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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Washington, D.C. 20549
Form 10-Q
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
| For the quarterly period ended June 30, 2008 | ||
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.
(Exact name of registrant as specified in its charter)
(Exact name of registrant as specified in its charter)
| Michigan (State or other jurisdiction of incorporation or organization) | 38-3543910 (IRS employer identification number) |
1301 North Hagadorn Road, East Lansing, Michigan 48823
(Address of principal executive offices, including zip code)
(Address of principal executive offices, including zip code)
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 þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o | Accelerated filer þ | Non-accelerated filer o | Smaller reporting company o |
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act) Yes o No þ
The number of shares outstanding of the registrant’s common stock, no par value per share, as of July 31, 2008, was 9,693,252.
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PART I. FINANCIAL INFORMATION
| ITEM 1. | FINANCIAL STATEMENTS |
AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| June 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| (Unaudited) | ||||||||
| (In thousands, except share data) | ||||||||
ASSETS | ||||||||
| Investments: | ||||||||
| Fixed-income securities | ||||||||
| Available-for-sale, at fair value | $ | 229,106 | $ | 262,301 | ||||
| Held-to-maturity, at amortized cost | 493,917 | 497,662 | ||||||
| Other investments | 15,534 | 11,487 | ||||||
| Total investments | 738,557 | 771,450 | ||||||
| Cash and cash equivalents | 112,070 | 87,498 | ||||||
| Premiums receivable | 30,883 | 35,542 | ||||||
| Reinsurance recoverable | 103,797 | 106,961 | ||||||
| Deferred federal income taxes | 21,840 | 22,439 | ||||||
| Federal income tax recoverable | 224 | 1,076 | ||||||
| Property and equipment, net of accumulated depreciation | 15,443 | 13,789 | ||||||
| Other assets | 18,504 | 18,707 | ||||||
| Total assets | $ | 1,041,318 | $ | 1,057,462 | ||||
LIABILITIES | ||||||||
| Unpaid losses and loss adjustment expenses | $ | 657,910 | $ | 664,117 | ||||
| Unearned premiums | 54,775 | 60,080 | ||||||
| Long-term debt | 30,928 | 30,928 | ||||||
| Other liabilities | 32,703 | 38,780 | ||||||
| Total liabilities | 776,316 | 793,905 | ||||||
Commitments & Contingencies | ||||||||
Shareholders’ Equity | ||||||||
| Common stock, no par value, 50,000,000 shares authorized: 9,721,252 and 10,127,740 shares outstanding at June 30, 2008 and December 31, 2007, respectively | — | — | ||||||
Additionalpaid-in-capital | — | — | ||||||
| Retained earnings | 260,323 | 257,502 | ||||||
| Accumulated other comprehensive income: | ||||||||
| Net unrealized appreciation on investments, net of deferred federal income taxes | 4,679 | 6,055 | ||||||
| Total shareholders’ equity | 265,002 | 263,557 | ||||||
| Total liabilities and shareholders’ equity | $ | 1,041,318 | $ | 1,057,462 | ||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Income
| Three Months Ended | Six Months Ended | |||||||||||||||
| June 30, | June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| (Unaudited) | ||||||||||||||||
| (In thousands, except per share data) | ||||||||||||||||
| Net premiums written | $ | 25,499 | $ | 26,967 | $ | 57,674 | $ | 61,861 | ||||||||
| Change in net unearned premiums | 5,921 | 7,929 | 5,393 | 8,067 | ||||||||||||
| Net premiums earned | 31,420 | 34,896 | 63,067 | 69,928 | ||||||||||||
| Investment income | 9,235 | 11,152 | 19,192 | 22,329 | ||||||||||||
| Net realized gains (losses) | 74 | (64 | ) | (708 | ) | (66 | ) | |||||||||
| Other income | 206 | 175 | 395 | 388 | ||||||||||||
| Total revenues and other income | 40,935 | 46,159 | 81,946 | 92,579 | ||||||||||||
| Losses and loss adjustment expenses | 17,667 | 12,916 | 33,865 | 35,278 | ||||||||||||
| Underwriting expenses | 6,623 | 7,566 | 13,639 | 14,927 | ||||||||||||
| Investment expenses | 241 | 230 | 503 | 417 | ||||||||||||
| Interest expense | 555 | 782 | 1,243 | 1,555 | ||||||||||||
| General and administrative expenses | 319 | 363 | 586 | 695 | ||||||||||||
| Other expenses | — | (1 | ) | — | 2 | |||||||||||
| Total expenses | 25,405 | 21,856 | 49,836 | 52,874 | ||||||||||||
| Income before federal income taxes | 15,530 | 24,303 | 32,110 | 39,705 | ||||||||||||
| Federal income tax expense | 4,487 | 7,970 | 9,693 | 12,867 | ||||||||||||
| Net income | $ | 11,043 | $ | 16,333 | $ | 22,417 | $ | 26,838 | ||||||||
| Net income — per common share | ||||||||||||||||
| Basic | $ | 1.14 | $ | 1.47 | $ | 2.28 | $ | 2.38 | ||||||||
| Diluted | $ | 1.11 | $ | 1.44 | $ | 2.24 | $ | 2.33 | ||||||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| Accumulated | ||||||||||||||||||||
| Additional | Other | |||||||||||||||||||
| Shares | Paid-in | Retained | Comprehensive | |||||||||||||||||
| Outstanding | Capital | Earnings | Income | Total | ||||||||||||||||
| (Unaudited) | ||||||||||||||||||||
| (In thousands, except share data) | ||||||||||||||||||||
| Balance, December 31, 2007 | 10,127,740 | $ | — | $ | 257,502 | $ | 6,055 | $ | 263,557 | |||||||||||
| Comprehensive income: | ||||||||||||||||||||
| Net income | 22,417 | 22,417 | ||||||||||||||||||
| Other comprehensive loss, net of taxes | (1,376 | ) | (1,376 | ) | ||||||||||||||||
| Total comprehensive income, net of taxes | 21,041 | |||||||||||||||||||
| Options exercised | 10,960 | 168 | 168 | |||||||||||||||||
| Amortization of unearned stock compensation, net of tax | ||||||||||||||||||||
| Shares tendered/netted in connection with option exercise | (1,448 | ) | (63 | ) | (63 | ) | ||||||||||||||
| Cash dividends to shareholders, $0.20 per share(1) | (1,952 | ) | (1,952 | ) | ||||||||||||||||
| Excess tax benefits from share-based awards | 101 | 101 | ||||||||||||||||||
| Fair value compensation of share-based awards | 37 | 37 | ||||||||||||||||||
| Purchase and retirement of common stock | (416,000 | ) | (243 | ) | (17,644 | ) | (17,887 | ) | ||||||||||||
| Balance, June 30, 2008 | 9,721,252 | $ | — | $ | 260,323 | $ | 4,679 | $ | 265,002 | |||||||||||
| Accumulated | ||||||||||||||||||||
| Additional | Other | |||||||||||||||||||
| Shares | Paid-in | Retained | Comprehensive | |||||||||||||||||
| Outstanding | Capital | Earnings | Income | Total | ||||||||||||||||
| (Unaudited) | ||||||||||||||||||||
| (In thousands, except share data) | ||||||||||||||||||||
| Balance, December 31, 2006 | 11,556,575 | $ | 41,106 | $ | 222,935 | $ | 4,769 | $ | 268,810 | |||||||||||
| Comprehensive income: | ||||||||||||||||||||
| Net income | 26,838 | 26,838 | ||||||||||||||||||
| Other comprehensive loss, net of taxes | (2,015 | ) | (2,015 | ) | ||||||||||||||||
| Total comprehensive income, net of taxes | 24,823 | |||||||||||||||||||
| Options exercised | 18,025 | 215 | 215 | |||||||||||||||||
| Amortization of unearned stock compensation, net of tax | ||||||||||||||||||||
| Shares tendered/netted in connection with option exercise | (3,201 | ) | (122 | ) | (122 | ) | ||||||||||||||
| Excess tax benefits from share-based awards | 315 | 315 | ||||||||||||||||||
| Fair value compensation of share-based awards | 113 | 113 | ||||||||||||||||||
| Purchase and retirement of common stock | (489,200 | ) | (18,514 | ) | (18,514 | ) | ||||||||||||||
| Balance, June 30, 2007 | 11,082,199 | $ | 23,113 | $ | 249,773 | $ | 2,754 | $ | 275,640 | |||||||||||
| (1) | Cash dividends of $0.10 per common share were paid in each of the first and second quarter of 2008. |
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 | Six Months Ended | |||||||||||||||
| June 30, | June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| (Unaudited) | ||||||||||||||||
| (In thousands) | ||||||||||||||||
| Net income | $ | 11,043 | $ | 16,333 | $ | 22,417 | $ | 26,838 | ||||||||
| Other comprehensive income (loss): | ||||||||||||||||
| Unrealized depreciation on available-for-sale investment securities arising during the period | (4,015 | ) | (2,859 | ) | (785 | ) | (2,559 | ) | ||||||||
| Amortization of net unrealized appreciation on held-to-maturity investment securities since the date of transfer from the available-for-sale category | (303 | ) | (240 | ) | (505 | ) | (482 | ) | ||||||||
| Adjustment for net realized gains (losses) on available-for-sale investment securities included in net income(1) | 31 | (60 | ) | �� | (827 | ) | (60 | ) | ||||||||
| Other comprehensive loss before tax | (4,287 | ) | (3,159 | ) | (2,117 | ) | (3,101 | ) | ||||||||
| Deferred federal income tax benefit | (1,500 | ) | (1,106 | ) | (741 | ) | (1,086 | ) | ||||||||
| Other comprehensive loss | (2,787 | ) | (2,053 | ) | (1,376 | ) | (2,015 | ) | ||||||||
| Comprehensive income | $ | 8,256 | $ | 14,280 | $ | 21,041 | $ | 24,823 | ||||||||
| (1) | Includes net realized gains of $7,000 for the three and six months ended June 30, 2008, related to held-to-maturity securities with unamortized, net unrealized gains related to the transfer of securities to the held-to-maturity category. |
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| Six Months Ended | ||||||||
| June 30, | ||||||||
| 2008 | 2007 | |||||||
| (Unaudited) | ||||||||
| (In thousands) | ||||||||
Cash flows from (for) operating activities | ||||||||
| Net income | $ | 22,417 | $ | 26,838 | ||||
| Adjustments to reconcile net income to net cash from operating activities: | ||||||||
| Depreciation and amortization | 1,948 | 1,415 | ||||||
| Net realized losses | 708 | 66 | ||||||
| Deferred federal income taxes | 1,340 | 5,654 | ||||||
| Current federal income taxes | 953 | 2,746 | ||||||
| Excess tax benefits from share-based awards | (101 | ) | (315 | ) | ||||
| Share-based compensation | 37 | 113 | ||||||
| Income on equity method investees | — | (96 | ) | |||||
| Changes in: | ||||||||
| Unpaid loss and loss adjustment expenses | (6,208 | ) | (7,907 | ) | ||||
| Unearned premiums | (5,305 | ) | (10,071 | ) | ||||
| Other assets and liabilities | 2,413 | 8,530 | ||||||
Net cash from operating activities | 18,202 | 26,973 | ||||||
Cash flows from (for) investing activities | ||||||||
| Purchases | ||||||||
| Available-for-sale — fixed income | (15,478 | ) | (56,234 | ) | ||||
| Held-to-maturity — fixed income | (96,766 | ) | (5,312 | ) | ||||
| Other investments | (3,364 | ) | (2,924 | ) | ||||
| Property and equipment | (2,136 | ) | (2,075 | ) | ||||
| Proceeds from sales and maturities | ||||||||
| Available-for-sale — fixed income | 44,878 | 19,984 | ||||||
| Held-to-maturity — fixed income | 99,329 | 7,755 | ||||||
| Other investments | — | 250 | ||||||
| Property and equipment | — | 20 | ||||||
| Pending securities transactions | 2,343 | — | ||||||
Net cash from (for) investing activities | 28,806 | (38,536 | ) | |||||
Cash flows from (for) financing activities | ||||||||
| Common stock repurchased | (17,887 | ) | (18,514 | ) | ||||
| Excess tax benefits from share-based awards | 101 | 315 | ||||||
| Change in payable for shares repurchased | (2,803 | ) | (283 | ) | ||||
| Cash dividends paid | (1,952 | ) | — | |||||
| Proceeds from stock options exercised | 105 | 93 | ||||||
Net cash for financing activities | (22,436 | ) | (18,389 | ) | ||||
Net increase (decrease) in cash and cash equivalents | 24,572 | (29,952 | ) | |||||
Cash and cash equivalents, beginning of period | 87,498 | 108,227 | ||||||
Cash and cash equivalents, end of period | $ | 112,070 | $ | 78,275 | ||||
The accompanying notes are an integral part of the condensed consolidated financial statements.
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AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
| 1. | Significant Accounting Policies |
Basis of Consolidation and Reporting
The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of American Physicians Capital, Inc. (“APCapital”) and its wholly owned subsidiaries, Insurance Corporation of America (“ICA”), APSpecialty Insurance Corporation (“APS”), Alpha Advisors, Inc., and American Physicians Assurance Corporation (“American Physicians”). APCapital and its consolidated subsidiaries are referred to collectively herein as the Company. All significant intercompany accounts and transactions are eliminated in consolidation.
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 forForm 10-Q andRule 10-01 ofRegulation 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. The December 31, 2007 Condensed Consolidated Balance Sheet of the Company presented in this Report onForm 10-Q was derived from audited 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 and six-month periods ended June 30, 2008 are not necessarily indicative of the results to be expected for the year ending December 31, 2008. The accompanying unaudited Condensed Consolidated Financial Statements should be read in conjunction with the annual consolidated financial statements, and notes thereto, contained in the Company’s Annual Report onForm 10-K for the year ended December 31, 2007.
Reclassifications
Cash flows pertaining to current federal income taxes in 2007, net of the benefit related to share-based payment awards, have been reclassified from changes in other assets and liabilities to their own line item within the operating activities section of the Condensed Consolidated Statements of Cash Flows to conform with the current year presentation.
Use of Estimates
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 liability for unpaid losses and loss adjustment expenses, the fair value of investments, income taxes, reinsurance, the reserve for extended reporting period claims and deferred policy acquisition costs. Although considerable judgment 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. Adjustments related to changes in estimates are reflected in the Company’s results of operations, or other comprehensive income, in the period in which those estimates changed.
Nature of Business
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers, with an emphasis on markets in the Midwest.
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Notes to Condensed Consolidated Financial Statements — (Continued)
| 2. | Effects of New Accounting Pronouncements |
Statement of Financial Accounting Standards (“SFAS”) No. 157,Fair Value Measurements, which was issued by the Financial Accounting Standards Board (“FASB”) in September 2006, defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. The Statement does not require any new fair value measurements and was initially effective for the Company beginning January 1, 2008. In February 2008, the FASB approved the issuance of FASB Staff Position (“FSP”)FAS No. 157-2. FSPFAS No. 157-2 defers the effective date of SFAS No. 157 until January 1, 2009 for nonfinancial assets and nonfinancial liabilities, except those items recognized or disclosed at fair value on an annual or more frequently recurring basis. The adoption of SFAS No. 157 is not expected to have a material effect on the Company’s consolidated results of operations, financial position or liquidity, based on nonfinancial assets and liabilities reported at June 30, 2008. However, the adoption of SFAS No. 157, as it pertains to financial assets, on January 1, 2008, has required the Company to make additional disclosures concerning fair values that can be found in Note 4.
In December 2007, the FASB issued SFAS No. 141R,Business Combinations,a replacement of SFAS No. 141, Business Combinations. SFAS No. 141R provides revised guidance on how an acquirer recognizes and measures in its financial statements, the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination. SFAS No. 141R also provides guidance specific to the recognition, classification, and measurement of assets and liabilities related to insurance and reinsurance contracts acquired in a business combination. SFAS No. 141R applies to business combinations for acquisitions occurring on or after January 1, 2009. The Company does not expect the provisions of SFAS No. 141R to have a material effect on its consolidated results of operations, financial position or liquidity unless a business combination transaction is consummated after January 1, 2009.
In December 2007, the FASB issued SFAS No. 160,Non-controlling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51. SFAS No. 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. In addition, it clarifies that a non-controlling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as a component of equity in the consolidated financial statements. SFAS No. 160 is effective on a prospective basis beginning January 1, 2009, except for the presentation and disclosure requirements which are applied on a retrospective basis for all periods presented. The Company does not expect the provisions of SFAS No. 160 to have a material effect on its consolidated results of operations, financial position or liquidity.
SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133,was issued by the FASB in March 2008. SFAS No. 161 does not change the accounting for derivative instruments and hedging activities, but rather requires enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued after November 15, 2008. The adoption of SFAS No. 161 is not expected to have a material effect on the Company’s disclosures, as the Company does not currently own any derivative financial instruments or participate in any hedging activities.
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Notes to Condensed Consolidated Financial Statements — (Continued)
| 3. | Income Per Share |
The following table sets forth the details regarding the computation of basic and diluted net income per common share for each period presented:
| Three Months Ended | Six Months Ended | |||||||||||||||
| June 30, | June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| (In thousands, except per share data) | ||||||||||||||||
Numerator for basic and diluted income per common share: | ||||||||||||||||
| Net income | $ | 11,043 | $ | 16,333 | $ | 22,417 | $ | 26,838 | ||||||||
Denominator: | ||||||||||||||||
| Denominator for basic income per common share — weighted average shares outstanding | 9,728 | 11,135 | 9,822 | 11,285 | ||||||||||||
| Effect of dilutive stock options and awards | 200 | 218 | 197 | 216 | ||||||||||||
| Denominator for diluted income per common share — adjusted weighted average shares outstanding | 9,928 | 11,353 | 10,019 | 11,501 | ||||||||||||
Net income — basic | $ | 1.14 | $ | 1.47 | $ | 2.28 | $ | 2.38 | ||||||||
Net income — diluted | $ | 1.11 | $ | 1.44 | $ | 2.24 | $ | 2.33 | ||||||||
In accordance with SFAS No. 128, “Earnings per Share,” the diluted weighted average number of shares outstanding includes an incremental adjustment for the assumed exercise of dilutive stock options and non-vested share awards. Stock options are considered dilutive when the average stock price during the period exceeds the exercise price and the assumed conversion of the options, using the treasury stock method as required by SFAS No. 128, produces an increased number of shares. Stock options with an exercise price that is higher than the average stock price during the period are excluded from the computation as their impact would be anti-dilutive. During the three and six months ended June 30, 2008 and 2007, there were no stock options that were considered to be anti-dilutive.
| 4. | Fair Value Measurements |
As discussed in Note 2, effective January 1, 2008, the Company implemented SFAS No. 157 relating to its financial assets and liabilities. SFAS No. 157 establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
| • | Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. | |
| • | Level 2: Significant observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means. | |
| • | Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. |
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Notes to Condensed Consolidated Financial Statements — (Continued)
The following is a description of the Company’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a recurring or nonrecurring basis:
Valuation of Investments
Fair values for the Company’s investment securities are obtained from a variety of independent pricing sources. Prices obtained from the various sources are then subjected to a series of tolerance and validation checks. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and quoted bid or ask prices are just a few of the observable inputs utilized. Prices determined by the model are then compared with prices provided by other vendors and against prior prices to ensure that deviations are within tolerable limits. If none of the pricing vendors are able to provide a current price for a security, a fair value must be developed using alternative sources based on a variety of less objective assumptions and inputs (Level 3).
Investments Measured at Fair Value on a Recurring Basis
Available-for-sale fixed-income securities —are recorded at fair value on a recurring basis. With the exception of U.S. Treasury securities, very few fixed-income securities are actively traded. Most fixed-income securities, such as government or agency mortgage-backed securities, tax-exempt municipal or state securities and corporate securities, are priced using the vendor’s pricing models and fall within Level 2 of the hierarchy. The Company has a small number of private placement fixed-income securities that may be valued using Level 2 or Level 3 inputs at a given reporting date depending on the timing and availability of observable input data from which pricing vendors can formulate a price based on their models.
Available-for-sale equity securities —are recorded at fair value on a recurring basis. Our available-for-sale equity security portfolio consists of publicly traded common stocks. As such quoted market prices in active markets are available for these investments, and they are therefore included in the amounts disclosed in Level 1.
Our financial assets with changes in fair value measured on a recurring basis at June 30, 2008 were as follows:
| Total | Level 1 | Level 2 | Level 3 | |||||||||||||
| (In thousands) | ||||||||||||||||
Available-for-sale investments: | ||||||||||||||||
| Fixed-income securities | $ | 229,106 | $ | — | $ | 222,382 | $ | 6,724 | ||||||||
| Equity securities(1) | 10,563 | 10,563 | — | — | ||||||||||||
| Total | $ | 239,669 | $ | 10,563 | $ | 222,382 | $ | 6,724 | ||||||||
| (1) | Included in other investments on the accompanying Condensed Consolidated Balance Sheets. |
During the six months ended June 30, 2008, the Company recorded a pre-tax charge of $858,000 related to certain securities whose decline in market value was considered to be other than temporary. The other than temporarily impaired securities were sold in the second quarter of 2008. No additional loss was recorded upon their disposition. All other declines in the fair value of investment securities were deemed to be interest rate related and temporary in nature based upon the Company’s ability and intent to hold any such securities for a sufficient period of time to enable the recovery of their fair value. Accordingly, there were no other than temporary impairment charges recorded during the six months ended June 30, 2008, or during the six months ended June 30, 2007.
The Company had no financial liabilities that it measured at fair value at June 30, 2008.
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Notes to Condensed Consolidated Financial Statements — (Continued)
The changes in the balances of Level 3 financial assets for the six months ended June 30, 2008, were as follows:
| Available-for-Sale | ||||
| Fixed-Income | ||||
| Securities | ||||
| (In thousands) | ||||
| Balance at January 1, 2008 | $ | 6,911 | ||
| Principal paydowns | (210 | ) | ||
| Net unrealized appreciation included in other comprehensive income | 23 | |||
| Balance at June 30, 2008 | $ | 6,724 | ||
Investment Measured at Fair Value on a Nonrecurring Basis
Held-to-maturity fixed-income securities —are recorded at amortized cost. However, the fair value of held-to-maturity securities is measured periodically, following the processes and procedures above, for purposes of evaluating whether any securities are other than temporarily impaired, as well as for purposes of disclosing, at least annually, the unrecognized holding gains and losses associated with the held-to-maturity investment security portfolio. Any other than temporarily impaired securities would be reported at the fair value used to measure the impairment in a table of nonrecurring assets and liabilities measured at fair value. At June 30, 2008, the Company did not have any held-to-maturity fixed-income securities that were considered to be other than temporarily impaired. Accordingly, there are no disclosures concerning assets and liabilities measured at fair value on a nonrecurring basis.
Other Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
Other non-financial assets that are measured at fair value on a nonrecurring basis for the purposes of determining impairment include such long-lived assets as property and equipment and investment real estate. The Company’s non-financial liabilities measured at fair value subsequent to initial recognition are limited to those liabilities associated with certain exit costs initiated in previous periods. Due to the nature of these assets and liabilities, inputs used to develop the fair value measurements will generally be based on unobservable inputs and therefore most of these assets and liabilities would be classified as Level 3. However, recent purchaseand/or sales activity with regard to real estate investments adjoining the property owned by the Company may qualify such investments for Level 2 classification. The Company will apply the fair value measurement and disclosure provisions of SFAS No. 157 effective January 1, 2009 to these non-financial assets measured on a nonrecurring basis.
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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 our Annual Report onForm 10-K for the year ended December 31, 2007, particularly “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations”. References to “we,” “our” and “us” are references to the Company.
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 “will,” “should,” “likely,” “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report.
We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all of our forward-looking statements. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any such forward-looking statements. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Factors that might cause such a difference include, without limitation, the risks and uncertainties discussed from time to time in this report and our other reports filed with the Securities and Exchange Commission, including those listed in our most recent Annual Report onForm 10-K under “Item 1A — Risk Factors,” and the following:
| • | Increased competition could adversely affect our ability to sell our products at premium rates we deem adequate, which may result in a decrease in premium volume. | |
| • | Our reserves for unpaid losses and loss adjustment expenses are based on estimates that may prove to be inadequate to cover our losses. | |
| • | An interruption or change in current marketing and agency relationships could reduce the amount of premium we are able to write. | |
| • | If we are unable to obtain or collect on ceded reinsurance, our results of operations and financial condition may be adversely affected. | |
| • | Our geographic concentration in certain Midwestern states and New Mexico ties our performance to the business, economic, regulatory and legislative conditions in those states. | |
| • | A downgrade in the A.M. Best Company rating of our primary insurance subsidiary could reduce the amount of business we are able to write. | |
| • | Changes in interest rates could adversely impact our results of operation, cash flows and financial condition. | |
| • | The unpredictability of court decisions could have a material impact on our operations. | |
| • | Our business could be adversely affected by the loss of one or more key employees. | |
| • | The insurance industry is subject to regulatory oversight that may impact the manner in which we operate our business, our ability to obtain future premium rate increases, the type and amount of our investments, the levels of capital and surplus deemed adequate to protect policyholder interests, or the ability of our insurance subsidiaries to pay dividends to the holding company. | |
| • | Our status as an insurance holding company with no direct operations could adversely affect our ability to meet our debt obligations and fund future cash dividends and share repurchases. | |
| • | Legislative or judicial changes in the tort system may have adverse or unintended consequences that could materially and adversely affect our results of operations and financial condition. | |
| • | Applicable law and various provisions in our articles and bylaws may prevent and discourage unsolicited attempts to acquire APCapital that you may believe are in your best interests or that might result in a substantial profit to you. |
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Other factors not currently anticipated by management may also materially and adversely affect our financial position and results of operations. We do not undertake, and expressly disclaim, any obligation to update or alter our statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
Overview of the Company’s Operations
We are an insurance holding company whose financial performance is heavily dependent upon the results of operations of our insurance subsidiaries. Our insurance subsidiaries are property and casualty insurers that write almost exclusively medical professional liability insurance for physicians and other healthcare professionals, principally in the Midwest and New Mexico. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
An insurance company earns investment income on what is commonly referred to as the “float.” The float is money that we hold, in the form of investments, from premiums that we have collected. While a substantial portion of the premiums we collect will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period that we hold the float prior to paying losses can extend over several years, especially with a long-tailed line of business such as medical professional liability. The key factors that determine the amount of investment income we are able to generate are the rate of return, or yield, on invested assets and the length of time we are able to hold the float. We focus on the after-tax yield of our investments, as significant tax savings can be realized on bonds that pay interest that is exempt from federal income taxes.
For further information regarding the operations of our medical professional liability insurance business see “Item 1. Business — Medical Professional Liability Operations” of our most recent Annual Report onForm 10-K.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts reported in the accompanying unaudited Condensed Consolidated Financial Statements and Notes thereto. 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, or 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. Adjustments related to changes in estimates are reflected in our results of operations in the period in which those estimates changed.
Our “critical” accounting policies are those policies that we believe to be most sensitive to estimates and judgments. These policies are more fully described in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, Significant Accounting Policies” of our Annual Report onForm 10-K for the year ended December 31, 2007, and in Note 1 to our Consolidated Financial Statements contained in that report. There have been no material changes to these policies since the most recent year end.
Description of Ratios and Other Metrics Analyzed
We measure our performance using several different ratios and other key metrics. These ratios and other metrics are calculated on a GAAP basis, unless otherwise indicated, and include:
Underwriting Gain or Loss: This metric measures the overall profitability of our insurance underwriting operations. It is the gain or loss that remains after deducting net loss and loss adjustment expenses and underwriting expenses incurred from net premiums earned. We use this measure to evaluate the underwriting performance of our insurance operations in relation to peer companies.
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 related
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settlement expenses compared to the amount of premiums we earn. The calendar year loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The accident year loss ratio, which is a non-GAAP financial measure, uses only those loss and loss adjustment expenses that relate to the current accident year (i.e., excludes the effect of development on prior year loss reserves). We believe the accident year loss ratio is useful in evaluating our current underwriting performance, as it focuses on the relationship between current premiums earned and losses incurred related to the current year. Our method of calculating accident year loss ratios may differ from the method used by other companies, and therefore, comparability may be limited. In the case of each loss ratio, accident year or calendar year, 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 managing our underwriting operations. 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 as more rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn 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.
Investment Yield: Investment yield represents the average return on investments as determined by dividing investment income for the period by the average ending monthly investment balance for the period. As we use average month ending balances, the yield for certain individual asset classes that are subject to fluctuations in a given month, such as cash and cash equivalents, may be skewed slightly. However, we believe that when calculated for the cash and invested asset portfolio in its entirety, the overall investment yield is an accurate and reliable measure for evaluating investment performance. We calculate investment yields using pre-tax investment income, which excludes the tax savings benefits of certain tax-exempt securities. Our calculation of investment yields may differ from those employed by other companies.
These ratios, when calculated using our reported statutory results, will differ from the GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, compared to net premiums written for the statutory underwriting expense ratio.
In addition to these measures of operating performance, we also use certain measures to monitor our premium writings and price level changes. We measure policy retention by comparing the number of policies that renew during a given period with the number of policies that expire. This retention ratio helps us to measure our success at retaining insured accounts. We also monitor our insured physician count, which counts the number of doctor equivalents associated with all policies, where a corporation or ancillary health care providers on a policy are assigned a value of one doctor equivalent. When used in conjunction with the retention ratio, the insured physician count helps us to monitor the overall increase or decrease in insureds that comprise our premium base.
One of the ways that we measure price level changes is by comparing the average in-force premium per physician at one period end to that of a prior period end. The in-force premium represents, at a point in time, the overall annual premium associated with policies that are in-force, or active, as of that point in time. Accordingly, it is a somewhat imprecise measure of price level changes as the in-force premium represents the annual premium associated with policies written over the last 12 months. In addition, the average in-force premium measure does not contemplate changes in mix of business, or specialty classes, that we write. Despite its limitations, the average in-force premium is an understandable and easy to obtain measure that management finds useful in evaluating overall changes in premium levels.
As a way of evaluating our capital management strategies we measure and monitor our return on equity, or ROE, in addition to our results of operations. We measure ROE as our net income for the period, annualized if necessary, divided by our total shareholders’ equity as of the beginning of the period. Other companies sometimes calculate ROE by dividing annualized net income by an average of beginning and ending shareholders’ equity.
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Accordingly, the ROE percentage we provide may not be comparable with those provided by other companies. We believe that an average target ROE of between 11% and 13%, using our calculation method, represents an acceptable return to our shareholders. We use a modified version of ROE as the basis for determining performance-based compensation for our executives.
We also track the book value per common share outstanding, which is calculated by dividing shareholders’ equity as of the end of the period by the total number of common shares outstanding at that date. Evaluating the relationship between the book value per common share and the cost of a common share in the open market helps us compare our stock value with that of our peers and to determine the relative premium that the market places on our stock and the stock of our peers.
Results of Operations — Three and Six Months Ended June 30, 2008 Compared to Three and Six Months Ended June 30, 2007
The following tables show our underwriting results, as well as other revenue and expense items included in our unaudited Condensed Consolidated Statements of Income, for the three and six-month periods ended June 30, 2008 and 2007.
| For the Three Months Ended June 30, | ||||||||||||||||
| Change | ||||||||||||||||
| 2008 | 2007 | Dollar | Percentage | |||||||||||||
| (Dollars in thousands) | ||||||||||||||||
| Direct premiums written | $ | 26,444 | $ | 27,847 | $ | (1,403 | ) | (5.0 | )% | |||||||
| Net premiums written | $ | 25,499 | $ | 26,967 | $ | (1,468 | ) | (5.4 | )% | |||||||
| Net premiums earned | $ | 31,420 | $ | 34,896 | $ | (3,476 | ) | (10.0 | %) | |||||||
| Losses and loss adjustment expenses | ||||||||||||||||
| Current year losses | 24,670 | 25,814 | (1,144 | ) | (4.4 | )% | ||||||||||
| Prior year losses | (7,003 | ) | (12,898 | ) | 5,895 | (45.7 | )% | |||||||||
| Total | 17,667 | 12,916 | 4,751 | 36.8 | % | |||||||||||
| Underwriting expenses | 6,623 | 7,566 | (943 | ) | (12.5 | )% | ||||||||||
| Total underwriting gain | 7,130 | 14,414 | (7,284 | ) | (50.5 | )% | ||||||||||
| Other revenue (expense) items | ||||||||||||||||
| Investment income | 9,235 | 11,152 | (1,917 | ) | (17.2 | )% | ||||||||||
| Net realized losses | 74 | (64 | ) | 138 | (215.6 | )% | ||||||||||
| Other income | 206 | 175 | 31 | 17.7 | % | |||||||||||
| Other expenses(1) | (1,115 | ) | (1,374 | ) | 259 | (18.9 | )% | |||||||||
| Total other revenue and expense items | 8,400 | 9,889 | (1,489 | ) | (15.1 | )% | ||||||||||
| Income before federal income taxes | 15,530 | 24,303 | (8,773 | ) | (36.1 | )% | ||||||||||
| Federal income tax expense | 4,487 | 7,970 | (3,483 | ) | (43.7 | )% | ||||||||||
| Net income | $ | 11,043 | $ | 16,333 | $ | (5,290 | ) | (32.4 | )% | |||||||
| Loss Ratio: | ||||||||||||||||
| Accident year | 78.5 | % | 74.0 | % | 4.5 | % | ||||||||||
| Prior years | (22.3 | )% | (37.0 | )% | 14.7 | % | ||||||||||
| Calendar year | 56.2 | % | 37.0 | % | 19.2 | % | ||||||||||
| Underwriting expense ratio | 21.1 | % | 21.7 | % | (0.6 | )% | ||||||||||
| Combined ratio | 77.3 | % | 58.7 | % | 18.6 | % | ||||||||||
| Investment yield | 4.38 | % | 5.10 | % | (0.7 | )% | ||||||||||
| (1) | Other expenses includes investment expenses, interest expense, general and administrative expenses and other expenses as reported in the unaudited Condensed Consolidated Statements of Income included elsewhere in this report. |
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| For the Six Months Ended June 30, | ||||||||||||||||
| Change | ||||||||||||||||
| 2008 | 2007 | Dollar | Percentage | |||||||||||||
| (Dollars in thousands) | ||||||||||||||||
| Direct premiums written | $ | 60,115 | $ | 64,149 | $ | (4,034 | ) | (6.3 | )% | |||||||
| Net premiums written | $ | 57,674 | $ | 61,861 | $ | (4,187 | ) | (6.8 | )% | |||||||
| Net premiums earned | $ | 63,067 | $ | 69,928 | $ | (6,861 | ) | (9.8 | )% | |||||||
| Losses and loss adjustment expenses | ||||||||||||||||
| Current year losses | 49,288 | 52,441 | (3,153 | ) | (6.0 | )% | ||||||||||
| Prior year losses | (15,423 | ) | (17,163 | ) | 1,740 | (10.1 | )% | |||||||||
| Total | 33,865 | 35,278 | (1,413 | ) | (4.0 | )% | ||||||||||
| Underwriting expenses | 13,639 | 14,927 | (1,288 | ) | (8.6 | )% | ||||||||||
| Total underwriting gain | 15,563 | 19,723 | (4,160 | ) | (21.1 | )% | ||||||||||
| Other revenue (expense) items | ||||||||||||||||
| Investment income | 19,192 | 22,329 | (3,137 | ) | (14.0 | )% | ||||||||||
| Net realized losses | (708 | ) | (66 | ) | (642 | ) | 972.7 | % | ||||||||
| Other income | 395 | 388 | 7 | 1.8 | % | |||||||||||
| Other expenses(1) | (2,332 | ) | (2,669 | ) | 337 | (12.6 | )% | |||||||||
| Total other revenue and expense items | 16,547 | 19,982 | (3,435 | ) | (17.2 | )% | ||||||||||
| Income before federal income taxes | 32,110 | 39,705 | (7,595 | ) | (19.1 | )% | ||||||||||
| Federal income tax expense | 9,693 | 12,867 | (3,174 | ) | (24.7 | )% | ||||||||||
| Net income | $ | 22,417 | $ | 26,838 | $ | (4,421 | ) | (16.5 | )% | |||||||
| Loss Ratio: | ||||||||||||||||
| Accident year | 78.2 | % | 75.0 | % | 3.2 | % | ||||||||||
| Prior years | (24.5 | )% | (24.5 | )% | 0.0 | % | ||||||||||
| Calendar year | 53.7 | % | 50.5 | % | 3.2 | % | ||||||||||
| Underwriting expense ratio | 21.6 | % | 21.3 | % | 0.3 | % | ||||||||||
| Combined ratio | 75.3 | % | 71.8 | % | 3.5 | % | ||||||||||
| Investment yield | 4.53 | % | 5.11 | % | (0.6 | )% | ||||||||||
| Return on beginning equity (annualized) | 17.0 | % | 20.0 | % | (3.0 | )% | ||||||||||
| (1) | Other expenses includes investment expenses, interest expense, general and administrative expenses and other expenses as reported in the unaudited Condensed Consolidated Statements of Income included elsewhere in this report. |
Overview
Net income for the three and six-month periods ended June 30, 2008 was less than the same periods of 2007 by $5.3 million and $4.4 million, respectively. The decreases in net income are largely attributable to decreases in the amount of favorable development on prior years’ loss reserves recognized for the three and six months ended June 30, 2008, compared with 2007, as well as decreases in our net premiums earned and investment income. Partially offsetting these negative influences on net income were decreases in current accident year incurred losses, underwriting expenses and interest expense.
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Premiums Written and Earned
The following table shows our direct premiums written by major geographical market, as well as the relationship between direct and net premiums written, for the three and six months ended June 30, 2008 and 2007.
| For the Three Months Ended June 30, | For the Six Months Ended June 30, | |||||||||||||||||||||||||||||||
| Change | Change | |||||||||||||||||||||||||||||||
| 2008 | 2007 | Dollar | Percentage | 2008 | 2007 | Dollar | Percentage | |||||||||||||||||||||||||
| (Dollars in thousands) | (Dollars in thousands) | |||||||||||||||||||||||||||||||
| Direct premiums written | ||||||||||||||||||||||||||||||||
| Michigan | $ | 9,409 | $ | 10,151 | $ | (742 | ) | (7.3 | )% | $ | 19,249 | $ | 19,414 | $ | (165 | ) | (0.8 | )% | ||||||||||||||
| Illinois | 7,252 | 7,497 | (245 | ) | (3.3 | )% | 15,806 | 17,337 | (1,531 | ) | (8.8 | )% | ||||||||||||||||||||
| Ohio | 4,830 | 5,686 | (856 | ) | (15.1 | )% | 12,277 | 14,051 | (1,774 | ) | (12.6 | )% | ||||||||||||||||||||
| New Mexico | 3,952 | 3,498 | 454 | 13.0 | % | 9,024 | 8,952 | 72 | 0.8 | % | ||||||||||||||||||||||
| Kentucky | 574 | 623 | (49 | ) | (7.9 | )% | 2,711 | 3,356 | (645 | ) | (19.2 | )% | ||||||||||||||||||||
| Other | 427 | 392 | 35 | 8.9 | % | 1,048 | 1,039 | 9 | 0.9 | % | ||||||||||||||||||||||
| Total | $ | 26,444 | $ | 27,847 | $ | (1,403 | ) | (5.0 | )% | $ | 60,115 | $ | 64,149 | $ | (4,034 | ) | (6.3 | )% | ||||||||||||||
| Net premiums written | $ | 25,499 | $ | 26,967 | $ | (1,468 | ) | (5.4 | )% | $ | 57,674 | $ | 61,861 | $ | (4,187 | ) | (6.8 | )% | ||||||||||||||
| Ratio of net premiums written to direct | 96.4 | % | 96.8 | % | (0.4 | )% | 95.9 | % | 96.4 | % | (0.5 | )% | ||||||||||||||||||||
The medical malpractice insurance market remains highly competitive. However, we retained 88% of our insureds whose policies expired during the first six months of 2008. Overall, our insured physician count was down 0.7% to 9,154 at June 30, 2008, compared with 9,217 at December 31, 2007. When compared with June 30, 2007, our insured physician count has decreased 1.6%. The decreases in the insured physician count were mostly the result of the competitive nature of select markets, particularly Illinois and Ohio. Our average in-force premium has decreased 3.7% to approximately $13,730 at June 30, 2008, from $14,260 at December 31, 2007, and 9.4% from $15,150 at June 30, 2007. The decreases in the average in-force premium were primarily the result of rate decreases we have taken in virtually all of our geographic markets.
The rate decreases taken recently have been in response to favorable claim trends noted in virtually all markets of the medical professional liability industry, causing other carriers to lower their rates as well, and increasing overall competition in the industry. We anticipate that the medical professional liability insurance pricing environment will remain highly competitive in the near future. However, we plan to adhere to our philosophy of underwriting discipline and adequate pricing, focusing on retaining our quality book of business, rather than pursuing premium growth in this soft market cycle.
The decreases in net premiums written were relatively consistent with the decreases in direct premiums written. Accordingly, as a percentage of direct premiums written, net premiums written has remained around 96% in the first six months of 2008 and 2007. The terms of our 2008 reinsurance treaty are very similar to those in the 2007 treaty, both in terms of coverage and premium rates. However, there was a small increase, approximately 0.5%, in the premium rate charged in 2008 compared with 2007.
Net premiums earned decreased 10.0% and 9.8% for the three and six month periods ended June 30, 2008, respectively, compared with the same periods of 2007. The decreases in net premiums earned were 4.6% and 3.0%, respectively, greater than the decreases in net premiums written. This was primarily due to the earned premium “lag effect.” Premiums written are earned over the policy term, which is typically one year. As a result, written premium volume changes take up to 12 months to “earn in.” Over the last several quarters this lag effect has resulted in decreases in net premiums earned that were less than the decreases in net premiums written, which is typical in periods when written premium volume is decreasing at a relatively consistent, or accelerating, pace because the higher written premium volumes from prior periods continue to be earned in the current period. However, in 2008, the decreases in our net premiums written decelerated compared with decreases in previous quarters andyear-to-date periods. Under these conditions, net premiums earned typically decrease at a greater rate than net
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premiums written, as the premiums being earned in during the first six months of the current calendar year are based on premiums written over the last 18 months (January 1, 2007 through June 30 2008) while premiums earned during the first six months of the prior calendar year were written between 12 and 30 months prior (January 1, 2006 through June 30, 2007). Net premiums written during the 18 month period ended June 30, 2008 were $188.5 million, compared with $208.6 million of net premiums written during the 18 months ended June 30, 2007, representing a decrease of 9.6%, which is relatively consistent with the 9.8% decrease in net premiums earned for the six months ended June 30, 2008 compared with the six months ended June 30, 2007.
Loss and Loss Adjustment Expenses
Net incurred loss and loss adjustment expenses, which we refer to collectively as losses, for the second quarter of 2008 increased $4.8 million compared with the second quarter of 2007. For the six months ended June 30, 2008, losses incurred decreased $1.4 million. Due to the effect that actuarial estimates of loss reserves have on incurred losses, there are many judgments, assumptions and variables that impact the amount of incurred losses we report in any given period. However, when evaluating our losses, we believe it is useful to focus on three key components: 1) the change in the current accident year loss ratio, 2) the change in net premiums earned during the period, as current accident year losses incurred are a product of net premiums earned and the current accident year loss ratio, and 3) the change in the amount of development, favorable or unfavorable, on prior years’ loss reserves recognized during the period.
Our current accident year loss ratios in 2008 increased 4.5% for the quarter and 3.2% for theyear-to-date periods compared with 2007 as a result of premium rate decreases. In periods where premium rates decrease, accident year loss ratios typically increase, all other things being equal, because the loss exposure is spread over a smaller premium base. Although our current accident year loss ratios for the quarter andyear-to-date periods were up from last year, our current accident year losses were down for both periods compared with the same periods in 2007 due to the declines in net premiums earned for the three and six months ended June 30, 2008, compared with 2007.
The decreases in favorable prior years’ loss reserve development of $5.9 million and $1.7 million for the second quarter andyear-to-date periods of 2008 compared to 2007 were due to the historically low paid and reported losses in the second quarter of 2007, which resulted in a more optimistic outlook regarding favorable claims trends that had been emerging. Consequently, our projections of the ultimate cost to settle our claims obligations were reduced, resulting in $12.9 million of favorable development on prior years’ loss reserves in the second quarter of 2007. Favorable development for the first quarter of 2008 was $8.4 million, compared with $4.3 million for the first quarter of 2007, so theyear-to-date decrease in favorable prior year development from 2007 to 2008 was not as significant as the decrease in the second quarter of 2008 compared with 2007. Reported claim counts, paid loss and case reserve development trends remained positive in 2008, which were the primary reasons for the continued favorable development.
Although reported claims in the second quarter of 2008 decreased 3.0% to 261 from 269 in the second quarter of 2007, and decreased 4.5% during the first half of 2008 compared with the first half of 2007, the rate of decline in reported claim frequency has moderated as expected. We believe the decreases in reported claim frequency were due to our strict underwriting practices, as well as favorable external factors such as tort reform and changes in the overall legal climate. The average number of reported claims over the last eight quarters is 251, with a standard deviation of approximately 31. However, over the last 20 quarters, the average number of reported claims increases to 354 and the standard deviation increases to 116, suggesting that the decline in reported claim frequency is leveling off. Paid loss trends, as measured by the average amount of paid loss and loss adjustment expenses per closed claim, however, have remained relatively consistent with an average paid loss of $69,200 over the last eight quarters, and $69,100 over the last 20 quarters.
While we believe that our current loss reserve estimate represents our best estimate of the ultimate cost to settle our claims obligations as of June 30, 2008. However, should actual loss trends continue to develop more favorably than our estimates, we likely will experience additional favorable development in future periods. Historical favorable prior year development is not indicative of future operating results, as the amount, if any, and timing of future favorable development is contingent upon the continued emergence of the stable claim trends we have been experiencing, as well as many other internal and external factors, including those discussed in our most recent Annual Report onForm 10-K.
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Underwriting Expenses
The decreases in underwriting expenses are primarily attributable to the declines in our premium volume. The underwriting expense ratio for the second quarter of 2008 decreased 0.6% to 21.1%, from 21.7% in the second quarter of 2007, primarily as a result of reduced fees for professional services as a result of carefully monitoring and limiting these types of cost when possible, as well as a slight reduction in personnel costs attributable to attrition and benefits restructuring. The underwriting expense ratio increased 0.3% to 21.6% for the six months ended June 30, 2008, from 21.3% for the same period of 2007. The increase in theyear-to-date underwriting expense ratio was primarily attributable to costs incurred in the first quarter of 2008 in connection with the development and implementation of a new policy and claims administration system, partially offset by the reductions discussed above. While most of the costs related to this project are being capitalized, certain costs, related primarily to data migration, must be expensed as incurred. We are currently targeting a launch date for some aspects of this new system in the fourth quarter of 2008, with the remaining portions of the system coming on-line in the first half of 2009. At that point, we will begin to amortize the costs incurred in connection with the project that we have capitalized, which will result in an estimated increase in our underwriting expenses of approximately $0.9 million annually, which will likely result in an additional increase in the underwriting expense ratio.
Investment Income
Investment income was down $1.9 million for the second quarter of 2008 and down $3.1 millionyear-to-date compared to the comparable periods a year ago. There are three factors driving the decreases in investment income. The first was the decline in short-term interest rates that started in the third quarter of 2007 and continued through the early part of 2008. This accounted for approximately $0.8 million and $1.5 million of the decreases for the quarter andyear-to-date periods, respectively. The second factor was that we have continued to increase the allocation of our investment portfolio to tax-exempt securities in 2008. During the second quarter of 2008, we purchased an additional $53.8 million of tax exempt securities having a weighted average yield of 3.87%. Year to date in 2008, we have purchased $112.2 million of tax exempt securities with a weighted average yield of 3.87%. These securities replaced approximately $144.2 million of taxable securities that matured, were called, sold or paid down in the first half of 2008 that had a weighted average yield of 5.10%. Third, our average invested asset balance for the first six months of 2008 was approximately $27 million less than during the same period of 2007, primarily due to the $57.2 million of share repurchases in the second half of 2007 and first half of 2008, partially offset by cash generated from operations.
We anticipate that pre-tax investment income will continue to decrease throughout 2008 as a result of the lower short-term interest rates and the increased allocation of our portfolio to tax-exempt securities. However, the impact on net income of the increase in tax-exempt securities should be relatively neutral as a result of the added tax savings.
Net Realized Losses
The increase in net realized losses during the six months ended June 30, 2008, was attributable to a pre-tax charge of $0.9 million related to the other than temporary impairment of CIT Group bonds in the first quarter of 2008. Although we believed that the ultimate collectability of these securities was not at issue, consistent with our philosophy of maintaining a strong, high-quality asset base and thereby protecting the strength of our financial position, we elected to dispose of the securities in question to mitigate any further down-side risk that could result from continued declines in the market value of the securities. Accordingly, we disposed of the securities in mid-April 2008, incurring no additional losses upon disposition beyond the impairment recorded in the first quarter of 2008.
Other Expenses
Other expenses for the second quarter andyear-to-date periods of 2008 decreased $0.3 million compared to the same periods a year ago. The decreases were primarily attributable to decreases in short-term interest rates, which affect the amount of interest expense associated with our long-term debt. We intend to repay $5.0 million of our outstanding $30.9 million in long-term debt in the third quarter of 2008. This should reduce the amount of interest expense in the fourth quarter of 2008 and subsequent periods by approximately $100,000 per quarter, based on the rates in effect for the second quarter of 2008.
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Income Taxes
The effective tax rate for the second quarter of 2008 was 28.9%, compared to 32.8% in the second quarter of 2007. The decrease in the effective tax rate is the result of the increased allocation of our investment portfolio to tax-exempt securities. Theyear-to-date decrease in the effective tax rate to 30.2%, from 32.4% a year ago, is not as dramatic as the decrease noted in the second quarter of 2008 as the $112.2 million of tax-exempt security purchases made in 2008 were not made until late in the first quarter or in the second quarter.
Liquidity and Capital Resources
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets and principal receipts from our mortgage-backed securities. The primary uses of cash, on both a short- and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, the repayment of long-term debt, the payment of shareholder dividends, and the repurchase of shares of APCapital’s outstanding common stock.
We paid quarterly cash dividends of $0.10 per common share on March 31, 2008 and June 30, 2008, totaling approximately $2.0 million for the two quarters. On July 31, 2008, the Board of Directors declared a third-quarter cash dividend of $0.10 per common share payable on September 30, 2008 to shareholders of record on September 12, 2008, which is expected to result in a total payout of slightly less than $1.0 million.
The Board’s current intention is to pay a comparable cash dividend on a quarterly basis for the foreseeable future. However, the payment of future dividends will depend upon the availability of cash resources at APCapital, the financial condition and results of operations of the Company and such other factors as are deemed relevant by the Board of Directors.
We continued to repurchase shares of our outstanding common stock during the first and second quarters of 2008. A total of 404,000 shares were repurchased during the first quarter at a cost of $17.3 million, or $42.93 per share. Our repurchases slowed in the second quarter with only 12,000 shares being repurchased at a total cost of $0.5 million, or $45.17 per share. See Part II, Item 2. “Unregistered Sales of Equity Securities and Use of Proceeds” for details of our share repurchase plans.
APCapital’s only material assets are cash and the capital stock of American Physicians and its other subsidiaries. APCapital’s 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 certain limitations imposed by applicable law. In accordance with the dividend limits, dividend payments totaling $63.1 million can be made in 2008 by our American Physicians subsidiary without prior regulatory approval. We have notified the State of Michigan Office of Financial and Insurance Regulation of our plans to cause our American Physicians Subsidiary to pay approximately $50 million in dividends to APCapital prior to the end of 2008. As of June 30, 2008, $10 million of the planned $50 million had been paid. At June 30, 2008, APCapital’s cash and cash equivalent resources totaled approximately $29.2 million.
Our net cash flow from operations was $18.2 million during the six months ended June 30, 2008, a decrease of $8.8 million compared to $27.0 million for the same period of 2007. The decrease in cash provided by operations was primarily the result of an $8.4 million decrease in premium receipts due to our declining premium volume, a $2.3 million decrease in interest receipts from our investment portfolio, due to lower short-term interest rates and an increase in lower interest tax-exempt securities, and an increase in estimated federal income taxes paid of $2.2 million, as we have used virtually all of our net operating loss carryforwards and minimum tax credits. Partially offsetting the decrease in cash from operations caused by the aforementioned items was an increase in cash from operations of $5.0 million as a result of fewer paid loss and loss adjustment expenses in the first half of 2008, compared with a year ago.
At June 30, 2008, we had $112.1 million of cash and cash equivalents on hand to meet short-term cash flow needs. In addition, at June 30, 2008, we had $27.0 million ofavailable-for-sale andheld-to-maturity fixed-income
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securities that mature in the next year. On a longer-term basis, we attempt to match the projected payments of our claims obligations with the maturities of our long-term fixed-income security portfolio. Accordingly we have $180.5 million, $234.6 million, and $126.0 million ofavailable-for-sale andheld-to-maturity fixed-income securities that mature in the next one to five years, five to 10 years, and more than 10 years, respectively. In addition, we have $151.4 million of mortgage-backed securities that provide periodic principal repayments.
The $30.9 million of long-term debt carried on our Condensed Consolidated Balance Sheets, included elsewhere in this report, became callable in May 2008. We have initiated the repayment of $5.0 million of this long-term debt in the third-quarter of 2008. We frequently evaluate our capital management strategies with the intention of providing the most value to APCapital shareholders and making prudent use of APCapital’s cash resources. Any decision to make further repayments would be based on such evaluations, as well as changes in our available cash resources, capital needs and other relevant factors.
Based on historical trends, economic, market and regulatory conditions and our current business plans, we believe that our existing resources and sources of funds, including possible dividend payments from our insurance subsidiaries to APCapital, will be sufficient to meet our short- and long-term liquidity needs. However, these trends, conditions and plans are subject to change, and there can be no assurance that our available funds will be sufficient to meet our liquidity needs in the future. In addition, any acquisition or other extraordinary transaction we may pursue outside of the ordinary course of business could require that we raise additional capital.
Financial Condition
In evaluating our financial condition, two factors are the most critical: first, the availability of adequate statutory capital and surplus to satisfy state regulatory requirements and support our current A.M. Best Company rating, which was recently upgraded to A- (Excellent), and second, the adequacy of our reserves for unpaid loss and loss adjustment expenses.
Statutory Capital and Surplus
Our statutory capital and surplus (collectively referred to herein as “surplus”) at June 30, 2008 remains strong, at approximately $233.2 million. This represents an increase of $11.6 million from December 31, 2007, despite the $10 million dividend payment from American Physicians to APCapital in June 2008. The $233.2 million of statutory surplus represents a net premium written to surplus ratio of 0.54:1 based on $126.6 million of net premiums written in the 12 months ended June 30, 2008. In general, we believe that A.M. Best and state insurance regulators prefer to see a net premiums written to surplus ratio for long-tailed casualty insurance companies, such as ours, of 1:1 or lower. Our net leverage ratio, which is the sum of the net premiums written and net liabilities divided by statutory surplus at June 30, 2008, was 3.3. The net leverage ratio is used by regulators and rating agencies to measure a company’s combined exposure to pricing errors and errors in the estimation of its liabilities, net of reinsurance, in relation to its surplus. Generally, a ratio of less than 6.0 is acceptable for long-tailed casualty line carriers.
Reserves for Unpaid Losses and Loss Adjustment Expenses
Medical professional liability insurance is a “long-tailed” line of business, which means that claims may take several years from the date they are reported to us until the time at which they are either settled or closed. In addition, we also offer occurrence-based coverage in select markets, primarily Michigan and New Mexico. Occurrence-based policies offer coverage for insured events that occurred during the dates that a policy was in-force. This means that claims that have been incurred may not be reported to us until several years after the insured event has occurred. These claims, and their associated reserves, are referred to as incurred but not reported, or IBNR. IBNR reserves may also be recorded as part of the actuarial estimation of total reserves to cover any deficiency or redundancy in case reserves that may be indicated by the actuary’s analyses. Case reserves are established for open claims and represent management’s estimate of the ultimate net settlement cost of a claim, and the costs to investigate, defend and settle the claim, based on the information available about a given claim at a point in time.
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The table below shows the net case reserves, open claim counts, average net case reserves per open claim, net IBNR reserve and total net reserves for our medical professional liability line of business as of June 30, 2008, and December 31, 2007. Net reserves include direct and assumed reserves, reported as unpaid loss and loss adjustment expenses in the accompanying unaudited Condensed Consolidated Balance Sheets, reduced by the amount of ceded reserves, which are reported as a component of reinsurance recoverables in the balance sheet.
| June 30, | December 31, | |||||||||||||||
| 2008 | 2007 | Change | % Change | |||||||||||||
| (In thousands, except claim and per claim data) | ||||||||||||||||
| Net case reserves | $ | 245,903 | $ | 252,017 | $ | (6,114 | ) | (2.4 | )% | |||||||
| Number of open claims | 1,639 | 1,741 | (102 | ) | (5.9 | )% | ||||||||||
| Average net case reserve per open claim | $ | 150,032 | $ | 144,754 | $ | 5,278 | 3.6 | % | ||||||||
| Net IBNR reserves | $ | 285,987 | $ | 281,310 | $ | 4,677 | 1.7 | % | ||||||||
| Total net reserves | $ | 531,890 | $ | 533,327 | $ | (1,437 | ) | (0.3 | )% | |||||||
Medical professional liability total net reserves at June 30, 2008, were relatively unchanged from December 31, 2007. There have been 493 new claims reported to us in the first six months of 2008 and we closed 595 claims during the same period. Of the 595 claims we closed, 117 were closed with no payment, 375 were closed with expense payments only, and 103, or 17.3%, were closed with an indemnity payment.
We have added $4.7 million to net IBNR reserves during the first six months of 2008, primarily to cover future case reserve development as we have noted a moderate increase in the severity of claims reported to us recently. This increase in the severity of reported claims was expected, and was primarily the result of natural claim trends that indicate the severity of claims will typically increase when there is a trend of decreasing reported claim frequency, as it is assumed that those cases that continue to be reported are those with injuries of a more severe nature.
We have experienced $16.0 million of positive development on prior years’ medical professional liability net reserves in the six months ended June 30, 2008. The favorable development was the result of claim trends related to frequency and severity that developed better than originally anticipated. An unusually large percentage of the claims closed in the first quarter of 2008 in Florida and Nevada closed with little or no payment activity, which resulted in approximately $6.3 million of the positive development experienced so far in 2008.
Although considerable judgment is inherent in the estimation of net loss and loss adjustment expense reserves, we believe that our net reserves for medical professional liability claims are adequate. However, there can be no assurance that losses will not exceed the reserves we have recorded, or that we will not later determine that our reserve estimates were inadequate, as future trends related to the frequency and severity of claims, and other factors may develop differently than management has projected. The assumptions and methodologies used in estimating and establishing reserves for unpaid loss and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded eight-percent (8%) of our recorded net reserves as of the beginning of the period, but such adjustments can materially and adversely affect our results of operations when they are made.
Although we initiated our exit from workers’ compensation in 2003, and the last policy expired in the second quarter of 2005, workers’ compensation is also a long-tailed line of business, and as a result, it will be several years until we settle all workers’ compensation claims. Workers’ compensation net reserves at June 30, 2008, were $22.8 million compared with $25.6 million at December 31, 2007. Workers’ compensation net reserves developed unfavorably in the first half of 2008 by $0.6 million, compared with $4.2 million in calendar year 2007. As the remaining open claims age, the ultimate amount of claim settlement should become more evident. As a result, volatility inherent in the actuarial projection of ultimate losses begins to stabilize, which should reduce the need to adjust loss reserves for previous accident years. We had 240 open workers’ compensation claims at June 30, 2008, down 31, or 11.4%, from December 31, 2007.
As with medical professional liability reserves, there is a great deal of uncertainty inherent in workers’ compensation reserves estimates, and while we believe our estimate at June 30, 2008 is adequate, there can be no
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assurance that the ultimate cost of claims settlement will not exceed the reserves we have established, or that we will not later determine that our reserve estimates were inadequate.
Activity in the liability for unpaid loss and loss adjustment expenses for the six months ended June 30, 2008 and the year ended December 31, 2007 was as follows:
| Six Months | ||||||||
| Ended | Year Ended | |||||||
| June 30, 2008 | December 31, 2007 | |||||||
| (In thousands) | ||||||||
| Beginning balance, gross | $ | 664,117 | $ | 688,031 | ||||
| Less, reinsurance recoverables | (104,648 | ) | (107,965 | ) | ||||
| Net reserves, beginning balance | 559,469 | 580,066 | ||||||
| Incurred related to | ||||||||
| Current year | 49,288 | 103,673 | ||||||
| Prior years | (15,423 | ) | (34,245 | ) | ||||
| 33,865 | 69,428 | |||||||
| Paid related to | ||||||||
| Current year | 869 | 2,699 | ||||||
| Prior years | 37,191 | 87,326 | ||||||
| 38,060 | 90,025 | |||||||
| Net reserves, ending balance | 555,274 | 559,469 | ||||||
| Plus, reinsurance recoverables | 102,636 | 104,648 | ||||||
| Ending balance, gross | $ | 657,910 | $ | 664,117 | ||||
| Development as a% of beginning net reserves | (2.8 | )% | (5.9 | )% | ||||
The $15.4 million of favorable development recorded during the six months ended June 30, 2008, is not necessarily indicative of the results to be expected for the year ending December 31, 2008.
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Other Significant Balance Sheet Items
The following table shows the composition of our invested asset portfolio at June 30, 2008, and December 31, 2007.
| June 30, 2008 | December 31, 2007 | |||||||||||||||
| Amount | % of Total | Amount | % of Total | |||||||||||||
| (In thousands) | ||||||||||||||||
| U.S. Government and government agency securities | $ | 64,482 | 7.6 | % | $ | 145,021 | 16.9 | % | ||||||||
| States and political subdivisions (tax-exempt) securities | 376,282 | 44.2 | % | 269,013 | 31.2 | % | ||||||||||
| Corporate securities | 130,831 | 15.4 | % | 193,037 | 22.5 | % | ||||||||||
| Mortgage-backed securities | 151,428 | 17.8 | % | 152,892 | 17.8 | % | ||||||||||
| Total fixed-income securities | 723,023 | 85.0 | % | 759,963 | 88.4 | % | ||||||||||
| Publicly traded equity securities | 10,563 | 1.2 | % | 6,516 | 0.8 | % | ||||||||||
| Statutory trusts | 928 | 0.1 | % | 928 | 0.1 | % | ||||||||||
| Real estate LLCs | 2,550 | 0.3 | % | 2,550 | 0.3 | % | ||||||||||
| Real estate held for development | 1,493 | 0.2 | % | 1,493 | 0.2 | % | ||||||||||
| Total other investments | 15,534 | 1.8 | % | 11,487 | 1.4 | % | ||||||||||
| Cash and cash equivalents | 112,070 | 13.2 | % | 87,498 | 10.2 | % | ||||||||||
| Total invested assets | $ | 850,627 | 100.0 | % | $ | 858,948 | 100.0 | % | ||||||||
Available-for-sale fixed-income securities (at fair value) | $ | 229,106 | 31.7 | % | $ | 262,301 | 34.5 | % | ||||||||
Held-to-maturity fixed-income securities (at amortized cost) | 493,917 | 68.3 | % | 497,662 | 65.5 | % | ||||||||||
| Total fixed-income securities | $ | 723,023 | 100.0 | % | $ | 759,963 | 100.0 | % | ||||||||
As interest rates declined in 2008, approximately $99 million of U.S. Government and corporate securities we held were called by the issuers in the first six months of 2008. The proceeds received from these calls, along with various other maturities, sales and principal receipts, were primarily re-invested in tax-exempt securities, increasing the overall allocation of tax-exempt securities in our investment portfolio to 44.2% at June 30, 2008, compared with 31.2% at December 31, 2007. As mentioned in “— Results of Operations,” we had one security that we deemed to be other than temporarily impaired in the first quarter of 2008 that resulted in a write-down of approximately $0.9 million. Overall, the overall credit quality of our investment portfolio remains very strong, with a weighted average (excluding approximately $13.0 million, or 1.8%, of private placement fixed-income securities) Standard & Poor’s credit quality rating of AA+ at June 30, 2008. For additional information regarding the risks inherent in our investment portfolio see Item 3, Quantitative and Qualitative Disclosures About Market Risk.
Assets, other than our cash and invested assets, decreased approximately $7.8 million from December 31, 2007. Premiums receivable decreased $4.7 million as a result of the decline in our direct premiums written, and reinsurance recoverables decreased $3.2 million due to the closure of several large claims in excess of our retention level, many with no indemnity losses paid. In addition, property and equipment increased $1.7 million, primarily due to the capitalization of an additional $2.0 million of costs related to the development and implementation of a new policy and claims administration system, partially offset by depreciation on our East Lansing, Michigan home office building.
On the liability and equity side of the balance sheet, total liabilities decreased $17.6 million from December 31, 2007. The majority of the decrease was related to our loss reserves and unearned premium reserves, which decreased $6.2 million and $5.3 million respectively. The decrease in our loss reserves was primarily related to fewer reported claims and decreasing open claim counts as discussed in the section “— Reserves for Unpaid Losses and Loss Adjustment Expenses.” The decrease in unearned premiums was the result of our decreasing direct
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premiums written volume. Accrued expenses and other liabilities also decreased by approximately $6.1 million. Of the $6.1 million decrease, approximately $4.0 million relates to the payment of year-end bonus, pension and other miscellaneous year-end accruals in the first quarter of 2008.
Shareholders’ equity increased $1.4 million to $265.0 million at June 30, 2008. The increase was primarily the result of $22.4 million of net income, partially offset by share repurchases of $17.9 million and $2.0 million of shareholder dividends paid, as well as a $1.4 million decrease in unrealized gains, net of tax. Shares outstanding at June 30, 2008, were 9,721,252, a decrease of 406,488 from December 31, 2007, primarily due to the 416,000 shares of APCapital’s common stock we repurchased. Book value per share increased $1.24, or 4.8%, to $27.26 at June 30, 2008, from $26.02 at December 31, 2007.
Contractual Obligations and Off-Balance Sheet Arrangements
Our contractual obligations and off-balance sheet arrangements are described in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report onForm 10-K for the year ended December 31, 2007. Except as described elsewhere in this report onForm 10-Q, there have been no material changes to those obligations or arrangements outside of the ordinary course of business since the most recent fiscal year end.
Effects of New Accounting Pronouncements
The effects of new accounting pronouncements are described in Note 2 of the Notes to unaudited Condensed Consolidated Financial Statements included elsewhere in this report. Such information is incorporated herein by reference.
| 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. We invest primarily in fixed-income securities, which are interest-sensitive assets. Accordingly, our primary market risk is exposure to changes in interest rates.
In addition, our fixed-income securities, bothavailable-for-sale andheld-to-maturity, are subject to a degree of credit risk. Credit risk is the risk that the issuer will default on interest or principal payments, or both, which could prohibit us from recovering a portion or all of our original investment.
At June 30, 2008, the majority of our investment portfolio was invested in fixed-income security investments, as well as cash and cash equivalents. The fixed-income securities consisted primarily of U.S. government and agency bonds, high-quality corporate bonds, mortgage-backed securities and tax-exempt U.S. municipal bonds.
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Qualitative Information About Market Risk
At June 30, 2008, our entire fixed-income portfolio, bothavailable-for-sale andheld-to-maturity, excluding approximately $13.0 million of private placement issues (which constitutes 1.8% of our fixed-income security portfolio), was considered investment grade. We define investment grade securities as those that have a Standard & Poor’s credit quality rating of BBB and above. The following table shows the distribution of our fixed-income security portfolio by Standard & Poor’s credit quality rating at June 30, 2008 and December 31, 2007.
| June 30, 2008 | December 31, 2007 | |||||||||||||||
| Carrying | % of | Carrying | % of | |||||||||||||
Rating | Value(1) | Total | Value(1) | Total | ||||||||||||
| AAA | $ | 359,646 | 49.8 | % | $ | 506,774 | 66.7 | % | ||||||||
| AA | 251,861 | 34.8 | % | 115,818 | 15.2 | % | ||||||||||
| A | 72,573 | 10.0 | % | 94,078 | 12.4 | % | ||||||||||
| BBB | 25,933 | 3.6 | % | 30,046 | 4.0 | % | ||||||||||
| 710,013 | 98.2 | % | 746,716 | 98.3 | % | |||||||||||
| Private Placement | 13,010 | 1.8 | % | 13,247 | 1.7 | % | ||||||||||
| Total | $ | 723,023 | 100.0 | % | $ | 759,963 | 100.0 | % | ||||||||
| Average Rating | AA+ | AA+ | ||||||||||||||
| (1) | Carrying value is fair value foravailable-for-sale securities and amortized cost forheld-to-maturity securities. |
Non-investment grade securities typically bear more credit risk than those of investment grade quality. In addition, we try to limit credit risk by not maintaining fixed-income security investments pertaining to any one issuer, other than U.S. Government and agency backed securities, in excess of $6 million. We also diversify our holdings so that there is not a significant concentration in any one industry or geographical region. The decreases in the AAA, A and BBB rating categories were primarily due to due to calls by the issuer, or maturities, of government-sponsored agency and corporate securities. The increase in AA rated securities was primarily the result of the additional $112.2 million of tax-exempt securities purchased subsequent to December 31, 2007.
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. As a result of these reviews, we recorded a $0.9 million charge for other than temporary impairments related to certain securities in the first quarter of 2008. The impaired securities were disposed of in mid-April 2008 at no additional loss.
Ourheld-to-maturity portfolio is not carried at estimated fair value. As a result, changes in interest rates do not affect the carrying amount of these securities. However, 30.6%, or $151.3 million, of ourheld-to-maturity investment security portfolio consists of mortgage-backed securities. While the carrying value of these securities is not subject to fluctuations as a result of changes in interest rates, changes in interest rates could impact our cash flows as an increase in interest rates will slow principal payments, and a decrease in interest rates will accelerate principal payments.
Between ouravailable-for-sale andheld-to-maturity security portfolios, we had mortgage-backed securities with a total carrying value of approximately $151.4 million at June 30, 2008. With the exception of 0.2 million, all of our mortgage-backed securities were issued by the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac. All of the Fannie Mae and Freddie Mac mortgage-backed securities consist of “conforming” mortgage loans that were issued prior to April 2005, are guaranteed by the issuing government-sponsored agency and have support tranches designed to promote the predictability of principal repayment cash flows.
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Quantitative Information About Market Risk
At June 30, 2008, ouravailable-for-sale fixed-income security portfolio was valued at $229.1 million and had an average modified duration of 3.22 years, compared to a portfolio valued at $262.3 million with an average modified duration of 3.06 years at December 31, 2007. The following tables show the effects of a hypothetical change in interest rates on the fair value and duration of ouravailable-for-sale fixed-income security portfolio at June 30, 2008 and December 31, 2007. 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.
| June 30, 2008 | December 31, 2007 | |||||||||||||||||||||||
| Portfolio | Change in | Modified | Portfolio | Change in | Modified | |||||||||||||||||||
Change in Rates | Value | Value | Duration | Value | Value | Duration | ||||||||||||||||||
| (Dollars in thousands) | (Dollars in thousands) | |||||||||||||||||||||||
| +2% | $ | 215,813 | $ | (13,293 | ) | 2.96 | $ | 248,140 | $ | (14,161 | ) | 2.74 | ||||||||||||
| +1% | 222,406 | (6,700 | ) | 2.96 | 255,182 | (7,119 | ) | 2.82 | ||||||||||||||||
| 0 | 229,106 | 3.22 | 262,301 | 3.06 | ||||||||||||||||||||
| -1% | 237,189 | 8,083 | 3.28 | 270,958 | 8,657 | 3.13 | ||||||||||||||||||
| -2% | 245,280 | 16,174 | 3.35 | 279,652 | 17,351 | 3.20 | ||||||||||||||||||
| Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure material information required to be disclosed in the Company’s reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure. In designing and evaluating the disclosure controls and procedures, the Company recognized that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
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 Disclosure Committee and management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2008.
Changes in Internal Control Over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. OTHER INFORMATION
| Item 1A. | Risk Factors |
There have been no material changes in risk factors as previously disclosed in the Company’s Annual Report onForm 10-K for the year ended December 31, 2007.
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds. |
The following table sets forth the repurchases of common stock for the quarter ended June 30, 2008:
| Maximum Dollar Value of | ||||||||||||||||||||
| Total Number | Shares that May Yet Be | |||||||||||||||||||
| Total | of Shares | Repurchased Under the Plans or | ||||||||||||||||||
| Number of | Average | Purchased as | Programs | |||||||||||||||||
| Shares | Price Paid | Part of Publicly | Discretionary | Rule 10b5-1 | ||||||||||||||||
| Purchased | per Share | Announced Plans | Plan(a) | Plan(b) | ||||||||||||||||
| For the month ended April 30, 2008 | 2,000 | $ | 44.90 | 2,000 | $ | 21,760,730 | $ | 32,226,975 | ||||||||||||
| For the month ended May 31, 2008 | 10,000 | $ | 45.22 | 10,000 | $ | 21,760,730 | $ | 31,774,725 | ||||||||||||
| For the month ended June 30, 2008 | — | $ | — | — | $ | 21,760,730 | $ | 31,774,725 | ||||||||||||
| For the three months ended June 30, 2008 | 12,000 | $ | 45.17 | 12,000 | $ | 21,760,730 | $ | 31,774,725 | ||||||||||||
| (a) | On February 7, 2008, the Board of Directors authorized the repurchase of additional common shares with a cost of up to $25 million at management’s discretion. The timing of the repurchases and the number of shares to be bought at any time depend on market conditions and the Company’s capital resources and requirements. The discretionary plan has no expiration date and may be terminated or discontinued at any time or from time to time. | |
| (b) | On October 29, 2007, the Company’s Board of Directors authorized the repurchase of an additional $20 million of its common shares in 2008 pursuant to a plan underRule 10b5-1. In addition, the Board authorized the rollover into the 2008Rule 10b5-1 plan of any unused dollars allocated to the 2007Rule 10b5-1 plan adopted by the Board in October 2006, which totaled $19.4 million at December 31, 2007. TheRule 10b5-1 plan share repurchases are made pursuant to a formula in the plan and are expected to continue until the entire authorizations are utilized, subject to conditions specified in the plan, but not later than December 31, 2008. The Company may terminate the 2008Rule 10b5-1 plan at any time. |
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| Item 4. | Submission of Matters to a Vote of Security Holders |
The Company held its Annual Meeting of Shareholders on May 8, 2008, at which the shareholders approved the ratification of BDO Seidman, LLP as the Company’s independent registered public accountants and elected three directors. All nominees were elected. The following table sets for the results of the voting at the meeting.
| Votes | Votes | |||||||
Nominee | For | Withheld | ||||||
| AppaRao Mukkamala, M.D. | 9,185,537 | 296,185 | ||||||
| Joseph Stilwell | 9,169,232 | 312,490 | ||||||
| Spencer L. Schneider, J.D. | 9,169,232 | 312,490 | ||||||
| Broker | ||||||||||||||||
| For | Against | Abstain | Non-Votes | |||||||||||||
| Proposal to ratify appointment of BDO Seidman, LLP as the Company’s independent registered public accountants | 9,457,439 | 20,110 | 4,173 | — | ||||||||||||
| Item 6. | Exhibits |
Exhibits.
The Exhibits included as part of this report are listed in the attached Exhibit Index, which is incorporated herein by reference.
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SIGNATURES
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.
AMERICAN PHYSICIANS CAPITAL, INC.
| By: | /s/ R. Kevin Clinton |
R. Kevin Clinton
Its: President and Chief Executive Officer
| By: | /s/ Frank H. Freund |
Frank H. Freund
Its: Executive Vice President, Treasurer
and Chief Financial Officer
and Chief Financial Officer
Date: August 8, 2008
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EXHIBIT INDEX
Exhibit No. | Exhibit Description | |||
| 10 | .53 | Summary Amendment No. 2, dated May 9, 2008, to the Incentive Compensation Plan as of March 2007 (filed as an exhibit to the Company’s Current Report onForm 8-K filed on May 15, 2008 and incorporated herein by reference). | ||
| 31 | .1 | Certification of Chief Executive Officer pursuant toRule 13a-14(a) under the Securities Exchange Act of 1934. | ||
| 31 | .2 | Certification of Chief Financial Officer pursuant toRule 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 andRule 13a-14(b) under the Securities Exchange Act of 1934. | |||
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