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UNITED STATES
Form 10-Q
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2003 | |||
| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 000-32057 |
American Physicians Capital, Inc.
| Michigan | 38-3543910 | |
| (State or other jurisdiction of incorporation or organization) | (IRS employer identification number) |
1301 North Hagadorn Road, East Lansing, Michigan 48823
Registrant’s telephone number, including area code: (517) 351-1150
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 x NO o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)
YES x NO o
The number of shares outstanding of the registrant’s common stock, no par value per share, as of November 10 , 2003 was 8,452,228.
Table of Contents
PART I. FINANCIAL INFORMATION | |||||
| Item 1. Financial Statements | |||||
| Condensed Consolidated Balance Sheets | 3 | ||||
| Condensed Consolidated Statements of Income | 4 | ||||
| Condensed Consolidated Statements of Comprehensive Income | 5 | ||||
| Condensed Consolidated Statements of Cash Flows | 6 | ||||
| Notes to Condensed Consolidated Financial Statements | 7 | ||||
| Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 16 | ||||
| Item 3. Quantitative and Qualitative Disclosures About Market Risk | 33 | ||||
| Item 4. Controls and Procedures | 34 | ||||
PART II. OTHER INFORMATION | |||||
| Item 2. Changes in Securities and Use of Proceeds | 36 | ||||
| Item 6. Exhibits and Reports on Form 8-K | 36 | ||||
Signatures | 37 | ||||
Exhibit Index | 38 | ||||
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
ITEM 1. FINANCIAL STATEMENTS
| September 30, | December 31, | |||||||||
| 2003 | 2002 | |||||||||
| (Unaudited) | ||||||||||
| (In thousands, except share data) | ||||||||||
Assets | ||||||||||
| Investments: | ||||||||||
| Fixed maturities, at fair value | $ | 686,012 | $ | 618,899 | ||||||
| Equity securities, at fair value | 8,764 | 44 | ||||||||
| Other investments | 30,661 | 30,788 | ||||||||
| Total investments | 725,437 | 649,731 | ||||||||
| Cash and cash equivalents | 92,795 | 151,825 | ||||||||
| Premiums receivable | 73,121 | 62,531 | ||||||||
| Reinsurance recoverable | 110,240 | 98,128 | ||||||||
| Federal income tax recoverable | 4,321 | 1,100 | ||||||||
| Deferred federal income taxes | — | 42,542 | ||||||||
| Property and equipment, net of accumulated depreciation | 15,040 | 14,352 | ||||||||
| Intangible assets | �� | 362 | — | |||||||
| Other assets | 48,059 | 38,709 | ||||||||
| Total assets | $ | 1,069,375 | $ | 1,058,918 | ||||||
Liabilities | ||||||||||
| Unpaid losses and loss adjustment expenses | $ | 678,136 | $ | 637,494 | ||||||
| Unearned premiums | 113,581 | 103,420 | ||||||||
| Long term debt | 30,928 | — | ||||||||
| Note payable, officer | 5,839 | 6,567 | ||||||||
| Other liabilities | 36,536 | 31,148 | ||||||||
| Total liabilities | 865,020 | 778,629 | ||||||||
Shareholders’ Equity | ||||||||||
| Common stock, no par value, 50,000,000 shares authorized: 8,457,408 and 8,695,492 shares outstanding at September 30, 2003 and December 31, 2002, respectively | — | — | ||||||||
| Additional paid-in-capital | 85,240 | 92,148 | ||||||||
| Retained earnings | 87,250 | 164,183 | ||||||||
| Unearned stock compensation | (453 | ) | (678 | ) | ||||||
| Accumulated other comprehensive income: | ||||||||||
| Net unrealized appreciation on investments, net of deferred federal income taxes | 32,318 | 24,636 | ||||||||
| Total shareholders’ equity | 204,355 | 280,289 | ||||||||
| Total liabilities and shareholders’ equity | $ | 1,069,375 | $ | 1,058,918 | ||||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| Three Months Ended | Nine Months Ended | ||||||||||||||||
| September 30, | September 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| (In thousands, except per share data) | |||||||||||||||||
| Net premiums written | $ | 79,371 | $ | 74,944 | $ | 179,202 | $ | 188,323 | |||||||||
| Change in net unearned premiums | (22,783 | ) | (13,523 | ) | (9,682 | ) | (17,353 | ) | |||||||||
| Net premiums earned | 56,588 | 61,421 | 169,520 | 170,970 | |||||||||||||
| Investment income | 11,400 | 11,421 | 32,209 | 34,108 | |||||||||||||
| Net realized gains (losses) | 143 | (390 | ) | 1,291 | (678 | ) | |||||||||||
| Other income | 161 | 524 | 518 | 786 | |||||||||||||
| Total revenues and other income | 68,292 | 72,976 | 203,538 | 205,186 | |||||||||||||
| Losses and loss adjustment expenses | 96,721 | 62,928 | 203,733 | 178,461 | |||||||||||||
| Underwriting expenses | 11,721 | 11,945 | 36,828 | 35,306 | |||||||||||||
| Investment expenses | 934 | 609 | 2,083 | 2,529 | |||||||||||||
| Interest expense | 502 | 95 | 875 | 278 | |||||||||||||
| Amortization expense | 133 | — | 272 | — | |||||||||||||
| General and administrative expenses | 715 | 395 | 1,993 | 1,231 | |||||||||||||
| Total expenses | 110,726 | 75,972 | 245,784 | 217,805 | |||||||||||||
| Loss before federal income taxes and cumulative effect of a change in accounting principle | (42,434 | ) | (2,996 | ) | (42,246 | ) | (12,619 | ) | |||||||||
| Federal income tax expense (benefit) | 34,621 | (1,048 | ) | 34,687 | (4,421 | ) | |||||||||||
| Loss before cumulative effect of a change in accounting principle | (77,055 | ) | (1,948 | ) | (76,933 | ) | (8,198 | ) | |||||||||
| Cumulative effect of a change in accounting principle | — | — | — | (9,079 | ) | ||||||||||||
| Net loss | $ | (77,055 | ) | $ | (1,948 | ) | $ | (76,933 | ) | $ | (17,277 | ) | |||||
| Loss before cumulative effect of a change in accounting principle — per common share | |||||||||||||||||
| Basic | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (0.85 | ) | |||||
| Diluted | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (0.85 | ) | |||||
| Cumulative effect of a change in accounting principle — per common share | |||||||||||||||||
| Basic | $ | — | $ | — | $ | — | $ | (0.95 | ) | ||||||||
| Diluted | $ | — | $ | — | $ | — | $ | (0.95 | ) | ||||||||
| Net loss — per common share | |||||||||||||||||
| Basic | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (1.80 | ) | |||||
| Diluted | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (1.80 | ) | |||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||||
| (In thousands) | ||||||||||||||||||
| Net loss | $ | (77,055 | ) | $ | (1,948 | ) | $ | (76,933 | ) | $ | (17,277 | ) | ||||||
| Other comprehensive (loss) income: | ||||||||||||||||||
| Unrealized (depreciation) appreciation on investment securities arising during the period, net of deferred federal income tax (benefit) expense of $(536) and $3,746, respectively, in 2003 and $5,871 and $10,440, respectively, in 2002 | (996 | ) | 10,903 | 6,957 | 19,388 | |||||||||||||
| Less reclassification adjustment for realized losses (gains) on investment securities included in net loss, net of income tax benefit (expense) of $11 and $(391), respectively, in 2003 and $137 and $135, respectively, in 2002 | 21 | 254 | (725 | ) | 250 | |||||||||||||
| Other comprehensive (loss) income | (1,017 | ) | 10,649 | 7,682 | 19,138 | |||||||||||||
| Comprehensive (loss) income | $ | (78,072 | ) | $ | 8,701 | $ | (69,251 | ) | $ | 1,861 | ||||||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| Nine Months Ended | |||||||||||
| September 30, | |||||||||||
| 2003 | 2002 | ||||||||||
| (In thousands) | |||||||||||
Cash flows from operating activities | |||||||||||
| Net loss | $ | (76,933 | ) | $ | (17,277 | ) | |||||
| Adjustments to reconcile net loss to net cash (used in) provided by operating activities: | |||||||||||
| Depreciation and amortization | 4,790 | 3,011 | |||||||||
| Net realized (gains) losses | (1,291 | ) | 678 | ||||||||
| Change in fair value of derivatives instruments | (465 | ) | — | ||||||||
| Change in deferred federal income taxes | 38,285 | (5,085 | ) | ||||||||
| Loss on equity method investees | 272 | — | |||||||||
| Goodwill impairment | — | 13,968 | |||||||||
| Change in unpaid loss and loss adjustment expenses | 40,642 | 31,240 | |||||||||
| Change in unearned premiums | 10,161 | 19,454 | |||||||||
| Changes in other assets and liabilities | (24,403 | ) | (8,759 | ) | |||||||
Net cash (used in) provided by operating activities | (8,942 | ) | 37,230 | ||||||||
Cash flows from investing activities | |||||||||||
| Purchases | |||||||||||
| Available-for-sale — fixed maturities | (162,689 | ) | (84,973 | ) | |||||||
| Available-for-sale — equity securities | (10,561 | ) | — | ||||||||
| Other invested assets | (334 | ) | (224 | ) | |||||||
| Property and equipment | (2,141 | ) | (1,195 | ) | |||||||
| Sales and maturities | |||||||||||
| Available-for-sale — fixed maturities | 100,488 | 37,719 | |||||||||
| Available-for-sale — equity securities | 2,153 | — | |||||||||
Net cash used in investing activities | (73,084 | ) | (48,673 | ) | |||||||
Cash flows from financing activities | |||||||||||
| Common stock repurchased | (7,068 | ) | (27,483 | ) | |||||||
| Principal payment on note payable | (1,000 | ) | (1,000 | ) | |||||||
| Proceeds from issuance of long-term debt | 30,928 | — | |||||||||
| Proceeds from stock options exercised | 136 | 230 | |||||||||
Net cash provided by (used in) financing activities | 22,996 | (28,253 | ) | ||||||||
Net decrease in cash and cash equivalents | (59,030 | ) | (39,696 | ) | |||||||
Cash and cash equivalents, beginning of period | 151,825 | 106,444 | |||||||||
Cash and cash equivalents, end of period | $ | 92,795 | $ | 66,748 | |||||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Basis of Presentation
The accompanying Unaudited Condensed Consolidated Financial Statements include the accounts of American Physicians Capital, Inc. (“APCapital”) and its wholly owned subsidiaries, together referred to in this report as the “Company.” All significant intercompany accounts and transactions are eliminated in consolidation.
The Company is principally engaged in the business of providing medical professional liability and workers’ compensation insurance throughout the United States with a concentration of writings in the Midwest.
The accompanying Unaudited Condensed Consolidated Financial Statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X as they apply to interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The operating results for the three-month and nine-month periods ended September 30, 2003 are not necessarily indicative of the results to be expected for the year ending December 31, 2003. The accompanying Unaudited Condensed Consolidated Financial Statements should be read with the annual consolidated financial statements and notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The most significant estimates that are susceptible to significant change in the near-term relate to the determination of the loss and loss adjustment expense reserves, investments, taxes, reinsurance, the reserve for extended reporting period claims. Although considerable variability is inherent in these estimates, management believes that the current estimates are reasonable in all material respects. The estimates are reviewed regularly and adjusted as necessary. Such adjustments are reflected in current operations.
Certain 2002 amounts have been reclassified to conform with the 2003 presentation.
Stock-based Compensation
The Company uses the intrinsic value-based method to account for all stock-based employee compensation plans and has adopted the disclosure alternative of Statement of Financial Accounting Standard (“SFAS”) No. 123 “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” In accordance with SFAS No. 123, as amended by SFAS No. 148, the Company is required to disclose the pro forma effects on operating results as if the Company had elected the fair value approach to account for its stock-based employee compensation plans.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
If compensation had been determined based on the fair value at the grant date, consistent with the provisions of SFAS No. 123, our net loss and net loss per share would have been as follows for the three months and nine months ended September 30, 2003 and 2002:
| Three Months Ended | Nine Months Ended | ||||||||||||||||
| September 30, | September 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| (In thousands, except per share data) | |||||||||||||||||
| Net loss, as reported | $ | (77,055 | ) | $ | (1,948 | ) | $ | (76,933 | ) | $ | (17,277 | ) | |||||
| Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects | 75 | 75 | 225 | 227 | |||||||||||||
| Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards granted since 2000, net of related tax effects | (349 | ) | (537 | ) | (1,040 | ) | (1,729 | ) | |||||||||
| Pro forma net loss | $ | (77,329 | ) | $ | (2,410 | ) | $ | (77,748 | ) | $ | (18,779 | ) | |||||
| Basic net loss per share | |||||||||||||||||
| As reported | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (1.80 | ) | |||||
| Pro forma | $ | (9.06 | ) | $ | (0.27 | ) | $ | (9.07 | ) | $ | (1.96 | ) | |||||
| Diluted net loss per share(1) | |||||||||||||||||
| As reported | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (1.80 | ) | |||||
| Pro forma | $ | (9.06 | ) | $ | (0.27 | ) | $ | (9.07 | ) | $ | (1.96 | ) | |||||
| (1) | As the Company was in a net loss position for the three months and nine months ended September 30, 2003 and 2002, no effect of options or other stock awards was calculated as the impact would be anti-dilutive. |
Such pro forma disclosures may not be representative of future compensation costs as options may vest over several years and additional grants may be made.
There were no options granted during the three months ended September 30, 2003. During the nine months ended September 30, 2003, there were 5,000 options granted.
Derivative Financial Instruments
During the second quarter of 2003, the Company purchased interest-only certificates that may not allow for the recovery of substantially all of its investment. These certificates pay a variable rate of interest that is inversely related to the London Interbank Offered Rate (“LIBOR”). The Company has determined that these certificates contain an embedded derivative instrument as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”
All interest-only certificates with an inverse floating rate of interest are carried on the balance sheet at fair value as a fixed maturity security. These certificates are not linked to specific assets or liabilities on the balance sheet or to a forecasted transaction and, therefore, do not qualify for hedge accounting. In addition, the Company does not feel that it can reliably identify and separately measure the embedded derivative instrument. Any changes in the fair value of the entire interest-only certificates, based on quoted market prices, are recorded in current period earnings as investment income.
At September 30, 2003 the Company had such certificates with a fair value of approximately $7.9 million. The fair value of these certificates increased approximately $65,000 and $465,000 during the three months and nine months ended September 30, 2003.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The Company uses these certificates as a part of its overall interest rate risk-management strategy related to its investment portfolio.
2. Effects of New Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45. “Guarantor’s Accounting and Disclosure Requirements for Guarantees of Indebtedness of Others” (“FIN No. 45”). This interpretation clarifies disclosures required to be made by a guarantor in its interim and annual financial statements and requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The provisions of FIN No. 45 pertaining to the recording of a liability are effective for all guarantees entered into, or modified, after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 31, 2002. APCapital has issued guarantees in connection with its establishment of trusts and issuance of debentures. The amounts due under the guarantees are also recorded as liabilities in the Company’s Unaudited Condensed Consolidated Financial Statements in accordance with the structure of the transaction. See Note 7 of the Notes to the Unaudited Condensed Consolidated Financial Statements for further details on the nature of the guarantees and the transactions that gave rise to the guarantees.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN No. 46”). This interpretation addresses consolidation by business enterprises of variable interest entities and is effective immediately for all variable interest entities created after January 31, 2003 and for the fiscal year or interim period beginning after June 15, 2003 for all variable interest entities in which the Company holds a variable interest that it acquired before February 1, 2003. The Company has evaluated certain investments, as required by FIN No. 46, and has determined that its investments in statutory trusts used to issue mandatorily redeemable trust preferred securities should not be consolidated. Accordingly, the Company has not consolidated the trusts in the accompanying Unaudited Condensed Consolidated Financial Statements.
3. Loss Per Share
Net loss per common share is computed by dividing net loss by the weighted average number of shares of common stock and common stock equivalents (e.g., stock options and stock awards) outstanding, calculated on a daily basis. Basic weighted average shares outstanding for the three months and nine months ended September 30, 2003 were 8,533,929 and 8,575,742, respectively, and 9,061,300 and 9,597,521, respectively, for the three months and nine months ended September 30, 2002. As the Company was in a net loss position for the three months and nine months ended September 30, 2003 and 2002, no effect of options or other stock awards was calculated as the impact would have been anti-dilutive.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The following table sets forth the computation of basic and diluted loss before cumulative effect of a change in accounting principle per common share:
| Three Months Ended | Nine Months Ended | ||||||||||||||||
| September 30, | September 30, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| (In thousands, except per share data) | |||||||||||||||||
Numerator for basic and diluted loss per common share: | |||||||||||||||||
| Loss before cumulative effect of a change in accounting principle | $ | (77,055 | ) | $ | (1,948 | ) | $ | (76,933 | ) | $ | (8,198 | ) | |||||
Denominator: | |||||||||||||||||
| Denominator for basic loss per common share — weighted average shares outstanding | 8,534 | 9,061 | 8,576 | 9,598 | |||||||||||||
| Effect of dilutive stock options and awards(1) | — | — | — | — | |||||||||||||
| Denominator for diluted loss per common share — adjusted weighted average shares outstanding | 8,534 | 9,061 | 8,576 | 9,598 | |||||||||||||
Loss per share: | |||||||||||||||||
| Loss before cumulative effect of a change in accounting principle | |||||||||||||||||
| Basic | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (0.85 | ) | |||||
| Diluted(1) | $ | (9.03 | ) | $ | (0.21 | ) | $ | (8.97 | ) | $ | (0.85 | ) | |||||
| (1) | As the Company was in a net loss position for the three months and nine months ended September 30, 2003 and 2002, no effect of options or other stock awards was calculated as the impact would be anti-dilutive. |
4. Segment Information
The Company is organized and operates principally in the property and casualty insurance industry and has five reportable segments — medical professional liability, workers’ compensation, health, personal and commercial, and corporate and other. The accounting policies of the segments are described in the Notes to the Unaudited Condensed Consolidated Financial Statements included in the Company’s most recent Annual Report on Form 10-K.
Expense allocations are based primarily on loss and loss adjustment expenses by line of business and certain other estimates for underwriting expenses. Investment income, investment expense, amortization expense and interest expense are allocated to the segments based on that segment’s “ownership” percentage of the assets or liabilities underlying the income or expense. General and administrative expenses are all attributed to the holding company and are included in corporate and other.
| September 30, | December 31, | |||||||||
| 2003 | 2002 | |||||||||
| (In thousands) | ||||||||||
Total assets: | ||||||||||
| Medical professional liability | $ | 884,45 | $ | 859,804 | ||||||
| Workers’ compensation | 135,709 | 153,612 | ||||||||
| Health | 14,523 | 19,003 | ||||||||
| Personal and commercial | 4,486 | 4,089 | ||||||||
| Corporate and other | 247,509 | 284,075 | ||||||||
| Intersegment eliminations | (217,311 | ) | (261,665 | ) | ||||||
| Total | $ | 1,069,375 | $ | 1,058,918 | ||||||
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||||
| (In thousands) | ||||||||||||||||||
Total revenue: | ||||||||||||||||||
| Medical professional liability | $ | 50,939 | $ | 49,387 | $ | 147,343 | $ | 135,810 | ||||||||||
| Workers’ compensation | 11,713 | 17,768 | 38,109 | 52,296 | ||||||||||||||
| Health | 5,431 | 5,690 | 17,780 | 17,362 | ||||||||||||||
| Personal and commercial | 34 | (21 | ) | (185 | ) | (946 | ) | |||||||||||
| Corporate and other | 314 | 295 | 929 | 1,076 | ||||||||||||||
| Intersegment eliminations | (139 | ) | (143 | ) | (438 | ) | (412 | ) | ||||||||||
| Total | $ | 68,292 | $ | 72,976 | $ | 203,538 | $ | 205,186 | ||||||||||
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| September 30, | September 30, | |||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||||
| (In thousands) | ||||||||||||||||||
Income (loss) before federal income taxes and cumulative effect of a change in accounting principle: | ||||||||||||||||||
| Medical professional liability | $ | (41,591 | ) | $ | (4,711 | ) | $ | (39,933 | ) | $ | (13,294 | ) | ||||||
| Workers’ compensation | 160 | 2,816 | 1,395 | 4,951 | ||||||||||||||
| Health | 361 | (482 | ) | (149 | ) | (2,029 | ) | |||||||||||
| Personal and commercial | (371 | ) | (395 | ) | (1,381 | ) | (1,648 | ) | ||||||||||
| Corporate and other | (993 | ) | (224 | ) | (2,178 | ) | (599 | ) | ||||||||||
| Total | $ | (42,434 | ) | $ | (2,996 | ) | $ | (42,246 | ) | $ | (12,619 | ) | ||||||
In September 2003, management formally adopted a plan to exit the health insurance line of business. The day to day aspects of the Company’s health insurance business are administered by a third party administrator (“TPA”). The contract between the TPA and the Company requires the Company to provide a 180 day notice to the TPA of its intent to terminate the agreement. The Company plans to give notice of this termination effective December 31, 2003. The Company will continue to renew policies during this 180-day period, after which, the Company will not issue any additional health insurance policies.
Subsequent to the end of the third quarter the Company has entered into a non-binding letter of intent for the sale of its workers’ compensation policy renewals. The sale would provide the Company with a 2.5% fee for all premiums renewed over the next three years. The Company would continue to write business in Michigan and Minnesota under a 100% reinsurance arrangement with the purchaser. This fronting arrangement would continue for approximately one year, or until the purchaser is licensed in those states. The Company would be paid a fronting fee of 5.0% under this arrangement.
The Company has also begun the process of negotiating a loss portfolio transfer for its existing workers compensation reserves for unpaid loss and loss adjustment expenses. As of September 30, 2003, workers’ compensation reserves for unpaid losses and loss adjustment expenses totaled $68.3 million, $62.4 million net of reinsurance.
During the fourth quarter of 2003, the Company will finalize the terms of this transaction.
5. Goodwill
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” At that date, the only goodwill or other
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
intangible asset recorded by the Company was the $13.9 million associated with the purchase of Stratton-Cheeseman Management Company in 1999. Based on the results of the impairment testing, the recorded net goodwill of $13.9 million was written off as the fair value of the Company’s reporting units did not support the carrying value of previously recorded goodwill. For purposes of the impairment testing, fair value was estimated using various methods, including multiples of projected net income and market capitalization. The goodwill impairment was recorded as a cumulative effect of a change in accounting principle, net of a deferred income tax benefit of $4.9 million. In accordance with the transition guidance given in SFAS No. 142, the goodwill impairment charge, net of tax, that was determined in the fourth quarter of 2002 was recorded in the first quarter of 2002.
6. Unpaid Losses and Loss Adjustment Expenses
Activity in unpaid loss and loss adjustment expenses for the nine months ended September 30, 2003 and 2002 was as follows:
| For the Nine Months | ||||||||||
| Ended September 30, | ||||||||||
| 2003 | 2002 | |||||||||
| (In thousands) | ||||||||||
| Balance, January 1 | $ | 637,494 | $ | 597,046 | ||||||
| Less, reinsurance recoverables | (90,673 | ) | (91,491 | ) | ||||||
| Net balance, beginning of year | 546,821 | 505,555 | ||||||||
| Incurred related to | ||||||||||
| Current year | 160,420 | 175,831 | ||||||||
| Prior years | 43,313 | 2,630 | ||||||||
| Total incurred | 203,733 | 178,461 | ||||||||
| Paid related to | ||||||||||
| Current year | 21,687 | 25,786 | ||||||||
| Prior years | 148,197 | 120,969 | ||||||||
| Total paid | 169,884 | 146,755 | ||||||||
| Net balance, September 30 | 580,670 | 537,261 | ||||||||
| Plus, reinsurance recoverables | 97,466 | 91,025 | ||||||||
| Balance, September 30 | $ | 678,136 | $ | 628,286 | ||||||
During the nine months ended September 30, 2003 and 2002, management made adjustments to prior year’s reserves for unpaid loss and loss adjustment expenses, specifically, accident years 1999 through 2002. The unfavorable development totaled $43.3 million in 2003 and $2.6 million in 2002. As a percentage of net reserves as of the beginning of the year, these adjustments represented 7.9% and 0.5% in 2003 and 2002, respectively.
Unfavorable development of $43 million was recorded in the third quarter of 2003 on the Company’s medical professional liability segment. This development was the result of increased severities in paid claims in the third quarter of 2003, which indicated a much higher trend in claims severity. As a result, actuarial projections calculated higher ultimate severities of loss on currently existing claims related to the 1999 to 2002 accident years. Due to the higher ultimate estimated severity and corresponding higher ultimate loss, management increased its estimate of incurred but not reported claims related to the 1999 through 2002 accident years.
The unfavorable development in the third quarter of 2003 was primarily related to the Company’s Florida ($16 million), Ohio ($16.4 million) and Kentucky ($15 million) markets, partially offset by positive
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
development in the Michigan market. The Company announced its exit of the Florida market in 2002 and discontinued writing occurrence policies in Ohio in early 2002. Primarily due to the elimination of poor risks in Kentucky, the Company’s insured physician count in that state has decreased approximately 10% from December 31, 2002.
Management believes that the estimate of the ultimate liability for losses and loss adjustment expenses at September 30, 2003 is reasonable and reflective of anticipated ultimate experience. However, it is possible that the Company’s actual incurred loss and loss adjustment expenses will not conform to the assumptions inherent in the determination of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying Unaudited Condensed Consolidated Financial Statements.
7. Long Term Debt
In May 2003, the Company formed American Physicians Capital Statutory Trust I and APCapital Trust II (the “Trusts”) by contributing equity of $464,000 to each trust. The trusts were formed for the purpose of issuing mandatorily redeemable trust preferred securities (“TPS”). Each trust issued $15 million of TPS to another trust formed by an institutional investor. The trusts received a total of $29.1 million in net proceeds, after the deduction of a total of approximately $906,000 of commissions paid to the placement agents in the transactions. These commissions were ultimately paid by APCapital, and have been capitalized and are included in other assets on the accompanying Unaudited Condensed Consolidated Balance Sheet. Issuance costs will be amortized over five years as a component of amortization expense. The TPS issued by the trusts have financial terms similar to the floating rate junior subordinated deferrable interest debentures (the “Debentures”) issued by APCapital.
The gross proceeds from the trust issuances, and the cash from the equity contribution, were used by the trusts to purchase Debentures issued by APCapital. In accordance with FIN No. 46, these trusts are not consolidated in the Company’s Unaudited Condensed Consolidated Financial Statements. See Note 2 for further discussion regarding the impact of FIN No. 46.
The Debentures issued by APCapital mature in 30 years and bear interest at an annual rate equal to the three-month LIBOR plus 4.10% for the first trust issuance, and plus 4.20% for the second trust issuance, payable quarterly beginning in August 2003. The interest rate is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 12.50%. The weighted average interest rates of 5.32% (Trust I issuance) and 5.42% (Trust II issuance) resulted in interest expense of approximately $414,000 and $602,000 for the three months and nine months ended September 30, 2003. At September 30, 2003, accrued interest payable to the trusts was approximately $182,000. The Debentures are callable by APCapital at par beginning in May 2008. APCapital has guaranteed that the payments made to the Trusts will be distributed by the Trusts to the holders of the TPS.
The Debentures are unsecured obligations of the Company and are junior in the right of payment to all future senior indebtedness of the Company. The Company estimates that the fair value of the debentures approximates the gross proceeds of cash received at the time of issuance.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
8. Income Taxes
The provision for income taxes for the three months and nine months ended September 30, 2003 and 2002 consists of:
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||
| (In thousands) | ||||||||||||||||
| Current (benefit) expense | $ | (12,355 | ) | $ | 3,145 | $ | (13,339 | ) | $ | (2,960 | ) | |||||
| Deferred benefit | (2,971 | ) | (4,193 | ) | (1,921 | ) | (1,461 | ) | ||||||||
| Deferred tax valuation allowance | 49,947 | — | 49,947 | — | ||||||||||||
| $ | 34,621 | $ | (1,048 | ) | $ | 34,687 | $ | (4,421 | ) | |||||||
Income taxes incurred do not bear the usual relationship to income before income taxes for the three-month and nine-month periods ended September 30, 2003 and 2002 due to the following:
| Three Months Ended | Nine Months Ended | ||||||||||||||||||||||||||||||||
| September 30, | September 30, | ||||||||||||||||||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||||||||||||
| Loss before income taxes | $ | (42,434 | ) | $ | (2,996 | ) | $ | (42,246 | ) | $ | (12,619 | ) | |||||||||||||||||||||
| Tax at statutory rate | $ | (14,852 | ) | 35.0% | $ | (1,049 | ) | 35.0% | $ | (14,786 | ) | 35.0% | $ | (4,417 | ) | 35.0% | |||||||||||||||||
| Tax effect of: | |||||||||||||||||||||||||||||||||
| Tax exempt interest | (124 | ) | 0.3% | (116 | ) | 3.9% | (372 | ) | 0.9% | (402 | ) | 3.2% | |||||||||||||||||||||
| Other items, net | (350 | ) | 0.8% | 117 | -3.9% | (102 | ) | 0.2% | 398 | -3.2% | |||||||||||||||||||||||
| Deferred tax valuation allowance | 49,947 | -117.7% | 0.0% | 49,947 | -118.2% | — | 0.0% | ||||||||||||||||||||||||||
| $ | 34,621 | -81.6% | $ | (1,048 | ) | 35.0% | $ | 34,687 | -82.1% | $ | (4,421 | ) | 35.0% | ||||||||||||||||||||
Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. The Company has reviewed its deferred federal income tax assets for recoverability based on the availability of future taxable income when the deductible temporary differences are expected to reverse, and has determined, based on its recent loss experience, that sufficient taxable income may not exist in the periods of reversal. Accordingly, the Company has recorded a deferred tax asset valuation allowance for the entire net deferred tax asset. The valuation allowance is recorded as federal income tax expense in the accompanying Unaudited Condensed Consolidated Statements of Income. Once the Company has re-established a pattern of profitability, the deferred tax asset valuation allowance may be reduced upon evaluation of the availability of future taxable income.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
At September 30, 2003 and December 31, 2002, the components of the net deferred tax asset were as follows:
| September 30, | December 31, | |||||||||
| 2003 | 2002 | |||||||||
| (In thousands) | ||||||||||
| Deferred tax assets arising from | ||||||||||
| Losses and loss adjustment expenses | $ | 29,672 | $ | 31,072 | ||||||
| Net operating loss carryforwards | 17,083 | 3,326 | ||||||||
| Unearned and audit premiums | 8,191 | 8,140 | ||||||||
| Minimum tax credits | 8,242 | 9,101 | ||||||||
| Realized losses on investments | 3,366 | 2,893 | ||||||||
| Goodwill | 4,899 | 5,485 | ||||||||
| Other | 2,663 | 1,846 | ||||||||
| Total deferred tax assets | 74,116 | 61,863 | ||||||||
| Deferred tax liabilities arising from | ||||||||||
| Deferred policy acquisition costs | (4,236 | ) | (3,807 | ) | ||||||
| Unrealized gain on securities | (17,402 | ) | (13,266 | ) | ||||||
| Other | (2,531 | ) | (2,248 | ) | ||||||
| Total deferred tax liabilities | (24,169 | ) | (19,321 | ) | ||||||
| Net deferred tax asset before valuation allowance | 49,947 | 42,542 | ||||||||
| Valuation allowance | (49,947 | ) | — | |||||||
| Net deferred tax asset | $ | — | $ | 42,542 | ||||||
At September 30, 2003, the Company had approximately $9.5 million of net operating loss carryforwards that expire in 2012 and are limited to approximately $910,000 annually, and approximately $39.3 million of net operating loss carryforwards that expire in 2018 and are not limited as to their annual use. Additionally, the Company has $8.2 million of minimum tax credits which can be carried forward indefinitely.
9. Shareholders Equity
On September 11, 2003, APCapital’s Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439. During the quarter, the Company purchased 251,300 shares at a cost of $7,068,000, or an average price per share of $28.13, bringing the total number of shares purchased pursuant to these authorizations to 3,175,570, at a total cost of $59,775,000, or an average price per share of $18.82. The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and the rules of the Nasdaq Stock Market. The timing of the purchases and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. As of September 30, 2003, the Company has approximately 440,000 shares of its September 11, 2003 stock repurchase program remaining to be purchased.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and the notes thereto included elsewhere in this report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. The following discussion of our financial condition and results of operations contains certain forward-looking statements related to our anticipated future financial condition and operating results and our current business plans. When we use words such as “believes,” “expects,” “anticipates,” “estimates” or similar expressions, we are making forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report. While we believe that any forward-looking statements we have made are reasonable, actual results could differ materially since these statements are based on our current expectations and are subject to risks and uncertainties. These risks and uncertainties are detailed from time to time in reports filed by the Company with the Securities and Exchange Commission (“SEC”). See, for example, the disclosures in “Item 1 — Business — Uncertainties Relating to Forward-Looking Statements” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2002, and in other reports filed by the Company with the SEC.
In addition to those factors previously detailed and stated elsewhere in this report, the Company has identified the following risks and uncertainties that could cause our future actual results to differ materially from our current expectations.
| • | A deterioration in the current accident year experience could result in a portion or all of our deferred policy acquisition costs not being recoverable, which would result in a charge to income. | |
| • | The continued adverse development related to the run-off of our personal and commercial business could result in additional unanticipated losses. | |
| • | We may be unable to collect the full amount of reinsurance recoverable from Gerling Global, a significant reinsurer, if their cash flow or surplus levels are inadequate to make claim payments, which could result in a future charge to income. | |
| • | We may experience unforeseen costs in the fourth quarter of 2003 and in future periods, associated with our exit from the health insurance line of business and possible run-off of workers’ compensation claims, which could result in future charges to income. |
Other factors not currently anticipated by management may also materially and adversely affect the Company’s financial position and results of operations. The Company does not undertake, and expressly disclaims any obligation, to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
We operate primarily in three insurance product segments: medical professional liability, workers’ compensation, and health. Effective December 31, 2001, the Company exited the personal and commercial lines of business. The personal and commercial insurance operating segment will continue to generate income (loss) due to the development of unpaid loss and loss adjustment expenses associated with this segment.
In September 2003, management formally adopted a plan to exit the health insurance line of business. Additionally, subsequent to the end of the third quarter of 2003, the Company has entered into a non-binding letter of intent for the sale of its workers’ compensation policy renewals.
See Note 4 of the Notes to Unaudited Condensed Consolidated Financial Statements, contained elsewhere in this report, for further information regarding the operating results of our business segments.
Non GAAP and Other Financial Measures
In the analysis of our operating results that follows, we refer to various financial ratios and other measures that management uses to analyze and compare the underwriting results of our insurance operations. These ratios are calculated on a GAAP basis and include:
| • | Loss ratio — This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and |
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| related settlement expenses compared to the amount of premiums we earn. The lower the percentage, the more profitable our insurance business is, all other things being equal. | ||
| • | Underwriting expense ratio — This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and operating the insurance segments. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business and improve our loss ratio, and overall profitability. | |
| • | Combined ratio — This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income. | |
| • | Underwriting gain (loss) — This measure equals the net premiums earned less loss and loss adjustment expenses as well as underwriting expenses. It is another measure of the underwriting performance of our various insurance segments. |
In addition to our reported GAAP loss ratios, we also report accident year loss ratios. The accident year loss ratio is computed by taking total incurred loss and loss adjustment expenses, less any development on prior year loss reserves, divided by net premiums earned. We believe this ratio is useful in evaluating our current underwriting performance, as it focuses on the relationships between current premiums earned and current losses. Considerable variability is inherent in the establishment of loss reserves related to the current accident year. While management believes that its estimate is reasonable, there can be no assurance that these loss reserves will develop as expected. Our method of calculating accident year loss ratios may differ from those used by other companies and, therefore, comparability may be limited.
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Results of Operations — Three Months and Nine Months Ended September 30, 2003, Compared to Three Months and Nine Months Ended September 30, 2002
Medical Professional Liability Insurance Operations
The following table sets forth the operating results of our medical professional liability insurance segment for the three-month and nine-month periods ended September 30, 2003 and 2002.
| Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||
| Percentage | Percentage | |||||||||||||||||||||||||||||||||
| 2003 | 2002 | Change | Change | 2003 | 2002 | Change | Change | |||||||||||||||||||||||||||
| (Dollars in thousands) | ||||||||||||||||||||||||||||||||||
| Direct premiums written: | ||||||||||||||||||||||||||||||||||
| Illinois | $ | 25,888 | $ | 15,180 | $ | 10,708 | 70.5% | $ | 46,726 | $ | 29,207 | $ | 17,519 | 60.0% | ||||||||||||||||||||
| Michigan | 20,764 | 18,852 | 1,912 | 10.1% | 36,545 | 35,309 | 1,236 | 3.5% | ||||||||||||||||||||||||||
| Ohio | 13,000 | 11,502 | 1,498 | 13.0% | 29,228 | 27,621 | 1,607 | 5.8% | ||||||||||||||||||||||||||
| Kentucky | 2,686 | 3,116 | (430 | ) | 13.8% | 12,699 | 13,129 | (430 | ) | -3.3% | ||||||||||||||||||||||||
| New Mexico | 5,132 | 4,330 | 802 | 18.5% | 12,157 | 8,375 | 3,782 | 45.2% | ||||||||||||||||||||||||||
| Florida | 1,638 | 7,335 | (5,697 | ) | -77.7% | 6,014 | 19,233 | (13,219 | ) | -68.7% | ||||||||||||||||||||||||
| Nevada | 1,661 | 1,539 | 122 | 7.9% | 4,079 | 3,553 | 526 | 14.8% | ||||||||||||||||||||||||||
| Other | 1,252 | 883 | 369 | 41.8% | 3,245 | 2,285 | 960 | 42.0% | ||||||||||||||||||||||||||
| Total | $ | 72,021 | $ | 62,737 | $ | 9,284 | 14.8% | $ | 150,693 | $ | 138,712 | $ | 11,981 | 8.6% | ||||||||||||||||||||
| Net premiums written | $ | 61,661 | $ | 54,842 | $ | 6,819 | 12.4% | $ | 128,395 | $ | 120,412 | $ | 7,983 | 6.6% | ||||||||||||||||||||
| Net premiums earned | $ | 41,043 | $ | 40,089 | $ | 954 | 2.4% | $ | 118,903 | $ | 108,064 | $ | 10,839 | 10.0% | ||||||||||||||||||||
| Incurred loss and loss adjustment expenses: | ||||||||||||||||||||||||||||||||||
| Current accident year losses | 40,823 | 44,656 | (3,833 | ) | -8.6% | 118,242 | 122,451 | (4,209 | ) | -3.4% | ||||||||||||||||||||||||
| Prior year losses | 43,000 | 1,500 | 41,500 | 2766.7% | 44,250 | 4,000 | 40,250 | 1006.3% | ||||||||||||||||||||||||||
| Total | 83,823 | 46,156 | 37,667 | 81.6% | 162,492 | 126,451 | 36,041 | 28.5% | ||||||||||||||||||||||||||
| Underwriting expenses | 7,770 | 7,404 | 366 | 4.9% | 22,662 | 20,471 | 2,191 | 10.7% | ||||||||||||||||||||||||||
| Underwriting loss | $ | (50,550 | ) | $ | (13,471 | ) | $ | (37,079 | ) | 275.3% | $ | (66,251 | ) | $ | (38,858 | ) | $ | (27,393 | ) | 70.5% | ||||||||||||||
| Income (loss) before federal income taxes and cumulative effect of a change in accounting principle | $ | (41,595 | ) | $ | (4,711 | ) | $ | (36,884 | ) | -782.9% | $ | (39,937 | ) | $ | (13,294 | ) | $ | (26,643 | ) | -200.4% | ||||||||||||||
| Loss ratio: | ||||||||||||||||||||||||||||||||||
| Accident year | 99.5% | 111.4% | -11.9% | 99.4% | 113.3% | -13.9% | ||||||||||||||||||||||||||||
| Prior years | 104.7% | 3.7% | 101.0% | 37.3% | 3.7% | 33.6% | ||||||||||||||||||||||||||||
| Calendar year | 204.2% | 115.1% | 89.1% | 136.7% | 117.0% | 19.7% | ||||||||||||||||||||||||||||
| Underwriting expense ratio | 18.9% | 18.5% | 0.4% | 19.1% | 18.9% | 0.2% | ||||||||||||||||||||||||||||
| Combined ratio | 223.1% | 133.6% | 89.5% | 155.8% | 135.9% | 19.9% | ||||||||||||||||||||||||||||
Direct premiums written increased $9.3 million, or 14.8%, to $72.0 million for the three months ended September 30, 2003 compared to the three months ended September 30, 2002. Direct premiums written for the nine months ended September 30, 2003 increased $12.0 million, or 8.6%, to $150.7 million compared to the same period of 2002. These increases were primarily the result of rate increases in all markets, especially Illinois, Ohio and New Mexico. The increases were partially offset by a decrease in the number of policies in-force primarily due to the exit from our Florida market, the discontinuance of Ohio occurrence-based policies and the elimination of poor risks in other markets such as Kentucky.
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We believe that the current pricing environment for medical professional liability insurance is favorable. We expect medical professional liability direct premiums written to increase moderately in the future as the Company is granted additional rate increases by regulatory authorities. However, this growth may be limited by the Company’s ability to allocate appropriate levels of statutory capital and surplus to the medical professional liability segment. The Company is continually seeking regulatory approval of additional rate increases.
In the second quarter of 2002, the Company announced its intention to discontinue writing medical professional liability insurance in Florida. Medical professional liability direct premiums written in the state of Florida for the year ended December 31, 2002 were $23.6 million, and the Company reported net loss and loss adjustment expenses for that period of $35.2 million relating to its Florida business. The Florida Department of Insurance approved the Company’s plan to exit this market and in October 2002, the Company began mailing non-renewal notices to medical professional liability policyholders whose renewals would have been effective in December 2002. Florida law requires the Company to offer extended reporting coverage for previously insured periods, commonly referred to as “tail policies,” at the time of non-renewal. Tail policies typically have written premiums of approximately two times the last annual policy premium. The Company expects that some physicians will opt for this extended reporting coverage, which will result in additional direct premiums written in 2003 and net premiums earned in 2004.
In March 2003, the Company invested $2.5 million, for a 49% ownership stake, in a new insurance company, Physicians Insurance Company (“PIC”), managed by the management of the Company’s third-party administrator who underwrites its Florida extended reporting coverage. This new insurance company is seeking to write as many of the tail policies as its capital and surplus levels will permit, thereby limiting the Company’s direct exposure to future losses associated with underwriting Florida medical professional liability extended reporting period coverages. During the three months and nine months ended September 30, 2003, the Company, on a direct basis, wrote $1.6 million and $6.0 million, respectively, in Florida. This compares with budgeted writings of $4.8 million and $13.4 million, respectively. The decrease in actual writings compared to budget is in large part due to the greater than expected number of policies being written by PIC. The Company lent $1 million to the President of PIC to enable him to complete the acquisition of the remaining 51% of outstanding shares of PIC’s common stock. As of September 30, 2003, this loan was entirely repaid.
In Ohio, the Company has experienced an increase in the overall severity and frequency of large losses in the Northeastern portion of the state. In response, early in 2002, the Company reduced policy limits, discontinued writing occurrence policies, and significantly restricted business writing in this area. In Kentucky, the frequency and severity of large losses has also increased. The Company has reduced policy limits, discontinued occurrence based policies and reduced the insured physician count, primarily through the non-renewal of poor risks, in this state.
Net premiums earned for the three months ended September 30, 2003 increased $954,000, or 2.4%, to $41.0 million compared to $40.1 million for the three months ended September 30, 2002. This increase was less than the increase in direct premiums written as premiums written during the quarter were largely unearned at September 30, 2003. Net premiums earned for the nine months ended September 30, 2003 increased $10.8 million, or 10.0%, compared to the same period of 2002. The increase in net premiums earned for the nine months ended September 30, 2003 was greater than the increase in direct premiums written, as premiums written in 2002 in Florida, continue to be earned in 2003.
The loss ratios for the three months and nine months ended September 30, 2003 were 204.2% and 136.7% compared to 115.1% and 117.0%, respectively, for the same periods of 2002. These increases were the result of $43 million of adverse development on prior year loss and loss adjustment expense reserves in the third quarter of 2003. This development occurred primarily in reserves for the accident years 1999 through 2002, in the Company’s Florida ($16.0 million), Ohio ($16.4 million) and Kentucky ($15.0 million) markets, partially offset by favorable development in the Michigan market. This reserve increase was primarily the result of an increase in the severity of paid claims, which became apparent in the third quarter, and indicated a much higher trend of ultimate average loss severity. As a result of the higher projected ultimate average loss severity,
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The loss ratio, on an accident year basis, was 99.5% for the three-month period and 99.4% for the nine-month period ended September 30, 2003 compared to 111.4% and 113.3%, respectively, for the same periods of 2002. The decreases in the accident year loss ratios were primarily the result of rate increases taken in all markets.
Underwriting expenses for the three months and nine months ended September 30, 2003 were $7.8 million and $22.7 million, respectively, which represent increases of $366,000 and $2.2 million, respectively, compared to the same periods of 2002. The increases in underwriting expenses were the result of commissions and premium taxes on higher premium volumes. As a percentage of net premiums earned, underwriting expenses were relatively unchanged in 2003 compared to 2002.
Management has evaluated the Company’s deferred policy acquisition costs for recoverability and has determined that, after consideration of future investment income, all deferred policy acquisition costs carried on the balance sheet as of September 30, 2003 are recoverable. However, a deterioration in our projected accident year loss ratios may result in these deferred costs not being recoverable, which would result in additional underwriting expense in the period the costs are charged off.
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Workers’ Compensation Insurance Operations
The following table sets forth the results of operations of our workers’ compensation insurance segment for the three-month and nine-month periods ended September 30, 2003 and 2002.
| Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||
| Percentage | Percentage | |||||||||||||||||||||||||||||||||
| 2003 | 2002 | Change | Change | 2003 | 2002 | Change | Change | |||||||||||||||||||||||||||
| (Dollars in thousands) | ||||||||||||||||||||||||||||||||||
| Direct premiums written: | ||||||||||||||||||||||||||||||||||
| Minnesota | $ | 3,758 | $ | 5,344 | $ | (1,586 | ) | -29.7% | $ | 12,079 | $ | 25,483 | $ | (13,404 | ) | -52.6% | ||||||||||||||||||
| Michigan | 3,359 | 3,232 | 127 | 3.9% | 8,515 | 9,663 | (1,148 | ) | -11.9% | |||||||||||||||||||||||||
| Illinois | 2,955 | 3,326 | (371 | ) | -11.2% | 6,387 | 7,869 | (1,482 | ) | -18.8% | ||||||||||||||||||||||||
| Indiana | 1,591 | 2,376 | (785 | ) | -33.0% | 3,765 | 5,748 | (1,983 | ) | -34.5% | ||||||||||||||||||||||||
| Wisconsin | 631 | 60 | 571 | 951.7% | 1,491 | 309 | 1,182 | 382.5% | ||||||||||||||||||||||||||
| Iowa | (1 | ) | 151 | (152 | ) | -100.7% | 84 | 1,184 | (1,100 | ) | -92.9% | |||||||||||||||||||||||
| Kentucky | (2 | ) | 624 | (626 | ) | -100.3% | (26 | ) | 3,762 | (3,788 | ) | -100.7% | ||||||||||||||||||||||
| Other | 135 | 196 | (61 | ) | -31.1% | 299 | 690 | (391 | ) | -56.7% | ||||||||||||||||||||||||
| Total | $ | 12,426 | $ | 15,309 | $ | (2,883 | ) | -18.8% | $ | 32,594 | $ | 54,708 | $ | (22,114 | ) | -40.4% | ||||||||||||||||||
| Net premiums written | $ | 12,440 | $ | 14,603 | $ | (2,163 | ) | -14.8% | $ | 33,788 | $ | 51,641 | $ | (17,853 | ) | -34.6% | ||||||||||||||||||
| Net premiums earned | $ | 10,275 | $ | 15,832 | $ | (5,557 | ) | -35.1% | $ | 33,598 | $ | 46,636 | $ | (13,038 | ) | -28.0% | ||||||||||||||||||
| Incurred loss and loss adjustment expenses: | ||||||||||||||||||||||||||||||||||
| Current accident year losses | 8,442 | 11,808 | (3,366 | ) | -28.5% | 26,894 | 37,583 | (10,689 | ) | -28.4% | ||||||||||||||||||||||||
| Prior year losses | — | (500 | ) | 500 | -100.0% | (1,400 | ) | (2,000 | ) | 600 | -30.0% | |||||||||||||||||||||||
| Total | 8,442 | 11,308 | (2,866 | ) | -25.3% | 25,494 | 35,583 | (10,089 | ) | -28.4% | ||||||||||||||||||||||||
| Underwriting expenses | 2,966 | 3,516 | (550 | ) | -15.6% | 10,869 | 11,278 | (409 | ) | -3.6% | ||||||||||||||||||||||||
| Underwriting (loss) income | $ | (1,133 | ) | $ | 1,008 | $ | (2,141 | ) | -212.4% | $ | (2,765 | ) | $ | (225 | ) | $ | (2,540 | ) | 1128.9% | |||||||||||||||
| Income before federal income taxes and cumulative effect of a change in accounting principle | $ | 160 | $ | 2,816 | $ | (2,656 | ) | -94.3% | $ | 1,395 | $ | 4,951 | $ | (3,556 | ) | -71.8% | ||||||||||||||||||
| Loss ratio: | ||||||||||||||||||||||||||||||||||
| Accident year | 82.2% | 74.6% | 7.6% | 80.0% | 80.6% | -0.6% | ||||||||||||||||||||||||||||
| Prior years | 0.0% | -3.2% | 3.2% | -4.1% | -4.3% | 0.2% | ||||||||||||||||||||||||||||
| Calendar year | 82.2% | 71.4% | 10.8% | 75.9% | 76.3% | -0.4% | ||||||||||||||||||||||||||||
| Underwriting expense ratio | 28.9% | 22.2% | 6.7% | 32.4% | 24.2% | 8.2% | ||||||||||||||||||||||||||||
| Combined ratio | 111.1% | 93.6% | 17.5% | 108.3% | 100.5% | 7.8% | ||||||||||||||||||||||||||||
Beginning in June 2002, the Company filled several executive and management positions with the intent to improve the overall performance of this segment. Our plan was to upgrade management expertise, re-underwrite and restructure the book of business, and position this segment for growth. However, during 2003, the workers’ compensation market has remained very competitive and new business growth has not kept pace with expectations. As a result, management has refocused its plan for the workers’ compensation segment and there have been several departures among the senior management team of this line.
As a result of our re-underwriting and restructuring efforts in 2002 and 2003, direct premiums written have decreased as the Company began to exit the Kentucky market, and certain other higher-risk construction policies were non-renewed in all markets. Direct premiums written decreased $2.9 million, or 18.8%, for the three months ended September 30, 2003 and $22.1 million, or 40.4%, for the nine months ended September 30, 2003 compared to the same periods of 2002.
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Subsequent to the end of the third quarter the Company has entered into a non-binding letter of intent for the sale of workers’ compensation policy renewals. The sale would provide the Company with a 2.5% fee for all premiums renewed over the next three years. The Company would continue to write business in Michigan and Minnesota under a 100% reinsurance arrangement with the purchaser. This fronting arrangement would continue for approximately one year, or until the purchaser is licensed in those states. The Company would be paid a fronting fee of 5.0% under this arrangement.
The Company has also begun the process of negotiating a loss portfolio transfer for its existing workers’ compensation reserves for unpaid losses and loss adjustment expenses. As of September 30, 2003, workers’ compensation reserves for unpaid loss and loss adjustment expenses totaled $68.3 million, $62.4 million net of reinsurance.
During the fourth quarter of 2003, the Company will finalize the terms of this transaction, and determine what, if any, restructuring charges or reserve enhancements will be needed. If the Company is required to run-off existing claims, the charges related to this exit could be significant in the fourth quarter.
Net premiums earned for the three months ended September 30, 2003 decreased $5.6 million, or 35.1%, compared to the same period of 2002 due primarily to the restructuring efforts discussed above, which began primarily in the fourth quarter of 2002. Net premiums earned for the nine months ended September 30, 2003 decreased $13.0 million, or 28.0%, compared to the nine months ended September 30, 2002. This decrease was not as great as the decrease in direct premiums written, as premiums written in 2002 on business that was non-renewed in 2003 continued to be earned during the first nine months of 2003.
The restructuring of this book of business, described above, combined with rate increases and improved claims management, have translated into lower calendar year and accident year loss ratios, 75.9% and 80.0%, respectively, for the nine months ended September 30, 2003 compared to 76.3% and 80.6%, respectively, for the same period of 2002. The benefits of the improved claims management and rate increases, however, were partially offset by an increase in loss adjustment expenses related primarily to salaries of the executives and managers the Company hired to restructure the workers’ compensation book of business. The loss ratio for the three months ended September 30, 2003 was 82.2% compared to 71.4% for the same period of 2002. This increase was primarily attributable to loss adjustment expense costs associated with new staff, described above, that were not able to be absorbed due to the decrease in net premiums earned for the period.
Prior year loss and loss adjustment expense reserves developed favorably by $1.4 million during the nine months ended September 30, 2003. This prior year favorable development was related primarily to the Company’s Minnesota market, and was the result of losses on prior accident years settling for less than originally anticipated. Favorable development on prior year loss and loss adjustment expense reserves was $500,000 and $2.0 million, respectively, for the three months and nine months ended September 30, 2002.
Salary and severance costs related to the management team during the first half of 2003, combined with the decreases in net premiums earned, were the primary reasons for the increases in the underwriting expense ratios to 28.9% and 32.4%, respectively, during the three and nine-month periods ending September 30, 2003 compared to 22.2% and 24.2%, respectively, for the same periods of 2002.
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Health Insurance Operations
The following table sets forth the results of operations of our health insurance segment for the three-month and nine-month periods ended September 30, 2003 and 2002.
| For the Three Months Ended | ||||||||||||||||||||||||||||||||||
| September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||
| Percentage | Percentage | |||||||||||||||||||||||||||||||||
| 2003 | 2002 | Change | Change | 2003 | 2002 | Change | Change | |||||||||||||||||||||||||||
| (Dollars in thousands) | ||||||||||||||||||||||||||||||||||
| Direct premiums written | $ | 5,513 | $ | 5,773 | $ | (260 | ) | -4.5% | $ | 18,095 | $ | 17,118 | $ | 977 | 5.7% | |||||||||||||||||||
| Net premiums written | $ | 5,270 | $ | 5,500 | $ | (230 | ) | -4.2% | $ | 17,258 | $ | 16,860 | $ | 398 | 2.4% | |||||||||||||||||||
| Net premiums earned | $ | 5,270 | $ | 5,500 | $ | (230 | ) | -4.2% | $ | 17,258 | $ | 16,860 | $ | 398 | 2.4% | |||||||||||||||||||
| Incurred loss and loss adjustment expenses: | ||||||||||||||||||||||||||||||||||
| Current accident year losses | 4,076 | 5,140 | (1,064 | ) | -20.7% | 15,284 | 15,797 | (513 | ) | -3.2% | ||||||||||||||||||||||||
| Prior year losses | — | — | — | 0.0% | (468 | ) | — | — | 0.0% | |||||||||||||||||||||||||
| Total | 4,076 | 5,140 | (1,064 | ) | -20.7% | 14,816 | 15,797 | (981 | ) | -6.2% | ||||||||||||||||||||||||
| Underwriting expenses | 978 | 1,022 | (44 | ) | -4.3% | 3,077 | 3,557 | (480 | ) | -13.5% | ||||||||||||||||||||||||
| Underwriting income (loss) | $ | 216 | $ | (662 | ) | $ | 878 | -132.6% | $ | (635 | ) | $ | (2,494 | ) | $ | 1,859 | -74.5% | |||||||||||||||||
| Income (loss) before federal income taxes and cumulative effect of a change in accounting principle | $ | 361 | $ | (482 | ) | $ | 843 | -174.9% | $ | (149 | ) | $ | (2,029 | ) | $ | 1,880 | -92.7% | |||||||||||||||||
| Loss ratio: | ||||||||||||||||||||||||||||||||||
| Accident year | 77.3% | 93.5% | -16.2% | 88.6% | 93.7% | -5.1% | ||||||||||||||||||||||||||||
| Prior years | 0.0% | 0.0% | 0.0% | -2.7% | 0.0% | -2.7% | ||||||||||||||||||||||||||||
| Calendar year | 77.3% | 93.5% | -16.2% | 85.9% | 93.7% | -7.8% | ||||||||||||||||||||||||||||
| Underwriting expense ratio | 18.6% | 18.6% | 0.0% | 17.8% | 21.1% | -3.3% | ||||||||||||||||||||||||||||
| Combined ratio | 95.9% | 112.1% | -16.2% | 103.7% | 114.8% | -11.1% | ||||||||||||||||||||||||||||
All health direct premiums written are related to our involvement with a single preferred provider organization located in western Michigan. This coverage is provided as part of our strategic relationship with the physician organization that sponsors this plan. Direct premiums written decreased $260,000, or 4.5%, to $5.5 million for the three months ended September 30, 2003, compared to the same period of 2002. Direct premiums written increased $977,000, or 5.7%, to $18.1 million for the nine months ended September 30, 2003 compared to the same period of 2002. The changes in direct premiums written were the result of a decrease in the number of covered lives during 2003 and the effect of rate increases in 2003. The number of covered lives has been decreasing as we tighten our underwriting standards. The following table shows the number of covered lives and the per-member-per-month (“PMPM”) premium at September 30, 2003, December 31, 2002, and September 30, 2002.
| Covered | PMPM | ||||||||
| Lives | Premium | ||||||||
| (actual dollars) | |||||||||
Month Ended: | |||||||||
| September 30, 2003 | 8,072 | $ | 221 | ||||||
| December 31, 2002 | 12,898 | $ | 188 | ||||||
| September 30, 2002 | 11,230 | $ | 172 | ||||||
Change: | |||||||||
| September 2003 vs. December 2002 | (4,826 | ) | $ | 33 | |||||
| September 2003 vs. September 2002 | (3,158 | ) | $ | 49 | |||||
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The increase in net premiums earned for the nine months ended September 30, 2003 compared to the same period of 2002 was less than the increase in direct premiums written for the nine months ended September 30, 2003, as a result of fewer assumed premiums due to our exit from a reinsurance pool in the second quarter of 2002.
The decreases in loss ratio to 77.3% and 85.9%, respectively, for the three months and nine months ended September 30, 2003 compared to 93.5% and 93.7%, respectively, for the same periods of 2002, were primarily the result of improved underwriting and premium rate increases. Prior year loss and loss adjustment expense reserves developed favorably by $468,000 during the nine months ended September 30, 2003. This favorable development was the result of re-underwriting efforts in 2002.
Underwriting expenses and the underwriting expense ratio for the three months ended September 30, 2003 were relatively consistent with the same period of 2002. Underwriting expenses for the nine months ended September 30, 2003 decreased $480,000 to $3.1 million compared to the same period of 2002. As a percentage of net premiums earned, underwriting expenses for the nine months ended September 30, 2003 were 17.8% compared to 21.1% for the same period of 2002. The decrease in underwriting expenses and the underwriting expense ratio were primarily due to the reduction of certain corporate overhead expenses related to the health insurance segment as well as a reduction in fees charged by a third-party administrator who handles policy administration and premium collections on behalf of the Company.
In September 2003, management formally adopted a plan to exit the health insurance line of business. The day to day aspects of the Company’s health insurance business are administered by a third party administrator (“TPA”). The contract between the TPA and the Company requires the Company to provide a 180 day notice to the TPA of its intent to terminate the agreement. The Company plans to give notice of this termination effective December 31, 2003. The Company will continue to renew policies during this 180-day period, after which, the Company will not issue any additional health insurance policies. Due to the one year term of most health policies, the Company will continue to have written and earned health insurance premiums throughout 2004 and into 2005. However, the Company is pursuing the possible placement of this business with another insurance carrier.
Personal and Commercial Lines Insurance Operations
The Company’s personal and commercial insurance product segment experienced a loss before federal income taxes and cumulative effect of a change in accounting principle of $371,000 and $1.4 million, respectively, for the three months and nine months ended September 30, 2003. For the three months and nine months ended September 30, 2002, the losses were $395,000 and $1.6 million, respectively. Loss before federal income taxes and cumulative effect of a change in accounting principles is closely related to the underwriting loss of the segment, as the investment income and other expenses allocated to this segment are minimal. However, in the first nine months of 2002, this segment recorded a realized loss of $293,000 related to the write-off of software that had previously been used to administer personal and commercial insurance policies.
The 2003 underwriting losses were the result of a ceded premium adjustment of $239,000 during the nine months ended September 30, 2003, compared to an adjustment of $590,000, during the same period of 2002. Loss and loss adjustment expense reserves continued to develop unfavorably in the amount of $380,000 for the three months ended September 30, 2003 and $931,000 for the nine months ended September 30, 2003, as compared to $324,000 and $630,000 for the same periods of 2002. In addition, through September 30, 2003, the Company has paid approximately $100,000 for third-party administrative service related to one of its alternative-risk transfer programs that is in run-off, as well as guarantee fund assessments of approximately $112,000. There were no underwriting or other fees during the first nine months of 2002.
In the second quarter of 2003, we engaged a personal and commercial claims specialist to help the Company bring the personal and commercial business to closure. We anticipate that all outstanding personal and commercial claims will settle by year end 2003. At September 30, 2003, there were less than 50 claims outstanding. This segment, however, will continue to generate income (loss) through 2003, and potentially beyond, due to the development of unpaid loss and loss adjustment expenses.
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Corporate and Other
For this segment, loss before federal income taxes and cumulative effect of a change in accounting principle for the three months ended September 30, 2003 was $993,000 compared to $224,000 for the same period of 2002. The increase was primarily attributable to increases in general and administrative expenses and interest expense as a result of the issuance of floating rate junior subordinated deferrable interest debentures discussed in Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements. The increase in these expenses was partially offset by an increase in other income.
The increase in the loss before federal income taxes and cumulative effect of a change in accounting principle for the nine months ended September 30, 2003 to $2.2 million from $599,000 for the same period of 2002 is again attributable to increases in general and administrative expenses and interest expense, as well as a decrease in investment income related to this segment. In the first quarter of 2002, APCapital had a portion of its assets invested in long-term bonds that generated significantly more interest than the short-term holdings of this segment in 2003.
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Consolidated Results of Operations
The following table sets forth our results of operations on a consolidated basis. The discussion that follows should be read in connection with the Unaudited Condensed Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.
| For the Three Months Ended September 30, | For the Nine Months Ended September 30, | ||||||||||||||||||||||||||||||||||
| Percentage | Percentage | ||||||||||||||||||||||||||||||||||
| 2003 | 2002 | Change | Change | 2003 | 2002 | Change | Change | ||||||||||||||||||||||||||||
| (Dollars in thousands) | |||||||||||||||||||||||||||||||||||
| Net premiums earned by insurance segment: | |||||||||||||||||||||||||||||||||||
| Medical professional liability | $ | 41,043 | $ | 40,089 | $ | 954 | 2.4% | $ | 118,903 | $ | 108,064 | $ | 10,839 | 10.0% | |||||||||||||||||||||
| Workers’ compensation | 10,275 | 15,832 | (5,557 | ) | -35.1% | 33,598 | 46,636 | (13,038 | ) | -28.0% | |||||||||||||||||||||||||
| Health | 5,270 | 5,500 | (230 | ) | -4.2% | 17,258 | 16,860 | 398 | 2.4% | ||||||||||||||||||||||||||
| Personal and commercial | — | — | — | (239 | ) | (590 | ) | 351 | -59.5% | ||||||||||||||||||||||||||
| Total net premiums earned | 56,588 | 61,421 | (4,833 | ) | -7.9% | 169,520 | 170,970 | (1,450 | ) | -0.8% | |||||||||||||||||||||||||
| Investment income | 11,400 | 11,421 | (21 | ) | -0.2% | 32,209 | 34,108 | (1,899 | ) | -5.6% | |||||||||||||||||||||||||
| Net realized gains (losses) | 143 | (390 | ) | 533 | 136.7% | 1,291 | (678 | ) | 1,969 | 290.4% | |||||||||||||||||||||||||
| Other income | 161 | 524 | (363 | ) | -69.3% | 518 | 786 | (268 | ) | -34.1% | |||||||||||||||||||||||||
| Total revenues and other income | 68,292 | 72,976 | (4,684 | ) | -6.4% | 203,538 | 205,186 | (1,648 | ) | -0.8% | |||||||||||||||||||||||||
| Losses and loss adjustment expenses | 96,721 | 62,928 | 33,793 | 53.7% | 203,733 | 178,461 | 25,272 | 14.2% | |||||||||||||||||||||||||||
| Underwriting expenses | 11,721 | 11,945 | (224 | ) | -1.9% | 36,828 | 35,306 | 1,522 | 4.3% | ||||||||||||||||||||||||||
| Investment expenses | 934 | 609 | 325 | 53.4% | 2,083 | 2,529 | (446 | ) | -17.6% | ||||||||||||||||||||||||||
| Interest expense | 502 | 95 | 407 | 428.4% | 875 | 278 | 597 | 214.7% | |||||||||||||||||||||||||||
| Amortization expense | 133 | — | 133 | 272 | — | 272 | |||||||||||||||||||||||||||||
| General and administrative expenses | 715 | 395 | 320 | 81.0% | 1,993 | 1,231 | 762 | 61.9% | |||||||||||||||||||||||||||
| Total expenses | 110,726 | 75,972 | 34,754 | 45.7% | 245,784 | 217,805 | 27,979 | 12.8% | |||||||||||||||||||||||||||
| Income (loss) before federal income taxes and cumulative effect of a change in accounting principle | (42,434 | ) | (2,996 | ) | (39,438 | ) | -1316.4% | (42,246 | ) | (12,619 | ) | (29,627 | ) | -234.8% | |||||||||||||||||||||
| Federal income tax expense (benefit) | 34,621 | (1,048 | ) | 35,669 | 3403.5% | 34,687 | (4,421 | ) | 39,108 | 884.6% | |||||||||||||||||||||||||
| Income (loss) before cumulative effect of a change in accounting principle | (77,055 | ) | (1,948 | ) | (75,107 | ) | -3855.6% | (76,933 | ) | (8,198 | ) | (68,735 | ) | -838.4% | |||||||||||||||||||||
| Cumulative effect of a change in accounting principle | — | — | — | — | (9,079 | ) | 9,079 | 100.0% | |||||||||||||||||||||||||||
| Net income (loss) | $ | (77,055 | ) | $ | (1,948 | ) | $ | (75,107 | ) | -3855.6% | $ | (76,933 | ) | $ | (17,277 | ) | $ | (59,656 | ) | -345.3% | |||||||||||||||
| Loss ratio | 170.9% | 102.5% | 68.4% | 120.2% | 104.4% | 15.8% | |||||||||||||||||||||||||||||
| Underwriting ratio | 20.7% | 19.4% | 1.3% | 21.7% | 20.7% | 1.0% | |||||||||||||||||||||||||||||
| Combined ratio | 191.6% | 121.9% | 69.7% | 141.9% | 125.1% | 16.8% | |||||||||||||||||||||||||||||
Net premiums earned for the three months ended September 30, 2003 decreased $4.8 million, or 7.9%, to $56.6 million and $1.5 million, or 0.8%, to $169.5 million for the nine months ended September 30, 2003, compared to the same periods of 2002. The decreases were primarily the result of the restructuring of our workers’ compensation book of business, partially offset by rate increases for workers’ compensation and medical professional liability policies.
The decrease in investment income of $1.9 million to $32.2 million for the nine months ended September 30, 2003 was the result of the Company’s unusually large cash position during the first half of 2003
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Included in investment income for the three months and nine months ended September 30, 2003 is approximately $65,000 and $465,000 relating to the increase in the fair value of derivative instruments. See “Item 3 — Quantitative and Qualitative Disclosures About Market Risk” and Note 1 of the Notes to Unaudited Condensed Consolidated Financial Statements included elsewhere in this report for further discussion regarding derivative instruments.
Net realized gains for the three months and nine months ended September 30, 2003 are reduced by a $300,000 and $1.3 million charge, respectively, for an “other than temporary impairment” (“OTTI”) on enhanced equipment trust certificates issued by Delta Airlines. Net realized losses for the three months and nine months ended September 30, 2002 were reduced by an OTTI charge of $390,000 for the write down of Frontier bonds.
Loss and loss adjustment expenses increased $33.8 million to $96.7 million for the three months ended September 30, 2003 and $25.3 million to $203.7 million for the nine months ended September 30, 2003 compared to the same period of 2002. The loss ratios for the three months and nine months ended September 30, 2003 were 170.9% and 120.2%, respectively, compared to 102.5% and 104.4%, respectively, for the same periods of 2002. The increases in incurred loss and loss adjustment expenses and the loss ratios were primarily the result of $43 million of unfavorable development on prior year reserves for unpaid loss and loss adjustment expenses on the Company’s medical professional liability segment in the third quarter of 2003. This development was the result of increased severities in paid claims in the third quarter of 2003, which indicated a much higher trend in claims severity. As a result, actuarial projections calculated higher ultimate severities of loss on currently existing claims related to the 1999 to 2002 accident years. Due to the higher ultimate estimated severity and corresponding higher ultimate loss, management increased its estimate of incurred but not reported claims related to the 1999 through 2002 accident years. The unfavorable development in the third quarter of 2003 was primarily related to the Company’s Florida ($16 million), Ohio ($16.4 million) and Kentucky ($15 million) markets, partially offset by positive development in the Michigan market. The Company announced its exit of the Florida market in 2002 and discontinued writing occurrence policies in Ohio in early 2002. Due to a very competitive pricing environment in Kentucky, the Company’s insured physician count in that state has decreased approximately 10% from December 31, 2002.
Underwriting expenses for the three months ended September 30, 2003 decreased $224,000 to $11.7 million compared to the same period of 2002. The decrease was primarily the result of reduced salary costs due to the departure of the workers’ compensation management team. Underwriting expenses for the nine months ended September 30, 2003 increased $1.5 million, or 4.3%, to $36.8 million compared to $35.3 million for the same period of 2002. The increase was primarily due to salary and other employee benefit costs associated with the new workers’ compensation management team prior to their departure, severance costs associated with these departures, and an increase in commissions and premium tax expense associated with increased premium writings. The underwriting expense ratios for the three months and nine months ended September 30, 2003 were 20.7% and 21.7%, respectively, compared to 19.4% and 20.7% for the same periods of 2002. The increase in the underwriting expense ratio for the nine months ended September 30, 2003 was primarily the result of the items described above, compounded by the decrease in net premiums earned. The increase in the loss ratio for the three months ended September 30, 2003 compared to 2002 was primarily attributable to the decrease in net premiums earned during the period.
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Investment expenses for the three months ended September 30, 2003 increased $325,000 to $934,000. The increase was primarily the result of expenses paid to the third-party managers of the Company’s high-yield bond portfolio, as well as other third-party administrative costs that were incurred in the third quarter of 2003. The expense for the three months ended September 30, 2003 is more representative of what management expects going forward. For the nine months ended September 30, 2003, investment expenses were $2.1 million compared to $2.5 million for the same period of 2002. The decrease in investment expenses for the nine-month period was primarily due to higher depreciation expense on several of the Company’s investment real estate properties in the first nine months of 2002.
The increases in interest expense of $407,000 and $597,000 for the three months and nine months ended September 30, 2003 compared to the same periods of 2002 were the result of the issuance of $30.9 million of floating rate junior subordinated deferrable interest debentures (the “Debentures”) in May of 2003. See Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements contained elsewhere in this report for a more detailed discussion of the Debentures.
Amortization expense in 2003 relates to a definite-lived intangible asset acquired in connection with the Company’s investment in Physicians Insurance Company, as well as capitalized debt issue costs associated with the Company’s issuance of the Debentures. The investment in Physicians Insurance Company is discussed more fully in our discussion of medical professional liability operating results contained elsewhere in this report. See Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements contained elsewhere in this report for a discussion of the Debentures.
The increases in the Company’s general and administrative expenses of $320,000 and $762,000 for the three months and nine months ended September 30, 2003, respectively, were primarily the result of a new errors and omissions liability insurance policy acquired in mid-2002 as well as increased legal, audit, and other professional fees pertaining to compliance with the new Sarbanes-Oxley legislation and related SEC rules.
The effective tax rates were (81.6%) and (82.1%), respectively, for the three and nine months ended September 30, 2003 compared to 35.0% for the three months and nine months ended September 30, 2002. Due to net losses reported by the Company in 2001 through 2003, the Company has determined that it may not realize some or all of the future tax benefits associated with its net deferred tax assets. Accordingly, we have established a valuation allowance on our net deferred tax assets of $49.9 million as of September 30, 2003. This valuation allowance represents 100% of the Company’s net deferred tax asset at September 30, 2003. These deferred tax assets will be reinstated to the extent the Company has taxable income in future years. See Note 8 of the Notes to Unaudited Condensed Consolidated Financial Statements included elsewhere in this report for further information regarding federal income taxes, deferred tax assets and the valuation allowance.
The cumulative effect of a change in accounting principle recorded in 2002 was the result of the write-off of goodwill. See Note 5 of the Notes to Unaudited Condensed Consolidated Financial Statements included elsewhere in this report for further information regarding the write-off of goodwill.
Liquidity, Capital Resources and Financial Condition
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurance, and proceeds from the maturity or sale of invested assets. We also enter into financing transactions from time to time to acquire additional capital. The primary uses of cash, on both a short- and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets, reinsurance premiums, taxes, and the repurchase of the Company’s stock.
APCapital is a holding company whose only material assets are the capital stock of APAssurance and its other subsidiaries, and cash. APCapital’s ongoing cash flow consists primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. The payment of dividends to APCapital by its insurance subsidiaries is subject to limitations imposed by applicable state law.
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The Company is indebted to its President and Chief Executive Officer (“CEO”) in the amount of $7.0 million (reflected on our balance sheet at its present value of $5.8 million at September 30, 2003) in connection with the purchase of Stratton-Cheeseman Management Company. The indebtedness is due in annual installments with the final installment due April 2008. See the table at the end of this section for further information regarding the timing and amounts of these payments. The amount of the annual payments will increase or decrease by $200,000 for each corresponding half-grade level increase or decrease in the Company’s A.M. Best Company, Inc. rating. Certain events, such as the termination, death or disability of the CEO, or a change in control of the Company, could accelerate these payments. Subsequent to the close of the third quarter, the Company received a half-grade down grade in its A.M. Best rating, which will decrease the annual payments in future years.
In May 2003, the Company issued Debentures totaling $30.9 million. These Debentures bear interest at a variable rate based on LIBOR, payable quarterly, and mature in 30 years. See Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements contained elsewhere in this report for a description of the Debentures and the transactions in which they were issued. Subsequent to the close of the third quarter, the Company issued an additional $20.6 million of floating rate junior subordinated deferrable interest debentures on substantially the same terms as the Debentures.
The Company’s net cash flow used in operations was approximately $8.9 million for the nine months ended September 30, 2003, compared to $37.2 million provided by operations for the nine months ended September 30, 2002. The decrease in cash provided by operations was primarily the result of an increase in paid losses of $23.1 million, an increase in premiums receivable of $10.6 million, and the decrease in net premiums written of $9.1 million.
At September 30, 2003, the Company had $92.8 million of cash available and an investment portfolio of $725.4 million. The portfolio includes $23.8 million of bonds maturing in the next year. On a long-term basis, fixed income securities are purchased on a basis intended to provide adequate cash flows from future maturities. As of September 30, 2003, $366.6 million of bonds mature in the next one to five years and $162.6 million mature in the next six to ten years. In addition, the Company has $43.6 million of mortgage-backed securities that provide periodic principal repayments.
Premiums receivable increased $10.6 million, or 16.9%, to $73.1 million at September 30, 2003 compared to $62.5 million at December 31, 2002. The increase in premiums receivable is a function of the timing of premiums written. July is a heavy renewal month for the Company, which is the primary reason for the increase in the premiums receivable balance at September 30, 2003.
Reinsurance recoverable increased $12.1 million to $110.2 million at September 30, 2003, compared to $98.1 million at December 31, 2002. The increase was primarily the result of reinsurance recoverables on a few large paid losses, as well as the increase in the estimate for incurred but not reported claims above the Company’s net retention level. We have a net reinsurance recoverable from Gerling Global (“Gerling”) of approximately $15.4 million at September 30, 2003. In 2002, Gerling’s parent company put Gerling’s United States subsidiary into run off resulting in a series of A.M. Best rating downgrades for Gerling. We have discussed the possibility of a settlement with Gerling, but have not received an offer that we deem financially adequate. We continue to believe that Gerling has adequate surplus and cash flow to satisfy its obligations to us and we have not experienced any difficulties in collecting amounts due from Gerling; however, there can be no assurance that amounts currently recoverable from Gerling will ultimately be collected. Because the Company has not experienced any difficulties in collecting amounts from Gerling, and in light of Gerling’s current surplus levels and cash flows, we determined not to accept the settlement offer because we do not believe that it is in the Company’s best long-term economic interest. We will continue to monitor Gerling’s financial strength and liquidity and may pursue a settlement in the future if circumstances change.
As the Company has incurred net losses for the last three years, management has evaluated the recoverability of the net deferred tax assets, and has determined, based on its recent loss experience, that sufficient taxable income may not exist in the years that our deductible temporary differences will reverse. Accordingly, the Company has established a deferred tax valuation allowance for 100% of its net deferred tax asset of $49.9 million. See Note 8 of the Notes to Unaudited Condensed Consolidated Financial Statements
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Reserves are reviewed for adequacy on a quarterly basis by the Company with the assistance of internal as well as independent actuaries. When reviewing reserves, the Company analyzes historical data, including per claim information, the Company’s actual loss experience and industry historical loss trends. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events.
The key assumptions used in management’s selection of ultimate reserves include the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and an analysis of claims development. As of December 31, 2002, and subsequent quarters, the Company recorded professional liability reserves based on internal and independent actuarial best estimates.
The payment of medical professional liability claims often is three to six years after the report of loss. As a result, the ultimate payment can be difficult to project and must be estimated using various actuarial methods. These projections are usually based on an estimated average payment (severity) times a projected total number of claims (frequency). Accordingly, the estimated ultimate severity of losses to be paid has a major impact on actuarial estimates of ultimate losses and thus recorded reserves.
For the nine months ended September 30, 2003, the Company reported an increase in net ultimate loss estimates for accident years 2002 and prior of $43.3 million, or 7.9% of $546.8 million of net loss and loss adjustment expense reserves at December 31, 2002. The increase in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2003 that differed from projected activity.
In the third quarter of 2003, a pattern of increasing paid severity emerged on the Company’s medical professional liability losses related to the 1999 through 2002 accident years. In view of this higher than expected trend of average paid severity, the Company’s internal and independent actuaries made significant upward adjustments to their estimated ultimate severities on all claims incurred in these accident years, which had the effect of significantly increasing the projected ultimate loss on these years. Accordingly, recorded reserves on these years were adjusted to match these ultimate loss projections.
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Activity in the liability for unpaid loss and loss adjustment expenses by insurance segment for the nine months ended September 30, 2003 was as follows.
| Medical | |||||||||||||||||||||
| Professional | Workers’ | All | |||||||||||||||||||
| Liability | Compensation | Health | Other | Segments | |||||||||||||||||
| (In thousands) | |||||||||||||||||||||
| Balance, December 31, 2002 | $ | 546,256 | $ | 80,274 | $ | 6,850 | $ | 4,114 | $ | 637,494 | |||||||||||
| Less, reinsurance recoverables | 81,501 | 7,282 | 280 | 1,610 | 90,673 | ||||||||||||||||
| Net reserves, December 31, 2002 | 464,755 | 72,992 | 6,570 | 2,504 | 546,821 | ||||||||||||||||
| Incurred related to | |||||||||||||||||||||
| Current year | 118,242 | 26,894 | 15,284 | — | 160,420 | ||||||||||||||||
| Prior years | 44,250 | (1,400 | ) | (468 | ) | 931 | 43,313 | ||||||||||||||
| 162,492 | 25,494 | 14,816 | 931 | 203,733 | |||||||||||||||||
| Paid related to | |||||||||||||||||||||
| Current year | 1,824 | 7,420 | 12,443 | — | 21,687 | ||||||||||||||||
| Prior years | 113,359 | 28,656 | 4,188 | 1,994 | 148,197 | ||||||||||||||||
| 115,183 | 36,076 | 16,631 | 1,994 | 169,884 | |||||||||||||||||
| Net reserves, September 30, 2003 | 512,064 | 62,410 | 4,755 | 1,441 | 580,670 | ||||||||||||||||
| Plus, reinsurance recoverables | 88,852 | 5,879 | 170 | 2,565 | 97,466 | ||||||||||||||||
| Balance, September 30. 2003 | $ | 600,916 | $ | 68,289 | $ | 4,925 | $ | 4,006 | $ | 678,136 | |||||||||||
| Development as a % of December 31, 2002 net reserves | 9.5% | -1.9% | -7.1% | 37.2% | 7.9% | ||||||||||||||||
The medical professional liability insurance sector is going through a period of unprecedented increases in loss costs. According to the American Medical Association, several states, including many in which the Company operates, are in a medical malpractice crisis. Claim settlements have been increasing significantly, making the projection of ultimate losses increasingly difficult. In addition, due to the long-tail nature of this line of business, changes in the actuarially projected ultimate severity can have a significant impact on the balance of recorded reserves. Medical professional liability reserves are expected to remain volatile for the foreseeable future. Given the current environment, there can be no assurance that additional significant reserve enhancements will not be necessary in the future.
If the Company is required to run-off its existing workers compensation claim reserves, reserve enhancements may be needed related to this segment in the future also.
The unearned premium reserve increased $10.2 million, or 9.8%, to $113.6 million at September 30, 2003, as compared to $103.4 million at December 31, 2002. The increase was primarily attributable to the increased volume of direct written premiums in the third quarter of 2003 compared to the fourth quarter of 2002. July is a heavy renewal month for the Company’s medical professional liability segment, which has the effect of increasing the September 30 balance compared to December 31.
The Company’s total shareholder’s equity decreased $75.9 million to $204.4 million at September 30, 2003 compared to $280.3 million at December 31, 2002. This decrease was related to the repurchase of outstanding common stock of the Company and the net loss for the year, offset by net unrealized appreciation on our investment securities. The market value of our fixed income security portfolio is inversely related to interest rates. Therefore, as interest rates have declined in 2003, the market value of the Company’s fixed income security portfolio has increased. Net unrealized appreciation, net of deferred federal income taxes, on the Company’s investments was $32.3 million at September 30, 2003, an increase of $7.7 million compared to December 31, 2002.
On September 11, 2003, APCapital’s Board of Directors authorized the Company to purchase an additional 500,000 shares of its outstanding common stock. This brings the total number of shares authorized to be repurchased under publicly announced plans to 3,615,439. During the quarter, the Company purchased
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Based on historical trends, market conditions and our business plans, we believe that our existing resources and sources of funds, including the funds raised from the issuance of the Debentures, will be sufficient to meet our short-term and long-term liquidity needs. However, economic, market and regulatory conditions may change, and there can be no assurance that our funds will be sufficient to meet our short-term liquidity needs.
The Company is contractually obligated by a note payable to an officer, the Debentures, long-term operating leases and other purchase commitments relating to capital expenditures. The following table shows the nature and timing of the Company’s contractual obligations as of September 30, 2003.
| Payments Due by Period | |||||||||||||||||||||
| Less Than | 1 - 3 | 3 - 5 | More Than | ||||||||||||||||||
| Contractual Obligations | Total | 1 Year | Years | Years | 5 Years | ||||||||||||||||
| (In Thousands) | |||||||||||||||||||||
| Note payable to officer | $ | 7,000 | $ | 1,000 | $ | 2,500 | $ | 3,500 | $ | — | |||||||||||
| Operating leases | 6,088 | 1,367 | 1,805 | 1,129 | 1,787 | ||||||||||||||||
| Long-term debt | 30,928 | — | — | — | 30,928 | ||||||||||||||||
| Purchase commitments | 500 | 500 | — | — | — | ||||||||||||||||
| Total | $ | 44,516 | $ | 2,867 | $ | 4,305 | $ | 4,629 | $ | 32,715 | |||||||||||
Significant Accounting Policies
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the accompanying Unaudited Condensed Consolidated Financial Statements and related footnotes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time.
The policies relating to unpaid losses and loss adjustment expenses, investments, taxes, reinsurance and the reserve for extended reporting period claims are those we believe to be the most sensitive to estimates and judgments. They are more fully described in Item 7 of our most recent Annual Report on Form 10-K and in Note 1 to our consolidated financial statements contained in that report. Other than as described below, there have been no material changes to these policies during the most recent quarter.
The estimate for unpaid loss and loss adjustment expenses at December 31, 2002 was adjusted to reflect an increase in the severity of paid losses in the third quarter of 2003. See Note 6 of the Notes to Unaudited Condensed Consolidated Financial Statements and “Managements Discussion and Analysis of Operating Results and Financial Condition” — “Liquidity, Capital Resources, and Financial Condition” contained elsewhere in this report for further discussion regarding these revised estimates.
The Company has invested in mortgage-backed interest-only certificates that have been determined to include an embedded derivative financial instrument as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Changes in the fair value of these derivative financial instruments are recorded as investment income. A key assumption in the determination of the fair value of these instruments is an assumption regarding pre-payment rates. A change in the pre-payment rate assumption could affect the
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Effects of New Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45. “Guarantor’s Accounting and Disclosure Requirements for Guarantees of Indebtedness of Others” (“FIN No. 45”). This interpretation clarifies disclosures required to be made by a guarantor in its interim and annual financial statements and requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The provisions of FIN No. 45 pertaining to the recording of a liability are effective for all guarantees entered into, or modified, after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 31, 2002. APCapital has issued guarantees in connection with its establishment of trusts and issuance of debentures. The amounts due under the guarantees are also recorded as liabilities in the Company’s consolidated financial statements in accordance with the structure of the transaction. See Note 7 for further details on the nature of the guarantees and the transaction that gave rise to the guarantees.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN No. 46”). This interpretation addresses consolidation by business enterprises of variable interest entities and is effective immediately for all variable interest entities created after January 31, 2003 and for the fiscal year or interim period beginning after June 15, 2003 for all variable interest entities in which the Company holds a variable interest that it acquired before February 1, 2003. The Company has evaluated certain of its investments, as required by FIN No. 46, and has determined that its investments in statutory trusts used to issue mandatorily redeemable trust preferred securities should not be consolidated. Accordingly, the Company has not consolidated the trusts in the Unaudited Condensed Consolidated Financial Statements included elsewhere in this report.
Other
Subsequent to the close of the third quarter, the Company has received a downgrade in its A.M. Best Company rating from “A-,” which is classified as “Excellent,” to “B++,” which is classified as “Very Good.” Both ratings are considered “secure” ratings by A.M. Best Company.
| Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
General
Market risk is the risk of loss due to adverse changes in market rates and prices. As of September 30, 2003, the majority of our investment portfolio was invested in fixed maturity securities, which are interest-sensitive assets, and cash and cash equivalents. Accordingly, our primary market risk is exposure to changes in interest rates. The fixed maturity securities primarily consisted of U.S. government and agency bonds, high-quality corporate bonds, high-yield corporate bonds, mortgage-backed securities and tax-exempt U.S. municipal bonds.
Qualitative Information About Market Risk
Investments in our portfolio have varying degrees of risk. The primary market risk exposure to the fixed maturity portfolio is interest rate risk, which is limited somewhat by our management of duration. The distribution of maturities and sector concentrations are monitored on a regular basis.
At September 30, 2003, approximately 92.0% of our fixed maturity portfolio (excluding approximately $24.5 million of private placement issues) was considered investment grade. Non-investment grade securities typically bear more credit risk than those of investment grade quality. Credit risk is the risk that amounts due the Company by creditors may not ultimately be collected.
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We periodically review our investment portfolio for any potential credit quality or collection issues and for any securities with respect to which we consider any decline in market value to be other than temporary. Investments which are considered to be OTTI are written down to their estimated net realizable value as of the end of the period. We utilize both quantitative and qualitative evaluation methods to evaluate the potential for OTTI. During the three months and nine months ended September 30, 2003 we recorded an impairment charge of $300,000 and $1.3 million, respectively, on enhanced equipment trust certificates that were issued by Delta Airlines. During the three months and nine months ended September 30, 2002 we recorded an impairment charge of $390,000 related to Frontier bonds. At September 30, 2003, the Company has remaining investments in Frontier and the Delta enhanced equipment trust certificates of $325,000 and $5.4 million, respectively, included in the Unaudited Condensed Consolidated Balance Sheet included elsewhere in this report.
In June 2003, the Company invested approximately $20 million in mortgage-backed securities and allocated an additional $50 million for high-yield corporate bonds and $6 million for equity investments. Through September 30, 2003, approximately $47 million of the high-yield allocation and $5.5 million of the equity allocation had been invested. High-yield corporate bonds are typically not investment grade.
Approximately $15 million of the mortgage-backed securities purchased are interest-only certificates. Unlike traditional fixed-maturity securities, the fair value of these investments is not inversely related to interest rates, but rather, moves in the same direction as interest rates as the underlying financial instruments are mortgage-backed securities. With mortgage-backed securities, as interest rates rise, prepayments will decrease, which means that the interest-only certificates will generate interest for a longer period of time than originally anticipated, which in turn will increase the market value of these investments.
In addition, approximately $8 million of these interest-only certificates have an inverse floating rate of interest tied to LIBOR. The Company has determined that these “inverse floating interest-only” certificates contain an embedded derivative as defined by SFAS No. 133. Because the Company cannot readily segregate the fair value of the embedded derivative from the host debt instrument, the entire change in the fair value of these inverse floating interest-only certificates is reported in earnings as investment income. For the three and nine months ended September 30, 2003, approximately $65,000 and $465,000, respectively, was included in investment income for the change in fair value of the inverse floating interest-only certificates.
Quantitative Information About Market Risk
At September 30, 2003, our fixed income security portfolio was valued at $686.0 million and had an average modified duration of 3.07 years, compared to a portfolio valued at $618.9 million with an average modified duration of 3.20 years at December 31, 2002. The following table shows the effects of a change in interest rates on the fair value and modified duration of our portfolio. We have assumed an immediate increase or decrease of 1% or 2% in interest rate for illustrative purposes. You should not consider this assumption, or the values shown in the table, to be a prediction of actual future results.
| September 30, 2003 | December 31, 2002 | |||||||||||||||||||||||
| Portfolio | Change in | Modified | Portfolio | Change in | Modified | |||||||||||||||||||
| Change in Rates | Value | Value | Duration | Value | Value | Duration | ||||||||||||||||||
| (Dollars in thousands) | ||||||||||||||||||||||||
| +2% | $ | 651,643 | $ | (34,369 | ) | 3.10 | $ | 581,066 | $ | (37,833 | ) | 2.94 | ||||||||||||
| +1% | 668,780 | (17,232 | ) | 2.92 | 599,244 | (19,655 | ) | 2.97 | ||||||||||||||||
| 0 | 686,012 | 3.07 | 618,899 | 3.20 | ||||||||||||||||||||
| -1% | 700,695 | 14,683 | 2.90 | 639,729 | 20,830 | 3.26 | ||||||||||||||||||
| -2% | 720,402 | 34,390 | 2.97 | 661,713 | 42,814 | 3.37 | ||||||||||||||||||
Item 4. Controls and Procedures
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure
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| Item 2. | Changes in Securities and Use of Proceeds |
(c) On October 29, 2003, a subsidiary trust of the Company issued $20 million of mandatorily redeemable trust preferred securities (“TPS”) to a trust formed by FTN Financial Capital Markets and Keefe, Bruyette & Woods, Inc. The Company’s trust received a total of $19.4 million in net proceeds, after the deduction of a total of approximately $600,000 of commissions paid to the placement agent in the transaction. The proceeds were invested in a debenture issued by the Company, as described in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity, Capital Resources and Financial Condition” included elsewhere in this report.
The Company’s trust sold the TPS in a non-public offering pursuant to Section 4(2) of the Securities Act of 1933, as amended, or alternatively, in an offshore transaction pursuant to Regulation S. The Company believes these exemptions were available because the TPS was sold in a private transaction to a trust organized outside the United States by an institutional accredited investor sophisticated and experienced with investments similar to the TPS, subject to resale limitations and offering restrictions.
| Item 6. | Exhibits and Reports on Form 8-K |
(a) Exhibits.
| 4.1 | Indenture relating to Floating Rate Junior Subordinated Deferrable Interest Debentures Dated As Of October 29, 2003 | |||
| 10.1 | Amended And Restated Declaration Of Trust Dated As Of October 29, 2003 by and among U.S. Bank National Association, American Physicians Capital, Inc., William B. Cheeseman and Frank H. Freund | |||
| 10.2 | Placement Agreement, dated October 16, 2003 between the Company, American Physicians Capital Statutory Trust III, FTN Financial Capital Markets and Keefe Bruyette & Woods, Inc. | |||
| 10.3 | Guarantee Agreement Dated As Of October 29, 2003 by and between U.S. Bank National Association and American Physicians Capital, Inc. | |||
| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | |||
| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | |||
| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934. |
(b) Reports on Form 8-K.
The Company filed reports on Form 8-K on (1) July 16, 2003, disclosing under Items 7 and 9 that it had issued a press release announcing the resignation of Raymond Jacobsen, Chief Executive Officer of the Company’s workers’ compensation business unit; (2) August 7, 2003, disclosing under Items 9 and 12 that it had issued a press release announcing its financial results for the three months and six months ended June 30, 2003 and certain other information; and (3) September 9, 2003, disclosing under Items 7 and 9 that it had issued a press release announcing its participation in a panel discussion at the Sandler O’Neill Insurance Conference. The information included in these reports was considered furnished rather than filed. No financial statements were filed with these reports.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: November 14, 2003
| AMERICAN PHYSICIANS CAPITAL, INC. |
| By: | /s/ WILLIAM B. CHEESEMAN |
| William B. Cheeseman | |
| Its: President and Chief Executive Officer |
| By: | /s/ FRANK H. FREUND |
| Frank H. Freund | |
| Its: Executive Vice President, Treasurer, | |
| Chief Financial Officer and | |
| principal accounting officer |
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| Exhibit No. | Exhibit Description | |||
| 4.1 | Indenture relating to Floating Rate Junior Subordinated Deferrable Interest Debentures Dated As Of October 29, 2003 | |||
| 10.1 | Amended And Restated Declaration Of Trust Dated As Of October 29, 2003 by and among U.S. Bank National Association, American Physicians Capital, Inc., William B. Cheeseman and Frank H. Freund | |||
| 10.2 | Placement Agreement, dated October 16, 2003 between the Company, American Physicians Capital Statutory Trust III, FTN Financial Capital Markets and Keefe Bruyette & Woods, Inc. | |||
| 10.3 | Guarantee Agreement Dated As Of October 29, 2003 by and between U.S. Bank National Association and American Physicians Capital, Inc. | |||
| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | |||
| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | |||
| 32 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934. | |||
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