UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended JUNE 30, 2005 or ______
[ ] 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 0-16533
ProAssurance Corporation
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
Delaware 63-1261433
------------------------------- ---------------------------------
(State or Other Jurisdiction of (IRS Employer Identification No.)
Incorporation of Organization)
100 Brookwood Place, Birmingham, AL 35209
---------------------------------------- ------------------------
(Address of Principal Executive Offices) (Zip Code)
(205) 877-4400
----------------------------------------------------
(Registrant's Telephone Number, Including Area Code)
_____________________________________________________
(Former Name, Former Address, and Former Fiscal Year,
if Changed Since Last Report
Indicate by check mark whether the registrant (l) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes [X] No [ ]
As of June 30, 2005 there were 29,405,452 shares of the registrant's
common stock outstanding.
Page 1 of 35
PROASSURANCE CORPORATION
FORM 10Q
TABLE OF CONTENTS
Part I - Financial Information
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets.......................................................... 3
Condensed Consolidated Statements of Changes in Capital........................................ 4
Condensed Consolidated Statements of Income.................................................... 5
Condensed Consolidated Statements of Comprehensive Income (Loss)............................... 6
Condensed Consolidated Statements of Cash Flows................................................ 7
Notes to Condensed Consolidated Financial Statements........................................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......... 17
Item 3. Quantitative and Qualitative Disclosures about Market Risk..................................... 31
Item 4. Controls and Procedures........................................................................ 32
Forward-Looking Statements.............................................................................. 33
Part II - Other Information
Item 1. Legal Proceedings.............................................................................. 34
Item 4. Submission of Matters to a Vote of Security Holders ........................................... 34
Item 6. Exhibits....................................................................................... 34
Signature............................................................................................... 35
2
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)
JUNE 30 December 31
2005 2004
------------- -------------
ASSETS
Investments:
Fixed maturities available for sale, at fair value $ 2,397,864 $ 2,257,985
Equity securities available for sale, at fair value 18,837 35,230
Equity securities, trading portfolio, at fair value 4,682 4,150
Real estate, net 22,220 19,244
Short-term investments 71,873 41,423
Business owned life insurance 55,276 54,138
Other 46,075 42,883
------------- -------------
Total investments 2,616,827 2,455,053
Cash and cash equivalents 37,075 30,084
Premiums receivable 117,007 131,736
Receivable from reinsurers on unpaid losses and
loss adjustment expenses 423,669 409,339
Prepaid reinsurance premiums 18,728 18,888
Deferred taxes 82,541 80,107
Other assets 112,826 113,991
------------- -------------
$ 3,408,673 $ 3,239,198
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Policy liabilities and accruals:
Reserve for losses and loss adjustment expenses $ 2,157,868 $ 2,029,592
Unearned premiums 304,455 314,179
Reinsurance premiums payable 75,584 69,507
------------- -------------
Total policy liabilities 2,537,907 2,413,278
Other liabilities 57,756 63,421
Long-term debt 151,628 151,480
------------- -------------
Total liabilities 2,747,291 2,628,179
Commitments and contingencies - -
Stockholders' Equity:
Common stock, par value $0.01 per share
100,000,000 shares authorized; 29,527,217 and
29,326,228 shares issued, respectively 295 293
Additional paid-in capital 319,466 313,957
Accumulated other comprehensive income, net of deferred tax expense
of $10,689 and $13,139, respectively 19,847 24,397
Retained earnings 321,830 272,428
------------- -------------
661,438 611,075
Less treasury stock, at cost, 121,765 shares (56) (56)
------------- -------------
Total stockholders' equity 661,382 611,019
------------- -------------
$ 3,408,673 $ 3,239,198
============= =============
See accompanying notes.
3
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN CAPITAL (UNAUDITED)
(IN THOUSANDS)
ACCUMULATED OTHER
COMPREHENSIVE RETAINED OTHER CAPITAL
TOTAL INCOME EARNINGS ACCOUNTS
--------- ----------------- ---------- -------------
Balance at December 31, 2004 $ 611,019 $ 24,397 $ 272,428 $ 314,194
Net income 49,402 - 49,402 -
Change in fair value of securities available
for sale, net of deferred taxes and
reclassification adjustments (4,550) (4,550) - -
Common stock issued for compensation 1,764 - - 1,764
Common stock options exercised 3,747 - - 3,747
--------- ----------------- ---------- -------------
Balance at June 30, 2005 $ 661,382 $ 19,847 $ 321,830 $ 319,705
========= ================= ========== =============
Accumulated Other
Comprehensive Retained Other Capital
Total Income Earnings Accounts
--------- ----------------- ---------- -------------
Balance at December 31, 2003 $ 546,305 $ 34,422 $ 199,617 $ 312,266
Net income 31,785 - 31,785 -
Change in fair value of securities available
for sale, net of deferred taxes and
reclassification adjustments (27,147) (27,147) - -
Common stock issued for compensation 1,598 - - 1,598
Common stock options exercised 194 - - 194
--------- ----------------- ---------- -------------
Balance at June 30, 2004 $ 552,735 $ 7,275 $ 231,402 $ 314,058
========= ================= ========== =============
See accompanying notes.
4
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------- -------------------------
2005 2004 2005 2004
---------- ---------- ---------- ----------
Revenues:
Gross premiums written $ 161,373 $ 163,756 $ 377,031 $ 382,483
========== ========== ========== ==========
Net premiums written $ 139,969 $ 144,253 $ 336,389 $ 339,715
========== ========== ========== ==========
Premiums earned $ 192,808 $ 184,870 $ 386,911 $ 373,398
Premiums ceded (20,687) (18,973) (40,611) (39,659)
---------- ---------- ---------- ----------
Net premiums earned 172,121 165,897 346,300 333,739
Net investment income 26,146 20,683 51,568 40,534
Net realized investment gains 1,454 626 2,396 4,283
Other income 1,426 1,232 3,073 2,243
---------- ---------- ---------- ----------
Total revenues 201,147 188,438 403,337 380,799
Expenses:
Losses and loss adjustment expenses 146,239 161,710 301,460 314,383
Reinsurance recoveries (15,169) (24,931) (31,174) (35,683)
---------- ---------- ---------- ----------
Net losses and loss adjustment expenses 131,070 136,779 270,286 278,700
Underwriting, acquisition and insurance
expenses 29,902 29,367 60,504 57,339
Interest expense 2,031 1,492 4,167 2,635
---------- ---------- ---------- ----------
Total expenses 163,003 167,638 334,957 338,674
---------- ---------- ---------- ----------
Income before income taxes 38,144 20,800 68,380 42,125
Provision for income taxes:
Current expense 10,536 2,328 19,018 7,654
Deferred expense (benefit) 143 2,668 (40) 2,686
---------- ---------- ---------- ----------
10,679 4,996 18,978 10,340
---------- ---------- ---------- ----------
Net income $ 27,465 $ 15,804 $ 49,402 $ 31,785
========== ========== ========== ==========
Earnings per share:
Basic $ 0.93 $ 0.54 $ 1.69 $ 1.09
========== ========== ========== ==========
Diluted $ 0.88 $ 0.52 $ 1.58 $ 1.04
========== ========== ========== ==========
Weighted average number of common shares
outstanding:
Basic 29,386 29,158 29,302 29,138
========== ========== ========== ==========
Diluted 32,205 31,995 32,138 31,964
========== ========== ========== ==========
See accompanying notes.
5
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
(IN THOUSANDS)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------- -------------------------
2005 2004 2005 2004
---------- ---------- ---------- ----------
COMPREHENSIVE INCOME (LOSS):
Net income $ 27,465 $ 15,804 $ 49,402 $ 31,785
Change in fair value of securities available
for sale, net of deferred taxes 19,611 (38,562) (2,925) (25,243)
Reclassification adjustment for realized investment
(gains) losses included in income, net of
deferred taxes (988) 1 (1,625) (1,904)
---------- ---------- ---------- ----------
Comprehensive income (loss) $ 46,088 $ (22,757) $ 44,852 $ 4,638
========== ========== ========== ==========
See accompanying notes.
6
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30
-------------------------
2005 2004
---------- ----------
OPERATING ACTIVITIES
Net Income $ 49,402 $ 31,785
Depreciation and amortization 13,310 13,318
Net realized investment gains (losses) and net purchases of
trading portfolio securities (2,965) (4,678)
Changes in assets and liabilities:
Premiums receivable 14,013 8,244
Reserve for losses and loss adjustment expenses 128,276 116,677
Unearned premiums (9,724) 9,085
Reinsurance related assets and liabilities (8,092) 2,465
Other (2,625) (5,303)
---------- ----------
Net cash provided by operating activities 181,595 171,593
---------- ----------
INVESTING ACTIVITIES
Purchases of:
Fixed maturities available for sale (562,272) (604,143)
Equity securities available for sale (212) (538)
Other investments (2,387) (3,137)
Proceeds from sale or maturity of:
Fixed maturities available for sale 406,807 327,277
Equity securities available for sale 16,139 5,798
Net (increase) decrease in short-term investments (30,450) 57,384
Other (5,863) (5,527)
---------- ----------
Net cash (used by) investing activities (178,238) (222,886)
---------- ----------
FINANCING ACTIVITIES
Proceeds from issuance of long-term debt - 46,395
Debt issuance costs - (1,491)
Other 3,634 22
---------- ----------
Net cash provided by financing activities 3,634 44,926
---------- ----------
Increase (decrease) in cash and cash equivalents 6,991 (6,367)
Cash and cash equivalents at beginning of period 30,084 42,045
---------- ----------
Cash and cash equivalents at end of period $ 37,075 $ 35,678
========== ==========
See accompanying notes.
7
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements
include the accounts of ProAssurance Corporation and its subsidiaries
(ProAssurance). The financial statements have been prepared in accordance with
accounting principles generally accepted in the United States (GAAP) for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
notes required by GAAP for complete financial statements. In the opinion of
management, all adjustments, consisting of normal recurring adjustments,
considered necessary for a fair presentation have been included. Operating
results for the six months ended June 30, 2005 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2005. The
accompanying condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes contained in
ProAssurance's December 31, 2004 report on Form 10-K/A.
Stock-Based Compensation
ProAssurance grants stock options to key employees under its various stock
compensation plans adopted by the Board of Directors and approved by the
stockholders ("the ProAssurance Plans"). ProAssurance accounts for such stock
options under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations ("APB
25"). The following table illustrates the effect on net income (in thousands)
and earnings per share as if ProAssurance had applied the fair value recognition
provisions of Statement of Financial Accounting Standard (SFAS) No. 123,
Accounting for Stock-Based Compensation, to options granted.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
Net income, as reported $ 27,465 $ 15,804 $ 49,402 $ 31,785
Add: Stock-based employee compensation expense
recognized under APB 25 related to the exercise of
options, net of related tax effects 14 84 30 148
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (612) (365) (1,000) (624)
----------- ----------- ----------- -----------
Pro forma net income $ 26,867 $ 15,523 $ 48,432 $ 31,309
=========== =========== =========== ===========
Earnings per share:
Basic -- as reported $ 0.93 $ 0.54 $ 1.69 $ 1.09
=========== =========== =========== ===========
Basic -- pro forma $ 0.91 $ 0.53 $ 1.65 $ 1.07
=========== =========== =========== ===========
Diluted -- as reported $ 0.88 $ 0.52 $ 1.58 $ 1.04
=========== =========== =========== ===========
Diluted -- pro forma $ 0.86 $ 0.51 $ 1.55 $ 1.03
=========== =========== =========== ===========
8
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
1. BASIS OF PRESENTATION (CONTINUED)
Reclassifications
Certain reclassifications have been made to the June 30, 2004 Statement of
Cash Flows to conform to the current year and December 31, 2004 presentation.
The reclassification did not affect cash flow from operating activities.
Accounting Changes
On December 16, 2004 the Financial Accounting Standards Board (FASB)
issued SFAS 123 (revised 2004), Share-Based Payment, hereafter referred to as
SFAS 123(R), which is a revision of SFAS 123, Accounting for Stock-Based
Compensation. SFAS 123(R) supersedes APB 25, Accounting for Stock Issued to
Employees, and amends SFAS 95, Statement of Cash Flows. SFAS 123(R) requires all
share-based payments to employees, including grants of employee stock options,
to be recognized in the financial statements based on their fair values. Under
current SEC rules, ProAssurance must adopt SFAS 123(R) no later than January 1,
2006; early adoption is permitted. ProAssurance plans to adopt SFAS 123(R)
effective January 1, 2006 using the "modified prospective" method permitted by
the statement.
Under the "modified prospective" method stock based compensation is
recognized (a) under the requirements of SFAS 123(R) for all share-based
payments granted after the effective date of SFAS 123(R) and (b) under the
requirements of SFAS 123 for all non-vested share-based payments granted prior
to the adoption of SFAS 123(R).
As permitted by SFAS 123, ProAssurance currently accounts for stock
options awarded to employees using APB 25's intrinsic value method and, as such,
generally recognizes no compensation cost related to such awards. SFAS 123(R)
differs from SFAS 123 in several key computational areas, and implementation of
SFAS 123(R) will require ProAssurance to select among various assumptions in
order to perform the computations required under SFAS 123(R). Those assumptions
have not yet been selected, thus the effect that SFAS 123(R) would have had on
prior periods has not been computed. The effect of adoption of SFAS 123(R) on
future operating results cannot be predicted at this time because the effect
will depend on the levels of share-based payments granted in the future and the
methods and assumptions used to determine the fair value of those share-based
payments. SFAS 123(R) also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as required under current literature.
In the fourth quarter of 2004, ProAssurance implemented the FASB's
September 2004 consensus regarding Issue 04-08 "Accounting Issues Related to
Certain Features of Contingently Convertible Debt and the Effect on Diluted EPS"
("EITF 04-8"). Under the new guidance, issuers of contingently convertible
(Co-Co) debt instruments must include the potential common shares underlying the
Co-Co (the Co-Co shares) in diluted earnings per share computations (if
dilutive) regardless of whether the market price contingency has been met or
not. Prior to implementation of EITF 04-8, ProAssurance followed commonly
accepted interpretations of SAFS 128, "Earnings Per Share" and did not include
the potential Co-Co shares in its diluted earnings per share computations
because the market price contingency had not been met. In accordance with EITF
04-8 diluted earnings per share for the three months and six months ended June
30, 2004 have been restated; the restatement reduced previously reported diluted
earnings per share by $0.02 in the three month period and $0.04 in the six month
period.
The FASB issued SFAS 154, Accounting Changes and Error Corrections, in May
2005 as a replacement of APB 20, Accounting Changes, and SFAS 3, Reporting
Accounting Changes in Interim Financial Statements. SFAS 154 applies to
voluntary changes in accounting principle and changes the requirements for
accounting for and reporting of a change in accounting principle and is
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. ProAssurance expects to adopt SFAS 154 on its
effective date.
9
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
2. SEGMENT INFORMATION
ProAssurance operates in the U.S. in two reportable industry segments: the
professional liability insurance segment and the personal lines segment.
The professional liability insurance segment principally provides
professional liability insurance for providers of health care services,
principally in the Southeast and Midwest. The professional liability segment
includes the operating results of three significant insurance companies. The
personal lines segment provides personal auto, homeowners, boat and umbrella
coverages to educational employees and their families through a single insurance
company, principally in the state of Michigan.
The accounting policies of each segment are consistent with those
described in the Notes to the Consolidated Financial Statements included in
ProAssurance's December 31, 2004 Annual Report on Form 10-K/A. Other than cash
and securities owned directly by the parent company, the assets of ProAssurance
are attributable to the reportable operating segments. Except for investment
income earned directly by the parent company and interest expense attributable
to long-term debt held by the parent company, all revenues and expenses of
ProAssurance are attributable to the operating segments for purposes of SFAS No.
131, Disclosures about Segments of an Enterprise and Related Information.
Revenue is primarily from unaffiliated customers and the effect of transactions
between segments has been eliminated.
The table below provides a reconciliation of segment information to total
consolidated information.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
In thousands In thousands
Revenues:
Professional liability segment:
Net premiums earned $ 124,699 $ 120,604 $ 251,971 $ 244,161
Net investment income 22,450 17,791 44,362 35,090
Other revenues 1,495 532 3,670 3,882
----------- ----------- ----------- -----------
Total segment revenues 148,644 138,927 300,003 283,133
Personal lines segment:
Net premiums earned 47,422 45,293 94,329 89,578
Net investment income 3,091 2,791 6,107 5,297
Other revenues 1,384 687 1,741 1,295
----------- ----------- ----------- -----------
Total segment revenues 51,897 48,771 102,177 96,170
Corporate (not attributed to segments) 606 740 1,157 1,496
----------- ----------- ----------- -----------
Total revenues $ 201,147 $ 188,438 $ 403,337 $ 380,799
=========== =========== =========== ===========
Income (loss) before taxes:
Professional liability $ 26,131 $ 11,868 $ 47,314 $ 22,724
Personal lines 13,438 9,684 24,076 20,540
Corporate (not attributed to segments) (1,425) (752) (3,010) (1,139)
----------- ----------- ----------- -----------
Income before taxes $ 38,144 $ 20,800 $ 68,380 $ 42,125
=========== =========== =========== ===========
JUNE 30 December 31
2005 2004
----------- -----------
In thousands
Assets:
Professional liability $ 2,826,716 $ 2,682,987
Personal lines 521,204 495,903
Corporate (not attributed to segments) 60,753 60,308
----------- -----------
Total assets $ 3,408,673 $ 3,239,198
=========== ===========
10
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
3. INVESTMENTS
The amortized cost of available-for-sale fixed maturities and equity
securities is $2.386 billion and $2.256 billion at June 30, 2005 and December
31, 2004, respectively. Proceeds from sales of fixed maturities and equity
securities during the six months ended June 30, 2005 and 2004 are $296.7 million
and $219.2 million, respectively.
Net realized investment gains (losses) are comprised of the following (in
thousands):
SIX MONTHS ENDED
JUNE 30
-----------------------
2005 2004
--------- ---------
Gross realized gains $ 3,640 $ 3,539
Gross realized (losses) (864) (602)
Other than temporary impairment (losses) (344) -
Trading portfolio gains (losses) (36) 1,346
--------- ---------
Net realized investment gains (losses) $ 2,396 $ 4,283
========= =========
4. INCOME TAXES
The provision for income taxes is different from that which would be
obtained by applying the statutory Federal income tax rate to income before
taxes primarily because a portion of ProAssurance's investment income is
tax-exempt.
5. DEFERRED POLICY ACQUISITION COSTS
Costs that vary with and are directly related to the production of new and
renewal premiums (primarily premium taxes, commissions and underwriting
salaries) are deferred to the extent they are recoverable against unearned
premiums and are amortized as related premiums are earned. Amortization of
deferred policy acquisition costs, net of ceding commissions earned, amounted to
approximately $32.6 million and $30.9 million for the six months ended June 30,
2005 and 2004, respectively.
6. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
ProAssurance establishes its reserve for losses and loss adjustment
expenses based on individual claims and actuarially determined estimates of
future losses based on ProAssurance's past loss experience, available industry
data and projections as to future claims frequency, severity, inflationary
trends and settlement patterns. ProAssurance believes that the methods it uses
to establish reserves are reasonable and appropriate. However, estimating
reserves, especially professional liability reserves, is a complex process.
Claims may be resolved over an extended period of time, often five years or
more, and are frequently subject to litigation and the inherent risks of
litigation. Estimating losses for liability claims requires ProAssurance to make
and revise judgments and assessments regarding multiple uncertainties over an
extended period of time. As a result, reserve estimates may vary significantly
from the eventual outcome. The assumptions used in establishing ProAssurance's
reserves are regularly reviewed and updated by management as new data becomes
available. Any adjustments necessary are reflected in then current operations.
11
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
7. LONG-TERM DEBT
Outstanding long-term debt, as of June 30, 2005 and December 31, 2004,
consisted of the following:
JUNE 30 December 31
2005 2004
--------- -----------
In thousands
Convertible Debentures due June 30, 2023 (the Convertible
Debentures), unsecured and bearing a fixed interest
rate of 3.9%, net of unamortized original issuer's
discounts of $2,367 and $2,515 at June 30, 2005 and
December 31, 2004, respectively $ 105,233 $ 105,085
Trust Preferred Subordinated Debentures (the Subordinated
Debentures), unsecured, and bearing interest at a
floating rate, adjustable quarterly, equal to the
three-month LIBOR plus 3.85%. At June 30, 2005 this
rate is 7.12%
Due
April 29, 2034 13,403 13,403
May 12, 2034 10,310 10,310
May 12, 2034 22,682 22,682
--------- -----------
$ 151,628 $ 151,480
========= ===========
Convertible Debentures
The Convertible Debentures are unsecured obligations that rank equally in
right of payment with all other existing and future unsecured and unsubordinated
obligations of the parent company, but are effectively subordinated to the
indebtedness and other liabilities of ProAssurance's subsidiaries, including
insurance policy-related liabilities.
The Convertible Debentures are convertible into shares of common stock of
ProAssurance. Holders may convert the Convertible Debentures at any time prior
to stated maturity from and after the date of the following events: if
ProAssurance calls the Convertible Debentures for redemption; upon the
occurrence of certain corporate transactions, including a change of control; or
if the sale price of ProAssurance's common stock exceeds 120% of the then
conversion price for a specified period as defined in the Indenture. The
conversion price was initially established at $41.83 per common share or 23.9037
shares per $1,000 principal amount of the Convertible Debentures surrendered for
conversion. ProAssurance has the right to deliver cash in lieu of common stock
for all or a portion of any conversion shares.
Holders of the Convertible Debentures may require ProAssurance to
repurchase all or a portion of the holder's Convertible Debentures on June 30,
2008, June 30, 2013 and June 30, 2018 at a purchase price equal to the principal
amount of the Convertible Debentures. ProAssurance may choose to pay the
purchase price in cash, shares of common stock, or a combination of cash and
shares of common stock.
ProAssurance may redeem some or all of the Convertible Debentures for cash
on or after July 7, 2008 with proper notice to the holders of the Convertible
Debentures.
12
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
7. LONG-TERM DEBT (CONTINUED)
For additional information regarding the terms of the Debentures see Note
10 of the Notes to the Consolidated Financial Statements in ProAssurance's
December 31, 2004 Annual Report on Form 10-K/A.
Subordinated Debentures
In April and May 2004, ProAssurance formed two business trusts,
ProAssurance Capital Trust I and ProAssurance Capital Trust II (the Trusts), as
the holder of all voting securities issued by the trusts, for the sole purpose
of issuing, in private placement transactions, $45.0 million of trust preferred
securities (TPS) and using the proceeds thereof, together with the equity
proceeds received from ProAssurance in the initial formation of the Trusts, to
purchase $46.4 million of variable rate Subordinated Debentures issued by
ProAssurance, which are the only assets of the Trusts. The Trusts will meet the
obligations of the TPS with the interest and principal ProAssurance pays to the
Trust on the Subordinated Debentures. In accordance with the provisions of FIN
46, the Trusts are not consolidated by ProAssurance. The Subordinated Debentures
payable to the Trusts are included as long-term debt in the accompanying
Condensed Consolidated Balance Sheets. ProAssurance received net proceeds from
the TPS transactions, after commissions and other costs of issuance, of $44.9
million. Issue costs of $1.5 million were capitalized and are being amortized
over five years as a component of amortization expense.
The Subordinated Debentures and the TPS are uncollateralized and bear a
floating interest rate equal to the three-month LIBOR plus 3.85%, adjustable and
payable quarterly, with a maximum rate within the first five years of 12.5%. The
Subordinated Debentures and the TPS have stated maturities of thirty years but
may be redeemed at any time after five years. The Subordinated Debentures do not
require ProAssurance to maintain minimum financial covenants.
For additional information regarding the terms of our Convertible and
Subordinated Debentures see Note 10 of the Notes to the Consolidated Financial
Statements in ProAssurance's December 31, 2004 Annual Report on Form 10-K/A.
Fair Value
At June 30, 2005, the fair value of our Convertible Debentures is
approximately 111% of face value based on available independent market quotes.
The fair value of our Subordinated Debentures approximates the face value of the
debentures.
13
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
8. STOCKHOLDERS' EQUITY
At June 30, 2005 ProAssurance had 100 million shares of authorized common
stock and 50 million shares of authorized preferred stock. The Board of
Directors has the authorization to determine the provisions for the issuance of
shares of the preferred stock, including the number of shares to be issued and
the designations, powers, preferences and rights and the qualifications,
limitations or restrictions of such shares. At June 30, 2005 the Board of
Directors had not authorized the issuance of any preferred stock nor determined
any provisions for the preferred stock.
In 2005 ProAssurance granted 314,985 options having a weighted average
exercise price of $41.16 per share. The weighted-average fair value of each
option is $16.59, using the Black-Scholes option pricing model and the following
model assumptions (on a weighted-average basis): risk-free interest rate of
4.3%, volatility of 0.33, expected life of 6 years; and dividend yield of 0%.
9. COMMITMENTS AND CONTINGENCIES
ProAssurance is involved in various legal actions against ProAssurance
arising primarily from claims related to insurance policies and claims handling,
including but not limited to claims asserted by policyholders. The legal actions
arising from these claims have been considered by ProAssurance in establishing
its reserves. While the outcome of all legal actions is not presently
determinable, ProAssurance's management is of the opinion, based on consultation
with legal counsel, that the resolution of these actions will not have a
material adverse effect on ProAssurance's financial position. However, to the
extent that the cost of resolving these actions exceeds the corresponding
reserves, the legal actions could have a material effect on ProAssurance's
results of operations for the period in which any such action is resolved.
14
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
10. EARNINGS PER SHARE
The following represents a reconciliation of the numerators and
denominators of the basic and diluted earnings per share computations (amounts
are in thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------- ----------------------
2005 2004 2005 2004
--------- --------- --------- ---------
Basic earnings per share calculation:
Numerator:
Net income $ 27,465 $ 15,804 $ 49,402 $ 31,785
========= ========= ========= =========
Denominator:
Weighted average number of common shares outstanding 29,386 29,158 29,302 29,138
========= ========= ========= =========
Basic earnings per share $ 0.93 $ 0.54 $ 1.69 $ 1.09
========= ========= ========= =========
Diluted earnings per share calculation:
Numerator:
Net income $ 27,465 $ 15,804 $ 49,402 $ 31,785
Effect of assumed conversion of contingently convertible
debt instruments 742 742 1,483 1,483
--------- --------- --------- ---------
Net income-diluted computation $ 28,207 $ 16,546 $ 50,885 $ 33,268
========= ========= ========= =========
Denominator:
Weighted average number of common shares outstanding 29,386 29,158 29,302 29,138
Assumed conversion of dilutive stock options and awards 247 265 264 254
Assumed conversion of contingently convertible debt
instruments 2,572 2,572 2,572 2,572
--------- --------- --------- ---------
Diluted weighted average equivalent shares 32,205 31,995 32,138 31,964
========= ========= ========= =========
Diluted earnings per share $ 0.88 $ 0.52 $ 1.58 $ 1.04
========= ========= ========= =========
In accordance with SFAS 128 "Earnings per Share", the diluted weighted
average number of shares outstanding includes an incremental adjustment for the
assumed exercise of dilutive stock options. Stock options are considered
dilutive stock options if the assumed conversion of the options, using the
treasury stock method as specified by SFAS 128, produces an increased number of
outstanding shares. Options are not dilutive when the exercise price of the
option is above the average share price during the quarter. During the six-month
periods ended June 30, 2005 and 2004 certain of ProAssurance's outstanding
options were not considered to be dilutive, because the exercise price of the
options was above the average ProAssurance share price during the period. The
average number of options not considered to be dilutive during the six months
ended June 30, 2005, and 2004 is approximately 313,000 and 119,000,
respectively.
ProAssurance has implemented the consensus reached in EITF 04-8 and has
assumed conversion of its outstanding convertible debt in the computation of
diluted earnings per share for the six-month periods ended June 30, 2005 and
2004. Prior to implementation of EITF 04-8 in the fourth quarter of 2004,
ProAssurance did not assume conversion of its convertible debt in the
computation of diluted earnings per share and previously reported diluted
earnings per share for the three- and six-month periods ended June 30, 2004 as
$0.54 and $1.08, respectively.
15
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 2005
11. SUBSEQUENT EVENT--MERGER WITH NCRIC GROUP, INC.
On August 3, 2005 ProAssurance acquired all of the outstanding common
stock of NCRIC Group, Inc. (NCRIC) in a stock-for-stock purchase transaction
whereby ProAssurance issued approximately 1.7 million shares to NCRIC
shareholders. The cost of the acquisition is approximately $69.9 million. NCRIC
principally holds a single property and casualty insurance company that provides
medical professional liability insurance in the District of Columbia, Delaware,
Maryland, Virginia and West Virginia. For the year ended December 31, 2004 NCRIC
reported total revenues of $79.4 million.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes (unaudited) thereto accompanying
this report and ProAssurance's Annual Report on Form 10-K/A for the year ended
December 31, 2004, which includes a Glossary of insurance terms and phrases.
Throughout the discussion, references to ProAssurance, "we," "us" and "our"
refers to ProAssurance Corporation and its subsidiaries. The discussion contains
certain forward-looking information that involves risks and uncertainties. As
discussed under "Forward-Looking Statements," our actual financial condition and
operating results could differ significantly from these forward-looking
statements.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America
(GAAP). Preparation of these financial statements requires us to make estimates
and assumptions in certain circumstances that affect the amounts reported in our
consolidated financial statements and related footnotes. We evaluate these
estimates and assumptions on an on-going basis based on historical developments,
market conditions, industry trends and other information that we believe to be
reasonable under the circumstances. There can be no assurance that actual
results will conform to our estimates and assumptions, and that reported results
of operations will not be materially affected by the need to make accounting
adjustments reflecting changes in these estimates and assumptions.
Management considers the following accounting policies to be critical
because they involve significant judgment by management and the effect of those
judgments could result in a material effect on the financial statements included
herein.
Reserve for Losses and Loss Adjustment Expenses (reserve for losses or reserve)
Our reserve for losses represents our estimate of the future amounts
necessary to pay claims and expenses associated with investigation and
settlement of claims. These estimates consist of case reserves and bulk
reserves. The estimates take into consideration our past loss experience,
available industry data and projections as to future claims frequency, severity,
inflationary trends and settlement patterns. Independent actuaries review our
reserve for losses each year and prepare reports that include recommendations as
to the level of such reserves. We consider these recommendations as well as
other factors, such as known, anticipated or estimated changes in frequency and
severity of claims and loss retention levels and premium rates, in establishing
the amount of our reserve for losses. Estimating casualty insurance reserves,
and particularly professional liability reserves, is a complex process. These
claims are typically resolved over an extended period of time, often five years
or more, and estimating loss costs for these claims requires multiple judgments
involving many uncertainties. Our reserve estimates may vary significantly from
the eventual outcome. The assumptions used in establishing our reserve for
losses are regularly reviewed and updated by management as new data becomes
available. Any adjustments necessary are reflected in then current operations.
Due to the size of our reserve for losses, even a small percentage adjustment to
these estimates could have a material effect on our results of operations for
the period in which the adjustment is made.
17
Reinsurance
Our receivable from reinsurers represents our estimate of the amount of
our future loss payments that will be recoverable from our reinsurers. These
estimates are based upon our estimates of the ultimate losses that we expect to
incur and the portion of those losses that we expect to be allocable to
reinsurers based upon the terms of our reinsurance agreements. We also estimate
premiums ceded under reinsurance agreements wherein the premium due to the
reinsurer, subject to certain maximums and minimums, is a percentage of the
losses reimbursed under the agreement. Given the uncertainty of the ultimate
amounts of our losses, these estimates may vary significantly from the eventual
outcome. Our estimates of the amounts receivable from and payable to reinsurers
are regularly reviewed and updated by management as new data becomes available.
Our assessment of the collectibility of the recorded amounts receivable from
reinsurers is based primarily upon public financial statements and rating agency
data. Any adjustments necessary are reflected in then current operations. Due to
the size of our receivable from reinsurers, even a small adjustment to these
estimates could have a material effect on our results of operations for the
period in which the adjustment is made.
We evaluate each of our ceded reinsurance contracts at their inception to
determine if there is sufficient risk transfer to allow the contract to be
accounted for as reinsurance under current accounting literature. At June 30,
2005 all such ceded contracts are accounted for as risk transferring contracts.
Investments
We consider our fixed maturity securities as available-for-sale and our
equity securities as either available-for-sale or trading portfolio securities.
Both available-for-sale and trading portfolio securities are carried at fair
value. Positive and negative changes in the market value (unrealized gains and
losses) of available-for-sale securities are included, net of the related tax
effect, in accumulated comprehensive income, a component of stockholders'
equity, and are excluded from current period net income. Positive and negative
changes in the market value of trading portfolio securities are included in
current period net income as a component of net realized investment gains
(losses).
We evaluate the securities in our available-for-sale investment portfolio
on at least a quarterly basis for declines in market value below cost for the
purpose of determining whether these declines represent other than temporary
declines. Some of the factors we consider in the evaluation of our investments
are:
- the extent to which the market value of the security is less than
its cost basis,
- the length of time for which the market value of the security has
been less than its cost basis,
- the financial condition and near-term prospects of the security's
issuer, taking into consideration the economic prospects of the
issuer's industry and geographical region, to the extent that
information is publicly available, and
- our ability and intent to hold the investment for a period of time
sufficient to allow for any anticipated recovery in market value.
A decline in the fair value of an available-for-sale security below cost
that we judge to be other than temporary is realized as a loss in the current
period income statement and reduces the cost basis of the security. In
subsequent periods, we base any measurement of gain or loss or decline in value
upon the adjusted cost basis of the security.
Deferred Policy Acquisition Costs
Policy acquisition costs, primarily commissions, premium taxes and
underwriting salaries, vary directly with, and are primarily related to, the
acquisition of new and renewal premiums. Such costs are capitalized and charged
to expense as the related premium revenue is recognized. We evaluate the
recoverability of our deferred policy acquisition costs based on our estimates
of the profitability of the underlying business and any amounts estimated to be
unrecoverable are charged to expense in the current period.
18
LIQUIDITY AND CAPITAL RESOURCES AND FINANCIAL CONDITION
ProAssurance Corporation is a legal entity separate and distinct from its
subsidiaries. Because the parent holding company has no other business
operations, dividends from its operating subsidiaries represent a significant
source of funds for its obligations, including debt service. The ability of
those insurance subsidiaries to pay dividends is subject to limitation by state
insurance regulations.
Within our operating subsidiaries our primary need for liquidity is to pay
losses and operating expenses in the ordinary course of business. Our operating
activities provided positive cash flow of $181.6 million for the six months
ended June 30, 2005 as compared to $171.6 million for the six months ended June
30, 2004. In both periods, the primary sources of our operating cash flows are
net investment income and the excess of premiums collected over net losses paid
and operating costs. Timing delays exist between the collection of premiums and
the payment of losses, particularly so with regard to our professional liability
premiums. A general measure of this timing delay is the paid loss ratio, which
is computed by dividing paid losses for the period by net earned premium. Our
paid loss ratios for the six months ended June 30, 2005 and 2004 are 45% and
50%, respectively.
We believe that premium adequacy is critical to our long-term liquidity.
We continually review rates and submit requests for rate increases to state
insurance departments as we consider necessary to maintain rate adequacy. We are
unable to predict whether we will continue to receive approval for our rate
filings.
We manage our investment portfolio to ensure that it will have sufficient
liquidity to meet our obligations. In performing this analysis we consider the
timing of maturity of the investments in our investment portfolio as well as the
expected cash flows to be generated by our operations. In 2004 we had operating
cash flow of $373.5 million and year-to-date in 2005 we have operating cash flow
of $181.6 million. At our insurance subsidiaries the primary outflow of cash is
related to the payment of claims and expenses. The payment of individual claims
cannot be predicted with certainty; therefore, we rely upon the history of paid
claims in determining the expected payout of our loss reserves. To the extent
that we have an unanticipated shortfall in cash we can either liquidate
securities held in our investment portfolio or borrow funds under previously
established borrowing arrangements. However, given the significant cash flows
being generated by our operations and the relatively short duration of our
investment portfolio we do not currently foresee any such shortfall.
We held cash and cash equivalents of approximately $37.1 million at June
30, 2005 as compared to $30.1 million at December 31, 2004. We transfer most of
the cash generated from operations into our investment portfolio.
At June 30, 2005 our investment in fixed maturity securities of $2.398
billion represented 91.6% of our total investments. Substantially all of our
fixed maturities are either United States government agency obligations or
investment grade securities as determined by national rating agencies. The fixed
maturity securities in our investment portfolio had a dollar weighted average
rating of "AA+" at June 30, 2005. Our investment policies implement an asset
allocation that uses length to maturity as one method of managing our long-term
rate of return. The weighted average modified duration of our fixed maturity
securities at June 30, 2005 is 3.81 years. Changes in market interest rate
levels generally affect our net income to the extent that reinvestment yields
are different than the original yields on maturing securities. Additionally,
changes in market interest rates also affect the fair value of our fixed
maturity securities. Bond market rates for five-year-or-less maturities have
increased since December 31, 2004 and as a result average bond prices have
decreased. On a pre-tax basis, net unrealized gains (losses) related to our
available-for-sale fixed maturity securities decreased from a net unrealized
gain of $33.9 million at December 31, 2004 to a net unrealized gain of $28.0
million at June 30, 2005.
At June 30, 2005, available-for-sale and trading portfolio equity
investments represented approximately 0.9% of our total investments, and
approximately 3.6% of our capital. Our equity investments are diversified
primarily among domestic growth and value holdings through common and preferred
stock.
Our investment in short-term securities at June 30, 2005 is $71.9 million
as compared to $118.3 million at March 31, 2005 and $41.3 million at December
31, 2004. During 2005 we have held new and matured funds in short-term
securities in order to increase our investment flexibility in an improving rate
environment. As our investment managers identify investment opportunities that
are consistent with our
19
longer range investment strategy we plan to move funds from short-term
securities to longer term fixed maturity securities.
For a more detailed discussion of the effect of changes in interest rates
on our investment portfolio see Item 3, "Quantitative and Qualitative
Disclosures about Market Risk."
Our reserves for losses, net of amounts receivable from reinsurers at June
30, 2005 are approximately $1.7 billion, an increase of $114 million over net
reserves at December 31, 2004. Substantially all of this increase is in our
professional liability segment, a long-tailed business. Whenever paid losses are
less than incurred losses, reserves will increase; this occurs more frequently
in a long-tailed business.
We use reinsurance to provide capacity to underwrite large limits of
liability, and to reduce losses of a catastrophic nature in those years in which
such losses occur. The purchase of reinsurance does not relieve us from the
ultimate risk on our policies, but it does provide reimbursement from the
reinsurer for certain losses paid by us.
The effective transfer of risk is dependent on the credit-worthiness of
the reinsurer. We purchase reinsurance from a number of companies to mitigate
concentrations of credit risk. Our reinsurance broker assists us in the analysis
of the credit quality of our reinsurers. We base our reinsurance buying
decisions on an evaluation of the then current financial strength, rating and
stability of prospective reinsurers. However, the financial strength of our
reinsurers, and their corresponding ability to pay us, may change in the future
due to forces or events we cannot control or anticipate.
We have not experienced any significant difficulties in collecting amounts
due from reinsurers due to the financial condition of the reinsurer. Should
future events lead us to believe that any reinsurer is unable to meet its
obligations to us, adjustments to the amounts recoverable would be reflected in
the results of current operations.
On August 3, 2005 ProAssurance acquired all of the outstanding common
stock of NCRIC Group, Inc. (NCRIC) in a stock-for-stock purchase transaction
whereby ProAssurance issued approximately 1.7 million shares to NCRIC
shareholders. The cost of the acquisition was approximately $69.9 million. NCRIC
principally holds a single property and casualty insurance company that provides
medical professional liability insurance in the District of Columbia, Delaware,
Maryland, Virginia and West Virginia. For the year ended December 31, 2004 NCRIC
reported total revenues of $79.4 million. A more detailed description of the
merger transaction is included in ProAssurance's registration statement on Form
S-4 (file #333-124156).
Off Balance Sheet Arrangements/Guarantees
In April and May 2004, we formed two business trusts (the Trusts) with the
sole purpose of the Trusts being to issue trust preferred stock (TPS), and use
the proceeds thereof to purchase our variable rate subordinated debentures
(Subordinated Debentures), which are the only assets of the Trusts. The terms
and maturities of the Subordinated Debentures mirror those of the TPS. The
Trusts will meet the obligations of the TPS with the interest and principal we
pay to the Trusts related to the Subordinated Debentures.
In accordance with the guidance given in Financial Accounting Standards
Board Interpretation No. 46R, "Variable Interest Entities" (FIN 46R) the Trusts
are not included in our consolidated financial statements because we are not the
primary beneficiary of either of the Trusts.
Our Subordinated Debentures are payable to the Trusts and are included in
our condensed consolidated financial statements as long-term debt. We have
issued guarantees that amounts paid to the Trusts related to the Subordinated
Debentures will subsequently be remitted to the holders of the TPS. The amounts
guaranteed are not expected to at any time exceed our obligations under the
Subordinated Debentures, and we have not recorded any additional liability
related to the TPS or the guarantee.
20
OVERVIEW
We are an insurance holding company and our operating results are almost
entirely derived from the operations of our insurance subsidiaries.
ProAssurance's professional liability segment primarily provides medical
professional liability insurance to physicians and physician groups principally
in the South and Midwest. The personal lines segment primarily provides auto
insurance to members of the Michigan educational community and their families.
The professional liability segment is our largest segment and contributed
approximately 74% of our total revenues during each of the six-month periods
ended June 30, 2005 and 2004, respectively, and held approximately 83% of total
assets at June 30, 2005. Approximately 95% of our net loss reserves at June 30,
2005 are professional liability reserves. The professional liability segment
principally operates through three insurance subsidiaries: The Medical Assurance
Company, Inc., ProNational Insurance Company and Red Mountain Casualty Insurance
Company, Inc.
Our personal lines segment provides personal property and casualty
insurance primarily to members of the educational community and their families
principally in the state of Michigan. Our personal lines segment includes the
operations of a single insurance company, MEEMIC Insurance Company.
Revenues and expenses are attributable to the operating segments with the
exception of corporate income, which consists of investment income earned
directly by the parent holding company and interest expense related to long-term
debt issued by the parent. Operating results by segment for the three and six
months ended June 30, 2005 and 2004 are summarized below.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------------ ------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
-------- -------- ---------- -------- -------- ----------
In thousands In thousands
Income before income taxes:
Professional liability segment $ 26,131 $ 11,868 $ 14,263 $ 47,314 $ 22,724 $ 24,590
Personal lines segment 13,438 9,684 3,754 24,076 20,540 3,536
Corporate (not attributed to
segments) (1,425) (752) (673) (3,010) (1,139) (1,871)
-------- -------- ---------- -------- -------- ----------
Consolidated $ 38,144 $ 20,800 $ 17,344 $ 68,380 $ 42,125 $ 26,255
======== ======== ========== ======== ======== ==========
Our professional liability segment operates in a challenging environment.
Medical malpractice loss and loss adjustment costs have increased significantly
in recent years. In response, we have implemented rate increases in all states,
even when this has resulted in non-renewal of business. We have been more
selective in our underwriting criteria and have elected to non-renew business
that we did not expect to write profitably. At the same time, we have also
worked to contain losses and to improve operating efficiencies. These combined
efforts have enabled us to significantly improve the underwriting results of
this segment.
Beginning in mid-2000 medical professional liability losses, and actuarial
estimates of loss costs, throughout the United States proved to be higher than
insurers anticipated, thus insurers found that both their rates and their
reserves were inadequate. Some competitors were forced out of business by
regulators; some chose to no longer offer medical professional liability
coverages. Most remaining carriers increased their rates and as rate adequacy
and profitability improved within the industry, competition in our markets
increased. In some states, price competition is making it more difficult to
generate new business that meets our criteria for profitability.
Our personal lines segment operates in a highly competitive environment
dominated by larger insurance organizations. The personal lines segment is
experiencing increased price competition. We must provide a high level of
service while operating efficiently in order to competitively price our
products and achieve operating goals.
Investment income is a substantial revenue source for the professional
liability segment because, on average, premiums are collected several years
before the related losses are paid. We consider total
21
return and our ability to realize net investment (capital) gains in the
execution of our investment strategy and adapt our strategy as market and
economic conditions change. The realization of investment (capital) gains or
losses is therefore not predictable; however, such gains or losses can have a
substantial effect on our revenues in the periods in which they occur.
Investment income is a less significant component of revenues for the
personal lines segment than for the professional lines segment because the
length of time between the collection of premiums and the settlement of claims
is generally short.
Losses are the largest component of expense for both the professional
liability segment and the personal lines segment. As discussed in critical
accounting policies, net losses in any period reflect our estimate of net losses
related to the premiums earned in that period as well as any changes to our
estimates of the reserve required for net losses of prior periods.
22
RESULTS OF OPERATIONS - THREE AND SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO
THREE AND SIX MONTHS ENDED JUNE 30, 2004
Selected consolidated financial data for each period is summarized in the
table below.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------------------ ------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
---------- ---------- ---------- ---------- ---------- ----------
In thousands
Revenues:
Gross premiums written $ 161,373 $ 163,756 $ (2,383) $ 377,031 $ 382,483 $ (5,452)
========== ========== ========== ========== ========== ==========
Net premiums written $ 139,969 $ 144,253 $ (4,284) $ 336,389 $ 339,715 $ (3,326)
========== ========== ========== ========== ========== ==========
Premiums earned $ 192,808 $ 184,870 $ 7,938 $ 386,911 $ 373,398 $ 13,513
Premiums ceded (20,687) (18,973) (1,714) (40,611) (39,659) (952)
---------- ---------- ---------- ---------- ---------- ----------
Net premiums earned 172,121 165,897 6,224 346,300 333,739 12,561
Net investment income 26,146 20,683 5,463 51,568 40,534 11,034
Net realized investment gains
(losses) 1,454 626 828 2,396 4,283 (1,887)
Other income 1,426 1,232 194 3,073 2,243 830
---------- ---------- ---------- ---------- ---------- ----------
Total revenues 201,147 188,438 12,709 403,337 380,799 22,538
---------- ---------- ---------- ---------- ---------- ----------
Expenses:
Losses and loss adjustment
expenses 146,239 161,710 (15,471) 301,460 314,383 (12,923)
Reinsurance recoveries (15,169) (24,931) 9,762 (31,174) (35,683) 4,509
---------- ---------- ---------- ---------- ---------- ----------
Net losses and loss
adjustment expenses 131,070 136,779 (5,709) 270,286 278,700 (8,414)
Underwriting, acquisition
and insurance expenses 29,902 29,367 535 60,504 57,339 3,165
Interest expense 2,031 1,492 539 4,167 2,635 1,532
---------- ---------- ---------- ---------- ---------- ----------
Total expenses 163,003 167,638 (4,635) 334,957 338,674 (3,717)
---------- ---------- ---------- ---------- ---------- ----------
Income before income taxes 38,144 20,800 17,344 68,380 42,125 26,255
Income taxes (benefit) 10,679 4,996 5,683 18,978 10,340 8,638
---------- ---------- ---------- ---------- ---------- ----------
Net Income $ 27,465 $ 15,804 $ 11,661 $ 49,402 $ 31,785 $ 17,617
========== ========== ========== ========== ========== ==========
Net loss ratio 76.1% 82.4% (6.3) 78.0% 83.5% (5.5)
Underwriting expense ratio 17.4% 17.7% (0.3) 17.5% 17.2% 0.3
---------- ---------- ---------- ---------- ---------- ----------
Combined ratio 93.5% 100.1% (6.6) 95.5% 100.7% (5.2)
Less: Investment income ratio 15.2% 12.5% 2.7 14.9% 12.1% 2.8
---------- ---------- ---------- ---------- ---------- ----------
Operating ratio 78.3% 87.6% (9.3) 80.6% 88.6% (8.0)
========== ========== ========== ========== ========== ==========
Return on equity * 17.3% 11.2% 6.1 15.5% 11.6% 3.9
========== ========== ========== ========== ========== ==========
* Net income, annualized, divided by the average of beginning and ending
stockholders' equity.
23
We measure performance in a number of ways, but particularly focus on our
combined ratio and investment returns, both of which directly affect our return
on equity (ROE). We target a ROE of 12% to 14%.
Our earnings are almost entirely derived from the operations of our
insurance subsidiaries. We manage our insurance operations at a segment level
because of the differing operating characteristics of each segment. We believe
that a focus on premium adequacy, selective underwriting and effective claims
management is required if we are to achieve our ROE targets and we closely
monitor premium revenues, losses and loss adjustment costs, and acquisition,
underwriting and insurance expenses at the segment level.
Investment income and net realized investment gains and losses are managed
and monitored both at the segment level and on a consolidated basis in order to
meet the liquidity and profitability needs of each insurance company as well as
to maximize after-tax income investment returns at a corporate level.
Our segments engage in activities that generate other income. Such
activities, principally fee generating and agency services, do not constitute a
significant source of revenues or profits on either a segment or a consolidated
basis.
The 2005 increase in our annualized ROE is primarily attributable to our
success in reducing our net loss ratio. The improvement in the professional
liability ratio had a pronounced effect on ROE since three fourths of our
consolidated earned premiums are attributable to this segment.
Our 2005 operating results also benefited from additional investment
income earned as a result of the growth in our invested assets in an improved
interest rate market.
Premiums
Gross Premiums Written
THREE MONTHS ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
-------------------------------------------- -------------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- --------- ---------------------- ---------- ---------- -------------------
In thousands In thousands
Gross premiums
written:
Professional
liability $ 104,037 $ 107,995 $ (3,958) (3.7%) $ 267,434 $ 277,733 $ (10,299) (3.7%)
Personal lines 57,336 55,761 1,575 2.8% 109,597 104,750 4,847 4.6%
--------- --------- ---------- ---------- ---------- ---------
Consolidated $ 161,373 $ 163,756 $ (2,383) (1.5%) $ 377,031 $ 382,483 $ (5,452) (1.4%)
========= ========= ========== ========== ========== =========
Professional liability written premiums vary from period to period for a
number of reasons. Some of the more common differences result from changes to
premium rates, the volume of new business written during the period, the loss of
business to competitors or due to our own underwriting decisions, and the
percentage of our policies that renew, which may also affect the level of tail
premiums written. Strategic factors, such as our decision to convert our
remaining occurrence policies to claims-made coverage, and market factors, such
as the entry or exit of a competitor in a given market, may also affect written
premiums from period to period. The effect of any of these changes also varies
by the proportion of policies written or renewed during each period in the
various geographical regions and classes of business in which we operate.
The decline in our professional liability premiums is the result of many
factors. We are writing more of our premiums in states in which we charge a
lower rate per unit of risk. In addition, we are seeing our insureds purchase
smaller coverage limits. We continue our focus on premium adequacy. During the
three- and the six months ended June 30, 2005, rates on renewed physician
policies averaged 12% to 13% higher than the expiring premiums, whereas rate
increases during the first six months of 2004 averaged 18%. Retention has
improved in 2005, averaging 85% in both the three- and the six-month periods as
compared to an average of 84% for the six months ended June 30, 2004. In some
markets, we are also experiencing strong competition for physician business, a
portion of which is almost entirely price-based.
Tail policies are offered to insureds that are discontinuing their
claims-made coverage with us, and the amount of tail premium written in any
period can and does vary widely. During the past two years tail premiums have
ranged from $4.9 million to $15.3 million per quarter. The six month period in
2005
24
included tail premiums of approximately $13.1 million which is approximately
$7.1 million lower than in the same period in 2004.
Personal lines premium revenues are almost entirely comprised of auto and
homeowner premiums with auto premiums representing approximately 80% of written
premiums in each period. During the three- and six-month periods ended June 30,
2005 auto premiums increased by approximately $650,000 and $2.9 million,
respectively, while homeowner premiums grew by approximately $926,000 and $2.0
million, respectively. The growth of auto premiums is primarily attributable to
increases in the value of insured autos. Homeowner premiums have increased as a
result of an increase in the number of insured homes and higher home values.
Premiums Earned
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------------------------- ---------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- --------- ------------------ -------------------- -----------------
In thousands In thousands
Premiums earned:
Professional
liability $ 137,833 $ 133,371 $ 4,462 3.3% $ 277,835 $ 271,794 $ 6,041 2.2%
Personal lines 54,975 51,499 3,476 6.7% 109,076 101,604 7,472 7.4%
--------- --------- -------- --------- --------- --------
Consolidated $ 192,808 $ 184,870 $ 7,938 4.3% $ 386,911 $ 373,398 $ 13,513 3.6%
========= ========= ======== ========= ========= ========
Because premiums are generally earned pro rata over the entire policy
period after the policy is written, fluctuations in premiums earned tend to lag
those of premiums written. Policies other than auto policies generally carry a
policy period of one-year; auto policies typically carry a six-month policy
period. Professional liability tail policies are 100% earned in the period
written because the policies insure only incidents that occurred in prior
periods.
The increase in 2005 earned premiums reflects on a pro rata basis the
changes in written premiums that occurred during both 2005 and 2004, reduced by
lower tail premiums written in 2005 as discussed in the section on premiums
written.
Premiums Ceded
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------------------------- ---------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- --------- ------------------ --------- --------- -----------------
In thousands In thousands
Premiums ceded:
Professional
liability $ 13,134 $ 12,767 $ 367 2.9% $ 25,864 $ 27,633 $ (1,769) (6.4%)
Personal lines 7,553 6,206 1,347 21.7% 14,747 12,026 2,721 22.6%
--------- --------- -------- --------- --------- --------
Consolidated $ 20,687 $ 18,973 $ 1,714 9.0% $ 40,611 $ 39,659 $ 952 2.4%
========= ========= ======== ========= ========= ========
Premiums ceded represent the portion of earned premiums that we must
ultimately pay to our reinsurers for their assumption of a portion of our
losses.
In general, as professional liability rates have increased, some of our
insureds have elected to purchase smaller coverage limits which reduces the
amount of premium that we cede to our reinsurers. The decrease in ceded premiums
for the six months ended June 30, 2005 as compared to 2004 reflects this choice
made by our insureds. The minor increase in premiums ceded shown for the
comparative three-month periods resulted from small shifts in the geographic and
coverage mix of premiums earned in 2005 as compared to 2004. Such shifts are
considered routine.
Personal lines premiums ceded primarily increased because of a significant
rise in the per vehicle assessment charged by the Michigan Catastrophic Claims
Association.
25
Losses and Loss Adjustment Expenses
Calendar year losses may be divided into three components: (i) actuarial
evaluation of incurred losses for the current accident year; (ii) actuarial
re-evaluation of incurred losses for prior accident years; and (iii) actuarial
re-evaluation of the reserve for the death, disability and retirement provision
(DDR) in our claims-made policies.
Accident year refers to the accounting period in which the insured event
becomes a liability of the insurer. For occurrence policies the insured event
becomes a liability when the event takes place; for claims-made policies the
insured event becomes a liability when the event is first reported to the
insurer. We believe that measuring losses on an accident year basis is the most
indicative measure of the underlying profitability of the premiums earned in
that period since it associates policy premiums earned with our estimate of the
losses incurred related to those policy premiums. Calendar year results include
the operating results for the current accident year and, as discussed in
critical accounting policies, any changes in estimates related to prior accident
years.
The following tables summarize net losses and net loss ratios for the
three and six months ended June 30, 2005 and 2004 by separating losses between
the current accident year and all prior accident years.
NET LOSSES
--------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
-------------------------------------- --------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
-------------------------------------- --------------------------------------
In thousands
Calendar year:
Professional
liability $ 103,124 $ 107,813 $ (4,689) $ 213,574 $ 223,020 $ (9,446)
Personal lines 27,946 28,966 (1,020) 56,712 55,680 1,032
---------- ---------- ---------- ---------- ---------- ----------
Consolidated $ 131,070 $ 136,779 $ (5,709) $ 270,286 $ 278,700 $ (8,414)
========== ========== ========== ========== ========== ==========
Current accident year:
Professional
liability $ 108,124 $ 107,813 $ 311 $ 218,574 $ 223,020 $ (4,446)
Personal lines 29,459 31,966 (2,507) 60,428 61,174 (746)
---------- ---------- ---------- ---------- ---------- ----------
Consolidated $ 137,583 $ 139,779 $ (2,196) $ 279,002 $ 284,194 $ (5,192)
========== ========== ========== ========== ========== ==========
Prior accident year:
Professional
liability $ (5,000) $ - $ (5,000) $ (5,000) $ - $ (5,000)
Personal lines (1,513) (3,000) 1,487 (3,716) (5,494) 1,778
---------- ---------- ---------- ---------- ---------- ----------
Consolidated $ (6,513) $ (3,000) $ (3,513) $ (8,716) $ (5,494) $ (3,222)
========== ========== ========== ========== ========== ==========
26
NET LOSS RATIOS*
------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------------- ------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
------- ------- ---------- -------- -------- ----------
Calendar year:
Professional liability 82.7% 89.4% (6.7) 84.8% 91.3% (6.5)
Personal lines 58.9% 64.0% (5.1) 60.1% 62.2% (2.1)
Consolidated 76.1% 82.4% (6.3) 78.0% 83.5% (5.5)
Current accident year:
Professional liability 86.7% 89.4% (2.7) 86.7% 91.3% (4.6)
Personal lines 62.1% 70.6% (8.5) 64.1% 68.3% (4.2)
Consolidated 79.9% 84.3% (4.4) 80.6% 85.2% (4.6)
Favorable development
related to prior accident
years:
Professional liability (4.0%) - (4.0) (1.9%) - (1.9)
Personal lines (3.2%) (6.6%) 3.4 (4.0%) (6.1%) 2.1
Consolidated (3.8%) (1.9%) (1.9) (2.6%) (1.7%) (0.9)
*Net losses as specified divided by net premiums earned.
The estimation of losses is inherently difficult. In establishing these
reserves management considers a variety of factors including historical paid and
incurred loss development trends, the effect of inflation on medical care,
general economic trends and the legal environment. Given the number of factors
considered it is neither practical nor meaningful to isolate a particular
assumption or parameter of the process and calculate the impact of changing that
single item. We perform an in-depth review of our loss reserves on a semi-annual
basis. However, management is continually reviewing and updating the data
underlying the estimation of its loss reserves and we make adjustments that we
believe the emerging data indicates. Any adjustments necessary are reflected in
then current operations.
Professional liability current accident year net loss ratios are lower in
2005 than in 2004 largely due to our continued focus on maintaining the adequacy
of our rates. As premium adequacy has improved, loss ratios have decreased.
During the second quarter of 2005 we recognized favorable development of $5
million related to our previously established professional liability reserves,
primarily to reflect slight reductions in our estimates of claim severity for
accident years 2002 and prior.
Personal lines current accident year loss ratios have decreased both
because the frequency of auto damage claims has declined and because the
frequency and severity of homeowner damage claims has decreased as compared to
2004, largely due to more favorable weather conditions in 2005. We experienced
favorable development in the personal lines segment of $1.5 million and $3.0
million for the three months, and $3.7 million and $5.5 million for the six
months ended June 30, 2005 and 2004, respectively, primarily related to prior
year loss reserves for auto bodily injury claims for accident years 2004 and
prior.
27
NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)
Net investment income is primarily derived from the interest income earned
by our fixed maturity securities and includes interest income from short-term
and cash equivalent investments, dividend income from equity securities,
earnings from limited partnerships, increases in the cash surrender value of
business owned executive life insurance contracts, and rental income earned by
our commercial real estate holdings. Investment fees and expenses and real
estate expenses are deducted from investment income.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
--------------------------------------- ---------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
-------- -------- ------------------- -------- -------- -------------------
In thousands In thousands
Net investment income:
Professional
liability $ 22,450 $ 17,791 $ 4,659 26.2% $ 44,362 $ 35,090 $ 9,272 26.4%
Personal lines 3,091 2,791 300 10.7% 6,107 5,297 810 15.3%
Not attributed to
segments 605 101 504 >100.0% 1,099 147 952 >100.0%
-------- -------- -------- -------- -------- --------
Consolidated $ 26,146 $ 20,683 $ 5,463 26.4% $ 51,568 $ 40,534 $ 11,034 27.2%
======== ======== ======== ======== ======== ========
The increase in our net investment income in 2005 as compared to 2004 is
due both to higher average invested funds and improved yields. Market interest
rates began to increase in mid-2004, allowing new and matured funds to be
invested at higher rates. Changes in the asset mix of the portfolio have also
helped to improve the after-tax yield of the portfolio. We increased the
proportion of the portfolio that is invested in tax-exempt securities because of
the higher after-tax yields available on these securities. Our average income
yield, on a consolidated basis, was 4.2% and 4.1% for the three and six months
ended June 30, 2005 as compared to 4.1% and 4.0% for the three and six months
ended June 30, 2004. Our average tax equivalent income yield on a consolidated
basis was 4.8% and 4.7% for the three and six months ended June 30, 2005 as
compared to 4.5% and 4.4% for the three and six months ended June 30, 2004.
Investment income is a more substantial revenue source for our
professional liability segment because professional liability premiums are
generally collected some years before the related losses are paid. In our
personal lines segment, the length of time between the collection of premiums
and the settlement of claims is generally short. The positive cash flow
generated by our insurance operations during 2005 significantly increased
average invested funds and the related net investment income. Personal lines
investment income has also increased due to higher average invested funds;
however, the improvement is less pronounced in this segment.
The components of net realized investment gains are shown in the following
table.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------- --------------------
2005 2004 2005 2004
-------- -------- -------- --------
In thousands
Net gains (losses) from sales $ 1,452 $ (2) $ 2,776 $ 2,937
Other-than-temporary impairment losses - - (344) -
Trading portfolio gains (losses) 2 628 (36) 1,346
-------- -------- -------- --------
Net realized investment gains $ 1,454 $ 626 $ 2,396 $ 4,283
======== ======== ======== ========
28
UNDERWRITING, ACQUISITION AND INSURANCE EXPENSES
Underwriting, acquisition and insurance expenses are comprised of variable
costs, such as commissions and premium taxes that are directly related to
premiums earned, and fixed costs that have an indirect relationship to premium
volume, such as salaries, benefits, and facility costs. Underwriting acquisition
and insurance expenses increased in 2005 in both segments, but because the
increase in expenses was proportional to the increase in net premiums earned,
ratios remained fairly consistent between periods.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
----------------------------------- ----------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- -------- ---------- --------- -------- ----------
In thousands
Underwriting, acquisition and
insurance expenses:
Professional liability $ 19,389 $ 19,246 $ 143 $ 39,115 $ 37,389 $ 1,726
Personal lines 10,513 10,121 392 21,389 19,950 1,439
--------- -------- ------- --------- -------- ---------
Consolidated $ 29,902 $ 29,367 $ 535 $ 60,504 $ 57,339 $ 3,165
========= ======== ======= ========= ======== =========
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
--------------------------- ---------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
---- ---- ---------- ---- ---- ----------
Expense ratio*
Professional liability 15.5% 16.0% (0.5) 15.5% 15.3% 0.2
Personal lines 22.2% 22.3% (0.1) 22.7% 22.3% 0.4
Consolidated 17.4% 17.7% (0.3) 17.5% 17.2% 0.3
* Underwriting, acquisition and insurance expenses divided by net premiums
earned.
Guaranty fund assessments (refunds) were approximately ($212,000) and
($114,000) for the three and six months ended June 30, 2005 as compared to
approximately $249,000 and $533,000 for the three and six months ended June 30,
2004.
INTEREST EXPENSE
Interest expense increased for the three and six months ended June 30,
2005 as compared to the same periods in 2004 primarily because the average
amount of debt outstanding was higher in 2005. Our Subordinated Debentures of
$46.4 million were issued in April and May of 2004; prior to the issuance of the
subordinated debentures our only outstanding debt was Convertible Debentures.
Thus, our average outstanding debt was significantly lower in the first six
months of 2004 than in the first six months of 2005.
TAXES
Our effective tax rate for each period is significantly lower than the 35%
statutory rate because a considerable portion of our net investment income is
tax-exempt. The effect of tax-exempt income on our effective tax rate is shown
in the table below:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------ ----------------
2005 2004 2005 2004
---- ---- ---- ----
Statutory rate 35% 35% 35% 35%
Tax-exempt income (8%) (8%) (8%) (8%)
Other 1% (3%) 1% (2%)
-- -- -- --
Effective tax rate 28% 24% 28% 25%
== == == ==
29
RECENT ACCOUNTING PRONOUNCEMENTS AND GUIDANCE
ACCOUNTING CHANGES
In late 2004 the Financial Accounting Standards Board (FASB) issued SFAS
123 (revised 2004), Share-Based Payment, hereafter referred to as SFAS 123(R),
which is a revision of SFAS 123, Accounting for Stock-Based Compensation. SFAS
123(R) supersedes APB 25, Accounting for Stock Issued to Employees and amends
SFAS 95, Statement of Cash Flows. SFAS 123(R) requires all share-based payments
to employees, including grants of employee stock options, to be recognized in
the financial statements based on their fair values. Under current SEC rules, we
are required to adopt this statement no later than January 1, 2006. ProAssurance
plans to adopt SFAS 123(R) effective January 1, 2006 using the "modified
prospective" method permitted by the statement.
Under the "modified prospective" method stock based compensation is
recognized (a) under the requirements of SFAS 123(R) for all share-based
payments granted after the effective date of SFAS 123(R) and (b) under the
requirements of SFAS 123 for all non-vested share-based payments granted prior
to the adoption of SFAS 123(R).
As permitted by SFAS 123, ProAssurance currently accounts for stock
options awarded to employees using APB 25's intrinsic value method and, as such,
generally recognizes no compensation cost related to such awards. SFAS 123(R)
differs from SFAS 123 in several key computational areas, and implementation of
SFAS 123(R) will require ProAssurance to select among various assumptions in
order to perform the computations required under SFAS 123(R). Those assumptions
have not yet been selected, thus the effect that SFAS 123(R) would have had on
prior periods has not been computed. The effect of adoption of SFAS 123(R) on
future operating results cannot be predicted at this time because the effect
will depend on the levels of share-based payments granted in the future and the
methods and assumptions used to determine the fair value of those share-based
payments. SFAS 123(R) also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as required under current literature.
In the fourth quarter of 2004, ProAssurance implemented the FASB's
September, 2004 consensus regarding Issue 04-08 "Accounting Issues Related to
Certain Features of Contingently Convertible Debt and the Effect on Diluted EPS"
("EITF 04-8"). Under the new guidance, issuers of contingently convertible
(Co-Co) debt instruments must include the potential common shares underlying the
Co-Co (the Co-Co shares) in diluted earnings per share computations (if
dilutive) regardless of whether the market price contingency has been met or
not. Prior to implementation of EITF 04-8, ProAssurance followed commonly
accepted interpretations of SAFS 128, "Earnings Per Share" and did not include
the potential Co-Co shares in its diluted earnings per share computations
because the market price contingency had not been met. In accordance with EITF
04-8 diluted earnings per share for the three and six months ended June 30, 2004
has been restated; the restatement reduced previously reported diluted earning
per share by $0.02 and $0.04, respectively.
The FASB issued SFAS 154, Accounting Changes and Error Corrections, in May
2005 as a replacement of APB 20, Accounting Changes, and SFAS 3, Reporting
Accounting Changes in Interim Financial Statements. SFAS 154 applies to
voluntary changes in accounting principle and changes the requirements for
accounting for and reporting of a change in accounting principle and is
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. ProAssurance expects to adopt SFAS 154 on its
effective date.
30
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We believe that we are principally exposed to three types of market risk
related to our investment operations. These risks are interest rate risk, credit
risk and equity price risk.
The term market risk refers to the risk of loss arising from adverse
changes in market rates and prices, such as interest rates, equity prices and
foreign currency exchange rates.
As of June 30, 2005, our fair value investment in fixed maturity
securities was $2.398 billion. These securities are subject primarily to
interest rate risk and credit risk. We have not and currently do not intend to
enter into derivative transactions.
Interest Rate Risk
Our fixed maturities portfolio is exposed to interest rate risk.
Fluctuations in interest rates have a direct impact on the market valuation of
these securities. As interest rates rise, market values of fixed income
portfolios fall and vice versa. We believe we are in a position to keep our
fixed income investments until maturity as we do not invest in fixed maturity
securities for trading purposes.
JUNE 30, 2005 December 31, 2004
------------------------------------- ---------------------
PORTFOLIO CHANGE IN MODIFIED Portfolio Modified
VALUE VALUE DURATION Value Duration
Interest Rates $ MILLIONS $ MILLIONS YEARS $ Millions Years
- ----------------------- ---------- ----------- -------- ---------- --------
200 basis point rise $2,210 $(188) 4.21 $2,082 4.11
100 basis point rise $2,304 $ (94) 4.04 $2,170 4.00
Current rate * $2,398 $ - 3.81 $2,258 3.81
100 basis point decline $2,489 $ 91 3.65 $2,344 3.70
200 basis point decline $2,581 $ 183 3.66 $2,434 3.79
*Current rates are as of June 30, 2005 and December 31, 2004
At June 30, 2005, the fair value of our investment in preferred stocks was
$5.2 million, including net unrealized losses of $123 thousand. Preferred stocks
are primarily subject to interest rate risk because they bear a fixed rate of
return. The investments in the above table do not include preferred stocks.
Computations of prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including the maintenance of the existing
level and composition of fixed income security assets, and should not be relied
on as indicative of future results.
Certain shortcomings are inherent in the method of analysis presented in
the computation of the fair value of fixed rate instruments. Actual values may
differ from those projections presented should market conditions vary from
assumptions used in the calculation of the fair value of individual securities,
including non-parallel shifts in the term structure of interest rates and
changing individual issuer credit spreads.
ProAssurance's cash and short-term investment portfolio at June 30, 2005
was on a cost basis which approximates its fair value. This portfolio lacks
significant interest rate sensitivity due to its short duration.
31
Credit Risk
We have exposure to credit risk primarily as a holder of fixed income
securities. We control this exposure by emphasizing investment grade credit
quality in the fixed income securities we purchase.
As of June 30, 2005, 98.4% of our fixed income portfolio consisted of
securities rated investment grade. We believe that this concentration in
investment grade securities reduces our exposure to credit risk on these fixed
income investments to an acceptable level. However, in the current environment
even investment grade securities can rapidly deteriorate and result in
significant losses.
Equity Price Risk
At June 30, 2005 the fair value of our investment in common stocks was
$18.4 million. These securities are subject to equity price risk, which is
defined as the potential for loss in market value due to a decline in equity
prices. The weighted average Beta of this group of securities is 0.98. Beta
measures the price sensitivity of an equity security or group of equity
securities to a change in the broader equity market, in this case the S&P 500
Index. If the S&P 500 Index increased or decreased in value by 10%, the fair
value of our investment in common equities would be expected to increase or
decrease, respectively, by 9.8% or $1.8 million. If the value of the S&P 500
Index increased by 10%, the fair value of these securities would be expected to
increase to $20.2 million. Conversely, a 10% decrease in the S&P 500 Index would
imply a decrease in the fair value of these securities to $16.6 million. The
selected hypothetical changes of plus or minus 10% does not reflect what could
be considered the best or worst case scenarios and are used for illustrative
purposes only.
ITEM 4. CONTROLS AND PROCEDURES
The Chief Executive Officer and Chief Financial Officer of the Company
evaluated the effectiveness of our disclosure controls and procedures (as
defined in SEC Rule 13a-15(e)) as of June 30, 2005. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures are effective.
During the quarter ended June 30, 2005, there was no change in our
internal control over financial reporting (as defined in Rule 13a-15(f)) that
has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.
32
FORWARD-LOOKING STATEMENTS
Any written or oral statements made by us or on our behalf may include
forward-looking statements that reflect our current views with respect to future
events and financial performance. Forward-looking statements are identified by
words such as, but not limited to, "believe", "expect", "intend", "anticipate",
"estimate", "project" and other analogous expressions. Forward-looking
statements relating to our business include among other things, statements
concerning: liquidity and capital requirements, return on equity, financial
ratios, net income, premiums, losses and loss reserves, premium rates and
retention of current business, competition and market conditions, the expansion
of product lines, the development or acquisition of business in new geographical
areas, the availability of acceptable reinsurance, actions by regulators and
rating agencies, payment or performance of our obligations under the debentures,
payment of dividends, and other matters. In addition, forward-looking statements
may also relate to the proposed merger between ProAssurance and NCRIC Group,
Inc. as well as the goals, plans, objectives, intentions, expectations,
financial condition, results of operations, future performance and business of
the combined company including, without limitation, statements relating to the
benefits of the merger, such as future financial and operating results, cost
savings, enhanced revenues and the accretion to reported earnings that may be
realized from the merger and statements regarding certain of ProAssurance's
and/or NCRIC's goals and expectations with respect to earnings, earnings per
share, revenue, expenses and the growth rate in such items, as well as other
measures of economic performance.
These forward-looking statements are based upon our estimates and
anticipation of future events that are subject to certain risks and
uncertainties that could cause actual results to vary materially from the
expected results described in the forward-looking statements. Due to such risks
and uncertainties, you are urged not to place undue reliance on forward-looking
statements. All forward-looking statements included in this document are based
upon information available to us on the date hereof, and we undertake no
obligation to publicly update or revise any forward-looking statements, whether
as a result of new information, future events or otherwise.
Risks that could adversely affect our operations or cause actual results
to differ materially from anticipated results include, but are not limited to,
the following:
- underwriting losses on the risks we insure are higher or lower than
expected,
- unexpected changes in loss trends and reserving assumptions which
might require the reevaluation of the liability for loss and loss
adjustment expenses, thus resulting in an increase or decrease in
the liability and a corresponding adjustment to earnings,
- our ability to retain current business, acquire new business, expand
product lines and a variety of other factors affecting daily
operations such as, but not limited to, economic, legal, competitive
and market conditions which may be beyond our control and are thus
difficult or impossible to predict,
- changes in the interest rate environment and/or the securities
markets that adversely impact the fair value of our investments or
our income,
- inability on our part to achieve continued growth through expansion
into other states or through acquisitions or business combinations,
- general economic conditions that are worse than anticipated,
- inability on our part to obtain regulatory approval of, or to
implement, premium rate increases,
- the effects of weather-related events,
- changes in the legal system, including retroactively applied
decisions that affect the frequency and severity of claims,
- significantly increased competition among insurance providers and
related pricing weaknesses in some markets,
- changes in the availability, cost, quality or collectibility of
reinsurance,
- changes to our ratings by rating agencies,
- regulatory and legislative actions or decisions that adversely
affect us, and
- our ability to utilize loss carryforwards and other deferred tax
assets.
Risks that could adversely affect our transaction with NCRIC include but
are not limited to the following:
- the business of ProAssurance and NCRIC may not be combined
successfully, or such combination may take longer to accomplish than
expected;
- the cost savings from the merger may not be fully realized or may
take longer to realize than expected;
- operating costs, customer loss and business disruption following the
merger, including adverse effects on relationships with employees,
may be greater than expected;
- there may be restrictions on our ability to achieve continued growth
through expansion into other states or through acquisitions or
business combinations.
33
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Note 9 to the condensed consolidated financial statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of the Stockholders of ProAssurance was held on May 18,
2005. At the meeting the shareholders of ProAssurance considered and acted
upon the following:
(a) The stockholders elected the four nominated directors of ProAssurance
with shares voted as follows:
FOR AGAINST
---------- -------
A. Derrill Crowe, M.D. 23,318,709 -
Lucian F. Bloodworth 23,087,410 -
Robert E. Flowers, M.D. 23,871,096 -
Ann F. Putallaz 22,757,972 -
ITEM 6. EXHIBITS
31.1 Certification of Principal Executive Officer of ProAssurance as
required under SEC rule 13a-14(a).
31.2 Certification of Principal Financial Officer of ProAssurance as
required under SEC rule 13a-14(a).
32.1 Certification of Principal Executive Officer of ProAssurance as
required under SEC Rule 13a-14(b) and Section 1350 of Chapter 63 of
Title 18 of the United States Code, as amended (18 U.S.C. 1350).
32.2 Certification of Principal Financial Officer of ProAssurance as
required under SEC Rule 13a-14(b) and Section 1350 of Chapter 63 of
Title 18 of the United States Code, as amended (18 U.S.C. 1350).
34
SIGNATURE
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.
PROASSURANCE CORPORATION
August 9, 2005
/s/ Edward L. Rand, Jr.
---------------------------------------
Edward L. Rand, Chief Financial Officer
(Duly authorized officer and principal
financial officer)
35