Services revenue decreased $14,863,000 (71%) for the year ended December 31, 2008 compared to 2007. APS Financial, our broker/dealer, derives most of its revenue from transactions in the fixed income market, in both investment and non-investment grade securities. As the table above shows, commission revenue at APS Financial was down 10,531,000 (67%) for the year ended December 31, 2008 compared to 2007 due to a continuing trend of very low transaction activity seen throughout the year. Among the factors affecting transaction activity include the well-publicized issues in the mortgage lending and financial markets with the anticipation of the continuation of these factors. This, along with widespread uncertainty as to the length and severity of the current economic recession, has led to the inclination of many of our investors to remain inactive. The same general market conditions affected the revenues derived from our investment banking and the bank debt/trade claims business. Decreases in investment banking revenues totaled $2,331,000 (93%) while bank debt-trade claim revenues were off $2,305,000 (76%) for the year ended December 31 2008 compared to 2007 due again to difficult credit market conditions. While our Financial Services business constitutes a much less significant portion of our consolidated results of operation since the acquisition of API, we are actively exploring avenues to return this segment to profitability. Cost cutting measures have been implemented which included reduction of personnel, compensation reductions and information services. However, a return to profitability for this segment will also depend, to a large extent, on improved market conditions and a corresponding increase in revenues. We cannot predict when this could occur.
Loss and Loss Adjustment Expenses
Actual
Loss and loss adjustment expenses for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Losses and loss adjustment expenses: |
|
|
|
|
|
|
|
|
|
|
Accident year | $ | 39,134 |
| $ | 29,751 |
| $ | 9,383 |
| 32% |
Prior years |
| (20,565) |
|
| (16,056) |
|
| (4,509) |
| 28% |
Calendar year | $ | 18,569 |
| $ | 13,695 |
| $ | 4,874 |
| 36% |
Loss and loss adjustment expenses increased $ 4,874,000 (36%) to $18,569,000 from $13,695,000 for the year ended December 31, 2008 compared to 2007 primarily as a result of the acquisition of API on April 1, 2007.
Pro forma
Loss and loss adjustment expenses for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Losses and loss adjustment expenses: |
|
|
|
|
|
|
|
|
|
|
Accident year | $ | 39,134 |
| $ | 40,682 |
| $ | (1,548) |
| -4% |
Prior years |
| (20,565) |
|
| (16,023) |
|
| (4,542) |
| 28% |
Calendar year | $ | 18,569 |
| $ | 24,659 |
| $ | (6,090) |
| -25% |
70
On a pro forma basis, loss and loss adjustment expenses for the year ended December 31, 2008 decreased by $6,090,000 (25%) to $18,569,000 from $24,659,000 for the year ended December 31, 2007. The decrease of $6,090,000 on a pro forma basis is the result of a lower accident year loss and loss adjustment expense and higher favorable development on prior year losses in 2008 as compared to 2007. For the year ended December 31, 2008, current accident year loss and loss adjustment expenses totaled $39,134,000 based on 371 claims reported and prior year losses developed favorably $20,565,000 as a result of reductions in our estimates of claims severity, principally the 2003 through 2007 report years. For the year ended December 31, 2006, current accident year loss and loss adjustment expenses were $40,682,000 based on 402 claims reported and there was $16,023,000 of favorable development on prior years. The positive effects of 2003 tort reform in Texas on average claim severity has resulted in continued favorable development of reserves and improved claim development patterns. API has favorably settled a number of post-tort reform claims from the 2004 and 2005 report years at below the reserved amounts. However, even though reported claims have decreased by 31 claims year over year, we continue to accrue our current accident year losses conservatively based on increases in policyholder count from 4,930 as of December 31, 2007 to 5,330 as of December 31, 2008.
We continually review and update the data underlying the estimation of the loss and loss adjustment expense reserves and make adjustments that we believe the emerging data warrant. Any adjustments to reserves that are considered necessary are reflected in the results of operations in the period the estimates are changed. As of December 31, 2008, we continue to reserve at the top of the actuarially determined reserve range.
Other Underwriting Expenses and Net Change in Deferred Acquisition Costs
Actual
Other underwriting expenses and net change in deferred acquisition costs for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Other underwriting expenses | $ | 11,074 |
| $ | 8,320 |
| $ | 2,754 |
| 33% |
|
|
|
|
|
|
|
|
|
|
|
Net change in deferred acquisition costs |
| 14 |
|
| (110) |
|
| 124 |
| -113% |
Total | $ | 11,088 |
| $ | 8,210 |
| $ | 2,878 |
| 35% |
Other underwriting expenses and the net change in deferred acquisition costs increased $2,878,000 (35%) to 11,088,000 from $8,210,000 for the year ended December 31, 2008 compared to 2007 as a result of the acquisition of API on April 1, 2007.
Pro forma
Other underwriting expenses and net deferred acquisition costs for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Other underwriting expenses | $ | 11,074 |
| $ | 11,635 |
| $ | (561) |
| -5% |
|
|
|
|
|
|
|
|
|
|
|
Net change in deferred acquisition costs |
| 14 |
|
| 31 |
|
| (17) |
| -55% |
Total | $ | 11,088 |
| $ | 11,666 |
| $ | (578) |
| -5% |
71
On a pro forma basis, other underwriting expenses decreased by $561,000 (5%) to $11,074,000 from $11,635,000 for the year ended December 31, 2008 as compared to the same period in 2007. Other underwriting expenses consist primarily of commissions to agents, premium taxes and other general underwriting expenses related to managing our Insurance Services segment. The pro forma decrease of $561,000 is mainly attributable to higher compensation expenses of $1,200,000 incurred with the acquisition of API in 2007. In addition, legal, auditing, actuarial and other professional fees were $287,000 higher in 2007 due to merger related costs offset by higher commission expenses of $205,000 incurred in 2008 as result of increasing commission rates to attract new business. On a pro forma basis, the net change in deferred acquisition costs, which is comprised of the change in deferred and amortized commissions paid to agents on new and renewal business and deferred and amortized premium taxes, decreased for the year ended December 31, 2008 by $17,000 to $14,000 from $31,000 for the comparable period in 2007 due to new costs capitalized exceeding the amortization of prior deferred expenses.
Management Service Expenses
Actual
Prior to the acquisition of API, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing APIs operations. In conjunction with the merger with API on April 1, 2007, our management agreement was terminated as of March 31, 2007, and as such is no longer included in our consolidated results of operations. Thus, as a result of the merger, insurance management services expenses decreased to zero from $3,823,000 for the year ended December 31, 2008 compared to 2007. Insurance services expenses were recorded only through the quarter ended March 31, 2007.
Financial Services Expenses
Actual
Financial services expenses for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Broker Commissions | $ | 3,291 |
| $ | 12,398 |
| $ | (9,107) |
| -73% |
Payroll and Benefits |
| 3,049 |
|
| 2,950 |
|
| 99 |
| 3% |
Bonus/Incentive Compensation |
| 69 |
|
| 1,270 |
|
| (1,201) |
| -95% |
Legal and Professional Fees |
| 1,926 |
|
| 886 |
|
| 1,040 |
| 117% |
Other |
| 1,414 |
|
| 1,526 |
|
| (112) |
| -7% |
Total Financial Services Expenses | $ | 9,749 |
| $ | 19,030 |
| $ | (9,281) |
| -49% |
Our Financial Services expenses decreased $9,281,000 (49%) for the year ended December 31, 2008 compared to 2007. The primary reason for the current year decrease is a reduction of commission expenses of $9,107,000 (73%) for the year ended December 31, 2008 compared to 2007 resulting from the decline in trading activity and associated commission revenues mentioned above. In addition, incentive compensation costs decreased $1,201,000 (95%) in 2008 as a result of the net loss incurred for the year in this operating segment. Partially offsetting these decreases was an increase in legal and professional expenses of $1,040,000 (117%) for the year ended December 31, 2008 compared to 2007 due primarily to costs incurred related to legal disputes. Lastly, payroll and employee benefits expense increased $99,000 (3%) due primarily to certain increases in staff at the investment banking and bank debt/trade claims businesses in early 2008. During the latter half of 2008, significant cost cutting measures were implemented in response to the sub-par performance of this segment in 2008 with cost reductions in personnel, compensation, consulting services, information services, rent and travel continuing throughout the remainder of the year.
72
General and Administrative Expenses
Actual
General and administrative expenses for the years ended December 31, 2008 and 2007 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2008 |
| 2007 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Salaries | $ | 1,381 |
| $ | 1,097 |
| $ | 284 |
| 26% |
Incentive Compensation |
| 1,414 |
|
| 1,688 |
|
| (274) |
| -16% |
Board Compensation and Fees |
| 1,046 |
|
| 625 |
|
| 421 |
| 67% |
Legal and Professional Fees |
| 445 |
|
| 588 |
|
| (143) |
| -24% |
Options and Other Compensation |
| 100 |
|
| 243 |
|
| (143) |
| -59% |
Other |
| 1,366 |
|
| 1,218 |
|
| 148 |
| 12% |
Total General & Administrative Expenses | $ | 5,752 |
| $ | 5,459 |
| $ | 293 |
| 5% |
General and administrative expenses increased $293,000 (5%) for the year ended December 31, 2008 compared to 2007. The increase in general and administrative expenses in the current year includes higher salaries of $284,000 or 26% resulting in part from expensing a full year's salary of our new Chief Operating Officer compared to only eight months in 2007 and expensing a full year's salary for a new Treasurer position for all of 2008 compared to just two months in 2007. Normal annual merit raises also affected the year-to-year salary variance. Board compensation and fees increased $421,000 (67%) resulting primarily from a full year's expensing of options granted in 2007 as a result of record earnings in 2007 and deferred compensation awarded to board members. In addition, there were a greater number of directors and increased fees paid to each non-management board member. Finally, a note receivable was written off to bad debt in 2008 in the amount of $323,000. Partially offsetting these increases was a decrease in incentive compensation totaling $274,000 (16%) and is the result of the lower earnings in 2008 compared to 2007. Legal and professional fees declined $143,000 (24%), the result of lower Sarbanes-Oxley (SOX) related consulting and audit fees in 2008. Finally, options and other expense to non-board member executives and key employees decreased $143,000 (59%) in 2008 compared to 2007 resulting from deferred compensation awarded and expensed in 2007 as a result of the successful merger with API and record earnings in 2007.
Impairment of Goodwill
Goodwill was originally recorded upon the repurchase of an interest in APS Insurance Services from a minority holder in 2003. Goodwill was determined to exist based on earnings expected to be generated from the management agreement with API. With our purchase of API and termination of the management agreement, we determined that the original circumstances creating the goodwill no longer existed and that the entire $1,247,000 balance was impaired. The goodwill was written off in the quarter ended June 30, 2007.
Minority Interest
The 3% minority interest in Asset Management, a subsidiary within our Financial Services segment, owned by key individuals within Asset Management, was repurchased by APS Investment Services in the third quarter of 2007 for a nominal amount.
73
Extraordinary Gain
Our extraordinary gain represents the excess of the assets received over the costs to acquire all of the issued and outstanding stock of API. The business combination was accounted for using the purchase method of accounting and, accordingly, the purchase price has been allocated to assets acquired and liabilities assumed based on fair values at April 1, 2007, the date of acquisition. The total purchase price was approximately $45,167,000 and consisted of 1,982,499 shares of the Companys common stock, valued at a per share price of $17.635, or $34,961,000 in aggregate, $35,000 in cash paid in lieu of fractional shares of common stock, 10,197.95 shares of preferred stock valued at $9,179,000, plus costs to complete the acquisition of $992,000. The net fair value of the assets acquired and the liabilities assumed was $47,431,000. The resulting excess of assets received over costs to acquire was recorded as an extraordinary gain in accordance with SFAS No. 141, Accounting for Business Combinations.
2007 Compared to 2006
Actual
Condensed income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands except per share data) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Revenues | $ | 84,403 |
| $ | 33,564 |
| $ | 50,839 |
| 151% |
Income from Operations |
| 32,939 |
|
| 5,039 |
|
| 27,900 |
| 554% |
Net Income |
| 23,273 |
|
| 3,194 |
|
| 20,079 |
| 629% |
Diluted Net Income Per Share | $ | 4.09 |
| $ | 1.09 |
| $ | 3.00 |
| 275% |
Pro forma
Condensed pro forma income statement data for the year ended December 31, 2007 and condensed pro forma income statement data for the year ended December 31, 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands except per share data) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Actual |
| Pro forma |
|
|
|
|
| ||
Revenues | $ | 98,721 |
| $ | 95,129 |
| $ | 3,592 |
| 4% |
Income from Operations |
| 36,558 |
|
| 28,170 |
|
| 8,388 |
| 30% |
Net Income |
| 23,436 |
|
| 18,274 |
|
| 5,162 |
| 28% |
Diluted Net Income Per Share | $ | 4.12 |
| $ | 3.72 |
| $ | 0.40 |
| 11% |
Further explanation for the year-to-year variances are described below throughout the remainder of the M,D&A section of this Form 10-K.
74
Premium related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Gross premiums and maintenance fees written - direct and assumed | $ | 50,120 |
| $ | - |
| $ | 50,120 |
| 100% |
|
|
|
|
|
|
|
|
|
|
|
Premium ceded: |
|
|
|
|
|
|
|
|
|
|
Current year |
| (6,075) |
|
| - |
|
| (6,075) |
| 100% |
Prior year |
| 10,888 |
|
| - |
|
| 10,888 |
| 100% |
Net premiums ceded |
| 4,813 |
|
| - |
|
| 4,813 |
| 100% |
|
|
|
|
|
|
|
|
|
|
|
Net premiums and maintenance fees earned | $ | 56,039 |
| $ | - |
| $ | 56,039 |
| 100% |
Pro forma premium related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Pro forma |
| Pro forma |
|
|
|
|
| ||
Gross premiums and maintenance fees written - direct and assumed | $ | 65,586 |
| $ | 74,833 |
| $ | (9,247) |
| -12% |
|
|
|
|
|
|
|
|
|
|
|
Premium ceded: |
|
|
|
|
|
|
|
|
|
|
Current year |
| (8,482) |
|
| (12,452) |
|
| 3,970 |
| -32% |
Prior year |
| 10,888 |
|
| 7,743 |
|
| 3,145 |
| 41% |
Net premiums ceded |
| 2,406 |
|
| (4,709) |
|
| 7,115 |
| -151% |
|
|
|
|
|
|
|
|
|
|
|
Net premiums and maintenance fees earned | $ | 72,350 |
| $ | 70,859 |
| $ | 1,491 |
| 2% |
Gross premiums and maintenance fees written
Actual
Gross premiums and maintenance fees written increased to $50,120,000 from $0 for year ended December 31, 2007 as compared to 2006 as a result of the acquisition of API on April 1, 2007.
Pro forma
On a pro forma basis, gross premiums and maintenance fees written decreased $9,247,000 (12%) to $65,586,000, from $74,833,000 for the year ended December 31, 2007 compared to the same period in 2006. While API increased in the number of policyholders to 4,930 at December 31, 2007 from 4,712 at December 31, 2006, gross premiums and maintenance fees written decreased due to rate decreases which averaged 14% for the year ended December 31, 2007. As a result of increased marketing efforts, we continued to experience growth in the number of policyholders; however, this growth slowed in 2007 as compared to 2006 as a result of pricing and competitive pressures.
Premiums Ceded
Actual
Premiums ceded increased to $4,813,000 from $0 for the year ended December 31, 2007 as compared 2006 as a result of the acquisition of API on April 1, 2007.
75
Pro forma
On a pro forma basis, premiums ceded expenses decreased $7,115,000 to $2,406,000 from ($4,709,000) for the year ending December 31, 2007 as compared to the same period in 2006. The reinsurance contracts beginning in 2002 through 2007 are variable premium treaties that have various minimum and maximum rates. The actual premium rate will depend upon the ultimate losses ceded to the reinsurer under the related treaty. We, supported periodically by outside consulting actuarial reviews, continually monitor the development of claims subject to reinsurance and adjust premiums ceded for estimated profit sharing provisions based on claims development in the reinsurance layers. The pro forma decrease in premiums ceded of $7,115,000 is primarily the result of lower estimated ceding rates due to lower estimated loss and loss adjustment expenses for prior treaty years 2002 through 2006. This prior year favorable development in the reinsurance layer resulted in us recognizing $10,888,000 primarily as a reduction to ceded premiums for the twelve months ended December 31, 2007. During 2006 we lowered the estimated ceding rates for prior treaty years 2002 through 2005, which caused us to recognize $7,743,000 in positive development as a reduction in ceded premium. Additionally, ceded premiums decreased year over year due to the Company retaining 20% of any claim in excess of $250,000 on individual claims and $350,000 on multiple insured claims for the 2007 reinsurance treaty. We retained 10% of any excess on the 2006 treaty. We retained this additional risk in the reinsurance layer based on decreases in claims since the passage of tort reform legislation in 2003. In addition, ceded premiums were lower for the current period due to lower earned premiums in 2007 as compared to 2006.
Net Premiums and Maintenance Fees Earned
Actual
Net premiums and maintenance fees earned increased to $56,039,000 from $0 for year ended December 31, 2007 as compared to 2006 as a result of the acquisition of API on April 1, 2007.
Pro forma
On a pro forma basis, net premiums and maintenance fees earned increased by $1,491,000 (2%) to $72,350,000 from $70,859,000 for the year ended December 31, 2007 as compared to the same period in 2006. While written premiums and maintenance fees were down $9,247,000 year over year primarily due to rate decreases, the aforementioned favorable development for the prior years reinsurance treaties contributed to the increase in net earned amounts.
76
Investment Income
Actual
Investment income related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Investment income: |
|
|
|
|
|
|
|
|
|
|
Fixed Maturities | $ | 7,850 |
| $ | 638 |
| $ | 7,212 |
| 1130% |
Equity Securities |
| 132 |
|
| 23 |
|
| 109 |
| 474% |
Short-term investments and other |
| 759 |
|
| 254 |
|
| 505 |
| 199% |
Finance charges on premiums receivable |
| 95 |
|
| - |
|
| 95 |
| 100% |
Structured annuity |
| 62 |
|
| - |
|
| 62 |
| 100% |
|
|
|
|
|
|
|
|
|
|
|
Total investment income | $ | 8,898 |
| $ | 915 |
| $ | 7,983 |
| 872% |
|
|
|
|
|
|
|
|
|
|
|
Investment expense |
| 205 |
|
| - |
|
| 205 |
| 100% |
|
|
|
|
|
|
|
|
|
|
|
Net investment income | $ | 8,693 |
| $ | 915 |
| $ | 7,778 |
| 850% |
Investment income, net of investment expenses increased by $7,778,000 (850%) to $8,693,000 from $915,000 for the year ended December 31, 2007 as compared to 2006 as a result of a substantial increase in invested assets resulting from the acquisition of API on April 1, 2007 and from capital received from our common stock offering in June 2007.
Pro forma
Pro forma investment income related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Pro forma |
| Pro forma |
|
|
|
|
| ||
Investment income: |
|
|
|
|
|
|
|
|
|
|
Fixed Maturities | $ | 9,581 |
| $ | 6,767 |
| $ | 2,814 |
| 42% |
Equity Securities |
| 158 |
|
| 113 |
|
| 45 |
| 40% |
Short-term investments and other |
| 842 |
|
| 490 |
|
| 352 |
| 72% |
Finance charges on premiums receivable |
| 132 |
|
| 283 |
|
| (151) |
| -53% |
Structured annuity |
| 85 |
|
| 90 |
|
| (5) |
| -6% |
|
|
|
|
|
|
|
|
|
|
|
Total investment income | $ | 10,798 |
| $ | 7,743 |
| $ | 3,055 |
| 39% |
|
|
|
|
|
|
|
|
|
|
|
Investment expense |
| 293 |
|
| 138 |
|
| 155 |
| 112% |
|
|
|
|
|
|
|
|
|
|
|
Net investment income | $ | 10,505 |
| $ | 7,605 |
| $ | 2,900 |
| 38% |
On a pro forma basis, investment income, net of investment expenses, increased by $2,900,000 (38%) to $10,505,000 from $7,605,000 for the year ended December 31, 2007 as compared to the same period for 2006. On a pro forma basis, cash and invested assets increased by $52,858,000 (31%) to $223,193,000 at December 31, 2007 from $170,335,000 at December 31, 2006 resulting in the increase in investment income. In addition, the increase in invested assets resulted primarily from the use of proceeds of our common stock offering as well as from positive net cash flow from operating activities.
77
Realized Capital Gains (Loss)
Actual
Realized capital gain and loss data for the years ended December 31, 2007 and 2006 are included in the following table:
| Year ended December 31, | |||||||||
(in thousands) | 2007 |
| 2006 |
| Change |
| % Change | |||
| Actual |
| Actual |
|
|
|
|
| ||
Realized capital gains (losses) - net |
|
|
|
|
|
|
|
|
|
|
Net realized gains | $ | 384 |
|