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 SEPTEMBER 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 (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ ]
As of September 30, 2005 there were 31,079,046 shares of the registrant's
common stock outstanding.
Page 1 of 43
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 ................................ 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..... 20
Item 3. Quantitative and Qualitative Disclosures about Market Risk................................ 39
Item 4. Controls and Procedures................................................................... 40
Forward-Looking Statements........................................................................ 41
Part II - Other Information
Item 1. Legal Proceedings......................................................................... 42
Item 6. Exhibits.................................................................................. 42
Signature......................................................................................... 43
2
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)
SEPTEMBER 30 December 31
2005 2004
------------ -----------
ASSETS
Investments:
Fixed maturities available for sale, at fair value $2,613,232 $2,257,985
Equity securities available for sale, at fair value 19,385 35,230
Equity securities, trading portfolio, at fair value 4,824 4,150
Real estate, net 25,383 19,244
Short-term investments 150,404 41,423
Business owned life insurance 55,856 54,138
Other 46,142 42,883
---------- ----------
Total investments 2,915,226 2,455,053
Cash and cash equivalents 30,137 30,084
Premiums receivable 128,815 131,736
Receivable from reinsurers on unpaid losses and loss adjustment expenses 465,333 409,339
Prepaid reinsurance premiums 19,629 18,888
Deferred taxes 114,041 80,107
Other assets 159,907 113,991
---------- ----------
$3,833,088 $3,239,198
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Policy liabilities and accruals:
Reserve for losses and loss adjustment expenses $2,394,631 $2,029,592
Unearned premiums 353,291 314,179
Reinsurance premiums payable 77,148 69,507
---------- ----------
Total policy liabilities 2,825,070 2,413,278
Other liabilities 102,380 63,421
Long-term debt 167,166 151,480
---------- ----------
Total liabilities 3,094,616 2,628,179
Commitments and contingencies - -
Stockholders' Equity:
Common stock, par value $0.01 per share
100,000,000 shares authorized; 31,200,811 and
29,326,228 shares issued, respectively 312 293
Additional paid-in capital 387,163 313,957
Accumulated other comprehensive income (loss), net of deferred
tax expense (benefit) of $(59) and $13,139, respectively (114) 24,397
Retained earnings 351,167 272,428
---------- ----------
738,528 611,075
Less treasury stock, at cost, 121,765 shares (56) (56)
---------- ----------
Total stockholders' equity 738,472 611,019
---------- ----------
$3,833,088 $3,239,198
========== ==========
See accompanying notes.
3
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN CAPITAL (UNAUDITED)
(IN THOUSANDS)
Accumulated
Other Other
Comprehensive Retained Capital
Total Income (Loss) Earnings Accounts
--------- ------------- --------- ---------
Balance at December 31, 2004 $ 611,019 $24,397 $ 272,428 $ 314,194
Net income 78,739 - 78,739 -
Change in fair value of securities available
for sale, net of deferred taxes and
reclassification adjustments (24,511) (24,511) - -
Common stock issued as compensation 2,048 - - 2,048
Equity issued in purchase transaction:
Common stock issued 67,196 - - 67,196
Fair value of options assumed 192 - - 192
Common stock options exercised 3,789 - - 3,789
--------- -------- --------- ---------
Balance at September 30, 2005 $ 738,472 $ (114) $ 351,167 $ 387,419
========= ======== ========= =========
Accumulated
Other Other
Comprehensive Retained Capital
Total Income (Loss) Earnings Accounts
--------- ------------- --------- ---------
Balance at December 31, 2003 $ 546,305 $ 34,422 $ 199,617 $ 312,266
Net income 51,302 - 51,302 -
Change in fair value of securities available
for sale, net of deferred taxes and
reclassification adjustments (5,646) (5,646) - -
Common stock issued as compensation 1,599 - - 1,599
Common stock options exercised 165 - - 165
--------- -------- --------- ---------
Balance at September 30, 2004 $ 593,725 $ 28,776 $ 250,919 $ 314,030
========= ======== ========= =========
See accompanying notes.
4
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------- ------------------------
2005 2004 2005 2004
--------- --------- --------- ---------
Revenues:
Gross premiums written $ 224,559 $ 217,812 $ 601,589 $ 600,295
========= ========= ========= =========
Net premiums written $ 203,405 $ 198,370 $ 539,794 $ 538,085
========= ========= ========= =========
Premiums earned $ 214,547 $ 196,185 $ 601,457 $ 569,583
Premiums ceded (24,208) (20,839) (64,818) (60,497)
--------- --------- --------- ---------
Net premiums earned 190,339 175,346 536,639 509,086
Net investment income 28,078 22,659 79,646 63,192
Net realized investment gains (losses) (635) 3,063 1,761 7,346
Other income 1,539 827 4,612 3,069
--------- --------- --------- ---------
Total revenues 219,321 201,895 622,658 582,693
Expenses:
Losses and loss adjustment expenses 158,625 163,583 460,084 477,966
Reinsurance recoveries (15,980) (19,302) (47,153) (54,986)
--------- --------- --------- ---------
Net losses and loss adjustment expenses 142,645 144,281 412,931 422,980
Underwriting, acquisition and insurance expenses 33,516 30,355 94,021 87,695
Interest expense 2,290 1,902 6,457 4,537
--------- --------- --------- ---------
Total expenses 178,451 176,538 513,409 515,212
--------- --------- --------- ---------
Income from continuing operations before income taxes 40,870 25,357 109,249 67,481
Provision for income taxes:
Current expense 12,123 6,760 31,140 14,414
Deferred expense (benefit) (635) (921) (675) 1,765
--------- --------- --------- ---------
11,488 5,839 30,465 16,179
--------- --------- --------- ---------
Income from continuing operations 29,382 19,518 78,784 51,302
Loss from discontinued operations, net of tax (45) - (45) -
--------- --------- --------- ---------
Net income $ 29,337 $ 19,518 $ 78,739 $ 51,302
========= ========= ========= =========
Basic earnings per share:
Income from continuing operations $ 0.96 $ 0.67 $ 2.65 $ 1.76
Loss from discontinued operations - - - -
--------- --------- --------- ---------
Net income $ 0.96 $ 0.67 $ 2.65 $ 1.76
Diluted earnings per share:
Income from continuing operations $ 0.90 $ 0.63 $ 2.49 $ 1.67
Loss from discontinued operations - - - -
--------- --------- --------- ---------
Net income $ 0.90 $ 0.63 $ 2.49 $ 1.67
Weighted average number of common shares outstanding:
Basic 30,480 29,182 29,700 29,153
========= ========= ========= =========
Diluted 33,345 31,972 32,546 31,967
========= ========= ========= =========
See accompanying notes.
5
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(IN THOUSANDS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------ ----------------------
2005 2004 2005 2004
-------- ------- ------- ---------
COMPREHENSIVE INCOME:
Net income $ 29,337 $19,518 $78,739 $51,302
Change in fair value of securities available
for sale, net of deferred taxes (20,401) 22,696 (23,325) (2,546)
Reclassification adjustment for realized investment
(gains) losses included in income, net of deferred taxes 440 (1,195) (1,186) (3,100)
-------- ------- ------- -------
Comprehensive income $ 9,376 $41,019 $54,228 $45,656
======== ======= ======= =======
See accompanying notes.
6
PROASSURANCE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30
----------------------
2005 2004
--------- ---------
OPERATING ACTIVITIES
Net Income $ 78,739 $ 51,302
Depreciation and amortization 19,795 20,271
Net realized investment (gains) losses and net purchases of
trading portfolio securities (2,431) (189)
Changes in assets and liabilities, net of the effects of
acquisition:
Premiums receivable 11,315 (6,422)
Reserve for losses and loss adjustment expenses 181,881 192,532
Unearned premiums (122) 30,802
Reinsurance related assets and liabilities (4,671) (8,614)
Other (2,147) 5,102
--------- ---------
Net cash provided by operating activities 282,359 284,784
--------- ---------
INVESTING ACTIVITIES
Purchases of:
Fixed maturities available for sale (764,651) (958,694)
Equity securities available for sale (632) (602)
Other investments (2,387) (3,150)
Other capital assets (8,842) (6,266)
Proceeds from sale or maturity of:
Fixed maturities available for sale 550,394 610,060
Equity securities available for sale 44,421 8,869
Net (increase) decrease in short-term investments (105,760) 10,474
Cash acquired in purchase transaction,
net of cash used in transaction of $2,520 1,791 -
Other (280) (1,896)
--------- ---------
Net cash used by investing activities (285,946) (341,205)
--------- ---------
FINANCING ACTIVITIES
Proceeds from issuance of long-term debt - 46,395
Debt issuance costs - (1,491)
Other 3,640 23
--------- ---------
Net cash provided by financing activities 3,640 44,927
--------- ---------
Increase (decrease) in cash and cash equivalents 53 (11,494)
Cash and cash equivalents at beginning of period 30,084 42,045
--------- ---------
Cash and cash equivalents at end of period $ 30,137 $ 30,551
========= =========
Significant non-cash transactions:
Common stock issued in acquisition $ 67,196 $ -
========= =========
See accompanying notes.
7
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 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 nine months ended September 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 under the plans.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------------ -------------------------------
2005 2004 2005 2004
---------- ---------- ---------- -----------
Net income, as reported $ 29,337 $ 19,518 $ 78,739 $ 51,302
Add: Stock-based employee compensation expense
recognized under APB 25 related to the exercise of
options, net of related tax effects 31 12 61 160
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (560) (338) (1,560) (962)
---------- ---------- ---------- ----------
Pro forma net income $ 28,808 $ 19,192 $ 77,240 $ 50,500
========== ========== ========== ==========
Earnings per share:
Basic -- as reported $ 0.96 $ 0.67 $ 2.65 $ 1.76
========== ========== ========== ==========
Basic -- pro forma $ 0.95 $ 0.66 $ 2.60 $ 1.73
========== ========== ========== ==========
Diluted -- as reported $ 0.90 $ 0.63 $ 2.49 $ 1.67
========== ========== ========== ==========
Diluted -- pro forma $ 0.89 $ 0.62 $ 2.44 $ 1.65
========== ========== ========== ==========
8
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2005
1. BASIS OF PRESENTATION (CONTINUED)
Reclassifications
Certain reclassifications have been made to the September 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), which superseded APB 25, Accounting for Stock Issued to
Employees (APB 25), and amends SFAS 95, Statement of Cash Flows. The provisions
of SFAS 123(R) require all share-based payments to employees, including grants
of employee stock options, to be recognized in the financial statements based on
their fair values. SFAS 123(R) also requires that 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. ProAssurance plans to adopt SFAS 123(R) on January 1, 2006, the
required effective date, using the "modified prospective" method permitted by
the statement and expects to value future grants of stock options using the
Black Scholes valuation method.
Under the "modified prospective" method stock-based compensation is
recognized under the requirements of SFAS 123(R) for all share-based payments
granted after the effective date of SFAS 123(R) and for the non-vested portion
of share-based payments granted prior to the adoption of SFAS 123(R). Under SFAS
123(R) compensation for non-vested share-based payments granted prior to
adoption shall continue to be calculated as disclosed under SFAS 123, except
that the effect of forfeitures is required to be estimated rather than
considered as forfeitures occur.
As permitted by SFAS 123, ProAssurance currently values employee
stock-based payments using APB 25's intrinsic value method. Accordingly,
ProAssurance generally recognizes no compensation cost related to such payments
but does provide pro forma disclosure of the effect on net income and earnings
per share of applying the fair value provisions of SFAS 123 to such payments
granted.
Had ProAssurance's SFAS 123 pro forma disclosures been prepared in
accordance with the provisions of SFAS 123(R) the effect would have been
different; however, the effect that SFAS 123(R) would have had on prior periods
is not readily determinable. SFAS 123(R) provides more extensive guidance than
does SFAS 123 with regard to factors that should be considered in valuing
share-based payments. Under SFAS 123(R), entities are required to "aggregate
individual awards into relatively homogeneous groups with respect to exercise
and post-vesting employment termination behaviors." Under SFAS 123, ProAssurance
utilized a single set of valuation assumptions for all employees. Additionally,
under SFAS 123(R), awards that vest upon retirement granted to employees who are
eligible for retirement should be expensed on the date of grant. Under SFAS 123,
ProAssurance calculated compensation expense (for pro forma disclosure) for all
awards based upon the vesting schedule for the award, and did not consider the
retirement eligibility of the recipient. Adoption of SFAS 123(R) will require
ProAssurance to establish numerous assumptions regarding the expected behavior
of ProAssurance employees as to continued employment, retirement, and option
exercises. ProAssurance's own history with regard to employee stock awards is
not sufficient to allow such assumptions to be developed statistically, and data
from other sources must also be considered. ProAssurance is in the process of
finalizing these assumptions; however, the selection of all assumptions is not
yet complete.
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, the groups of employees to whom the
awards are granted, the terms of any future awards, as well as the methods and
assumptions used to determine the fair value of those share-based payments.
9
PROASSURANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2005
1. BASIS OF PRESENTATION (CONTINUED)
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 debt
instruments (Co-Co) 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 SFAS 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 nine months ended
September 30, 2004 have been restated; the restatement reduced previously
reported diluted earnings per share by $0.03 in the three-month period and $0.08
in the nine-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.
10
2. ACQUISITION OF NCRIC CORPORATION
ProAssurance acquired 100% of the outstanding shares of NCRIC Corporation
(NCRIC) on August 3, 2005 primarily for the purpose of expanding the
distribution of its professional liability insurance products. NCRIC
Corporation, formerly known as NCRIC Group, Inc., is a holding company primarily
focused on providing medical professional liability insurance in Delaware, the
District of Columbia, Maryland, Virginia, and West Virginia. The aggregate
purchase price is comprised as follows:
(In thousands, except for per share amounts)
Fair value of 1.7 million ProAssurance common shares
issued, based on a fair value of $40.54 per share $ 67,196
Fair value of NCRIC options exchanged, estimated
using the Black Scholes valuation method 192
Cash paid for NCRIC options in lieu of exchange 775
Acquisition costs (primarily fees paid for legal,
accounting and financial advisory services) 1,746
Estimated benefits payable under termination
agreements provided to NCRIC employees,
net of related deferred tax benefit 1,216
----------
Aggregate purchase price 71,125
==========
The fair value per ProAssurance share is based on the average ProAssurance
common stock price for three days before and after February 28, 2005 (the date
the terms of the acquisition were agreed to and publicly announced). The
acquisition has been accounted for as a purchase transaction in accordance with
SFAS 141 and the purchase price has been allocated to the assets acquired and
liabilities assumed based on estimates of their respective fair values at the
date of acquisition. Goodwill of $25.0 million was recognized equal to the
excess of the purchase price over the fair values of the identifiable net assets
acquired. The goodwill is not expected to be tax deductible.
The fair value of NCRIC's reserve for losses and loss adjustment expense
and related reinsurance recoverables were estimated based on the present value
of the expected underlying cash flows of the loss reserves and reinsurance
recoverables, and include a risk premium and a profit margin. In determining the
fair value estimate, management discounted NCRIC's historical undiscounted net
loss reserves to present value assuming a discount rate of 5.03%, which is our
tax effected reinvestment rate. The discounting pattern was actuarially
developed from NCRIC's historical loss data. An expected profit margin of 5% was
applied to the discounted loss reserves, which is consistent with management's
understanding of the returns anticipated by the reinsurance market (the
reinsurance market representing a willing partner in the purchase of loss
reserves). Additionally, in consideration of the long-tail nature and the
related high degree of uncertainty of such reserves, an estimated risk premium
of 5% was applied to the discounted reserves. The above calculations resulted in
a fair value which was not materially different than NCRIC's historical reserves
and therefore did not result in an adjustment to NCRIC's carried reserve for
loss and loss adjustment expense.
ProAssurance's Condensed Consolidated Statements of Income for the three
and nine months ended September 30, 2005 include NCRIC activity commencing upon
August 3, 2005, the effective date of the acquisition. The unaudited pro forma
information below presents combined results of operations as if the acquisition
had occurred at the beginning of the respective periods, and includes the effect
of adjusting NCRIC's assets and liabilities to fair value on the date of
acquisition. The pro forma results for the nine months ended September 30, 2005
include non-recurring and transaction related expenses of $4.3 million, related
to compensation costs and professional fees, $8.7 million of unfavorable prior
year loss development and $19.5 million related to a loss contingency (see also
Note 11).
11
2. ACQUISITION OF NCRIC CORPORATION (CONTINUED)
The following unaudited pro forma information is not necessarily
indicative of the results of operations of the combined company had the
acquisition occurred at the beginning of the periods presented, nor is it
necessarily indicative of future results.
PRO FORMA RESULTS
----------------------------------------
NINE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30 SEPTEMBER 30
------------- -------------
2005 2004
------------- -------------
In thousands
Revenues $ 668,517 $ 637,698
============ =============
Income from continuing operations $ 58,773 $ 52,739
============ =============
Net Income $ 58,481 $ 52,484
============ =============
Net Income per share from continuing operations
Basic $ 1.89 $ 1.70
============ =============
Diluted $ 1.79 $ 1.63
============ =============
3. DISCONTINUED OPERATIONS
ProAssurance is actively pursuing a purchaser for ConsiCare, a subsidiary
acquired in the NCRIC transaction. ProAssurance does not believe that
ConsiCare's business, which is providing consulting and administrative services
to physician practices, fits into ProAssurance's corporate strategy as a
specialty insurer. Although no definitive agreement has been reached,
ProAssurance expects to complete the sale of ConsiCare within the next twelve
months. Accordingly, ConsiCare is classified as held for sale, and operating
results are included in ProAssurance's condensed consolidated statement of
income as Loss from Discontinued Operations in accordance with SFAS 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
ProAssurance's condensed consolidated balance sheet includes the following
assets and liabilities of ConsiCare:
SEPTEMBER 30
2005
------------
In thousands
Cash $ 120
Other assets 6,107
Other liabilities (2,841)
------------
Net assets held for sale $ 3,386
============
ConsiCare's results since its acquisition on August 3, 2005 are included
in income for the three and nine months ended September 30, 2005 as loss from
discontinued operations.
In thousands
Revenues $ 658
Costs and Expenses (689)
-------
Income (loss) before income taxes (31)
Income taxes (14)
-------
Loss from discontinued operations $ (45)
=======
12
4. SEGMENT INFORMATION
ProAssurance operates in the U.S. in two reportable segments: the
professional liability segment and the personal lines segment. The professional
liability insurance segment primarily provides professional liability insurance
to physicians and physician groups. The professional liability segment
principally includes the operating results of The Medical Assurance Company,
Inc., ProNational Insurance Company, Inc., Red Mountain Casualty Insurance
Company, and NCRIC, Inc. The personal lines segment provides personal auto and
homeowners insurance to educational employees and their families through a
single insurance company, MEEMIC 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 on long-term
debt, 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 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------------ -----------------------------------
2005 2004 2005 2004
----------- ----------- -------------- --------------
In thousands
Revenues:
Professional liability segment:
Net premiums earned $ 143,586 $ 129,175 $ 395,557 $ 373,337
Net investment income 24,255 19,480 68,617 54,569
Other revenues 248 1,986 3,918 5,868
----------- ----------- -------------- --------------
Total segment revenues 168,089 150,641 468,092 433,774
Personal lines segment:
Net premiums earned 46,753 46,171 141,082 135,749
Net investment income 3,230 2,645 9,337 7,942
Other revenues 630 580 2,371 1,874
----------- ----------- -------------- --------------
Total segment revenues 50,613 49,396 152,790 145,565
Corporate (not attributed to segments) 619 1,858 1,776 3,354
----------- ----------- -------------- --------------
Total revenues $ 219,321 $ 201,895 $ 622,658 $ 582,693
=========== =========== ============== ==============
Income (loss) from continuing operations before taxes:
Professional liability $ 28,715 $ 14,905 $ 76,028 $ 37,629
Personal lines 13,826 10,496 37,902 31,035
Corporate (not attributed to segments) (1,671) (44) (4,681) (1,183)
----------- ----------- -------------- --------------
Income from continuing operations before taxes $ 40,870 $ 25,357 $ 109,249 $ 67,481
=========== =========== ============== ==============
SEPTEMBER 30 December 31
2005 2004
-------------- --------------
In thousands
Assets:
Professional liability $ 3,246,600 $ 2,682,987
Personal lines 529,858 495,903
Corporate (not attributed to segments) 56,630 60,308
-------------- --------------
Total assets $ 3,833,088 $ 3,239,198
============== ==============
13
5. INVESTMENTS
The amortized cost of available-for-sale fixed maturities and equity
securities is $2.633 billion and $2.256 billion at September 30, 2005 and
December 31, 2004, respectively. Proceeds from sales of fixed maturities and
equity securities during the nine months ended September 30, 2005 and 2004 are
$398.7 million and $425.3 million, respectively.
Net realized investment gains (losses) are comprised of the following (in
thousands):
NINE MONTHS ENDED
SEPTEMBER 30
-------------------------
2005 2004
--------- ---------
Gross realized gains $ 4,281 $ 6,371
Gross realized (losses) (1,453) (1,595)
Other than temporary impairment (losses) (1,072) -
Trading portfolio gains (losses) 5 2,570
--------- ---------
Net realized investment gains (losses) $ 1,761 $ 7,346
========= =========
6. 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.
7. 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 $50.1 million and $46.6 million for the nine months ended
September 30, 2005 and 2004, respectively.
8. 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.
14
9. LONG-TERM DEBT
Outstanding long-term debt, as of September 30, 2005 and December 31,
2004, consisted of the following:
SEPTEMBER 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
$2,293 and $2,515 at September 30, 2005 and December
31, 2004, respectively. $ 105,307 $ 105,085
Trust Preferred Subordinated Debentures, unsecured, bearing interest at a
floating rate, adjustable quarterly.
September 30,2005
Due Rate
April 29, 2034 7.64% 13,403 13,403
May 12, 2034 7.64% 10,310 10,310
May 12, 2034 7.64% 22,682 22,682
December 4, 2032 7.86% 15,464 -
--------------- -----------------
$ 167,166 $ 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.
15
9. LONG-TERM DEBT (CONTINUED)
Trust Preferred Subordinated Debentures
In April and May 2004, ProAssurance formed two business trusts,
ProAssurance Capital Trust I and ProAssurance Capital Trust II (the PRA Trusts),
for the sole purpose of issuing, in private placement transactions, $45.0
million of trust preferred securities (PRA TPS) and using the proceeds thereof,
together with the equity proceeds received from ProAssurance in the initial
formation of the PRA Trusts, to purchase $46.4 million of variable rate
subordinated debentures (the 2034 Subordinated Debentures) issued by
ProAssurance. ProAssurance owns all voting securities of the PRA Trusts and the
2034 Subordinated Debentures are the sole assets of the PRA Trusts. The PRA
Trusts will meet the obligations of the PRA TPS with the interest and principal
paid on the 2034 Subordinated Debentures. The 2034 Subordinated Debentures
payable to the PRA Trusts are included as long-term debt in the accompanying
Condensed Consolidated Balance Sheets. ProAssurance received net proceeds from
the PRA TPS transactions, after commissions and other costs of issuance, of
$44.9 million.
In December 2002, NCRIC formed NCRIC Statutory Trust I (the NCRIC Trust),
for the sole purpose of issuing, in private placement transactions, $15.0
million of trust preferred securities (NCRIC TPS) and using the proceeds
thereof, together with the equity proceeds received from NCRIC in the initial
formation of the NCRIC Trust, to purchase $15.5 million of variable rate
subordinated debentures (the 2032 Subordinated Debentures) issued by NCRIC.
NCRIC owns all voting securities of the NCRIC Trust and the 2032 Subordinated
Debentures are the sole assets of the NCRIC Trust. The NCRIC Trust will meet the
obligations of the NCRIC TPS with the interest and principal paid on the 2032
Subordinated Debentures. ProAssurance assumed the obligations of the 2032
Subordinated Debentures as a part of the NCRIC purchase transaction.
The 2034 and 2032 Subordinated Debentures have the same maturities and
other applicable terms and features as the associated trust preferred
securities. The 2034 and 2032 Subordinated Debentures are uncollateralized and
bear a floating interest rate adjusted quarterly based upon the three-month
LIBOR rate, with a maximum rate for the first five years following issuance of
12.5%. Payment of interest may be deferred for up to 20 consecutive quarters;
however, stockholder dividends cannot be paid during any extended interest
payment period or at any time the debentures are in default. All have stated
maturities of thirty years but may be redeemed at any time following the fifth
anniversary of issuance. None of the securities require either PRA or NCRIC to
maintain minimum financial covenants. In accordance with the provisions of FIN
46, neither the PRA Trusts nor the NCRIC Trusts are consolidated by
ProAssurance.
Guarantees
ProAssurance and NCRIC have guaranteed that amounts paid to the PRA and
NCRIC Trusts under the associated subordinated debentures (the 2034 and 2032
Subordinated Debentures, respectively) will be remitted to the holders of the
associated trust preferred securities. These guarantees, when taken together
with the obligations of ProAssurance and NCRIC under their respective
debentures, the Indentures pursuant to which those debentures were issued, and
the related trust agreements (including obligations to pay related trust cost,
fees, expenses, debt and other obligations for the PRA and NCRIC Trusts other
than with respect to the common and trust preferred securities of the PRA and
NCRIC Trusts), provides a full and unconditional guarantee of amounts due on the
PRA and NCRIC TPS. The amounts guaranteed are not expected to at any time exceed
the obligations of the 2034 and 2032 Subordinated Debentures, and no additional
liability has been recorded related to the PRA and NCRIC TPS or the guarantees.
16
9. LONG-TERM DEBT (CONTINUED)
Fair Value
At September 30, 2005, the fair value of the Convertible Debentures is
approximately 119% of face value based on available independent market quotes.
The fair value of the 2034 and 2032 Subordinated Debentures approximates the
face value of the debentures.
Additional Information
For additional information regarding the terms of the Convertible
Debentures and the 2034 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.
10. STOCKHOLDERS' EQUITY
At September 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 September 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 employee stock options for 314,985 common
shares. On a weighted average basis, the options have an exercise price of
$41.16 and a fair value of $16.59 per option, using the Black-Scholes option
pricing model and the following model assumptions: risk-free interest rate of
4.3%, volatility of 0.33, expected life of 6 years; and dividend yield of 0%.
As a part of the NCRIC acquisition discussed in Note 2, in 2005
ProAssurance converted NCRIC options into ProAssurance options for 12,168 common
shares. On a weighted average basis, the options have an exercise price of
$31.66 and a fair value of $15.80 per option, using the Black-Scholes option
pricing model and the following model assumptions: risk-free interest rate of
3.69%, volatility of 23.54, expected life of 2.6 years; and dividend yield of
0%.
11. COMMITMENTS AND CONTINGENCIES
As a result of the acquisition of NCRIC, ProAssurance assumed the risk of
loss for a judgment entered against NCRIC on February 20, 2004 by a District of
Columbia Superior Court in favor of Columbia Hospital for Women Medical Center,
Inc. ("CHW") in the amount of $19.5 million (the "CHW Judgment") which includes
costs associated with pursuing the post-trial motions and any appeal of a final
judgment and projected post-trial interest. NCRIC timely filed post-trial
motions requesting the trial court to set aside the CHW Judgment or in the
alternative, to grant a new trial. In connection with the filing of the
post-trial motions, NCRIC posted a $19.5 million appellate bond and associated
letter of credit to secure payment of the CHW Judgment. By order of September
30, 2005, the trial court denied all post-trial relief sought by NCRIC and NCRIC
appealed the judgement. In accordance with SFAS 141, ProAssurance has
established a liability of $19.5 million for this judgment; this amount has been
included as a component of the fair value of assets acquired and liabilities
assumed in the allocation of the NCRIC purchase price.
ProAssurance is involved in various other 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.
17
12. EARNINGS PER SHARE
The following represents a reconciliation of the numerators and
denominators of the basic and diluted earnings per share computations:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------- --------------------
2005 2004 2005 2004
-------- -------- -------- --------
In thousands except per share data
Basic earnings per share calculation:
Numerator:
Income from continuing operations $ 29,382 $ 19,518 $ 78,784 $ 51,302
Loss from discontinued operations, net of tax (45) - (45) -
-------- -------- -------- --------
Net income $ 29,337 $ 19,518 $ 78,739 $ 51,302
======== ======== ======== ========
Denominator:
Weighted average number of common shares outstanding 30,480 29,182 29,700 29,153
======== ======== ======== ========
Basic earnings per share:
From continuing operations $ 0.96 $ 0.67 $ 2.65 $ 1.76
From discontinued operations 0.00 0.00 0.00 0.00
-------- -------- -------- --------
Net income per share $ 0.96 $ 0.67 $ 2.65 $ 1.76
======== ======== ======== ========
Diluted earnings per share calculation:
Numerator:
Income from continuing operations $ 29,382 $ 19,518 $ 78,784 $ 51,302
Effect of assumed conversion of contingently convertible
debt instruments 742 742 2,226 2,226
-------- -------- -------- --------
Income from continuing operations-diluted computation 30,124 20,260 81,010 53,528
Loss from discontinued operations, net of tax (45) - (45) -
-------- -------- -------- --------
Net income - diluted computation $ 30,079 $ 20,260 $ 80,965 $ 53,528
======== ======== ======== ========
Denominator:
Weighted average number of common shares outstanding 30,480 29,182 29,700 29,153
Assumed conversion of dilutive stock options 293 218 274 242
Assumed conversion of contingently convertible debt instruments 2,572 2,572 2,572 2,572
-------- -------- -------- --------
Diluted weighted average equivalent shares 33,345 31,972 32,546 31,967
======== ======== ======== ========
Diluted earnings per share:
From continuing operations $ 0.90 $ 0.63 $ 2.49 $ 1.67
From discontinued operations 0.00 0.00 0.00 0.00
-------- -------- -------- --------
Net income per share $ 0.90 $ 0.63 $ 2.49 $ 1.67
======== ======== ======== ========
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, computed quarterly and averaged for
each year-to-date period. 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.
During the nine-month periods ended September 30, 2005 and 2004, approximately
210,000 and 80,000 outstanding ProAssurance options, respectively, on average,
carried an exercise price that exceeded the average ProAssurance share price
during the quarter period and were excluded from the computation of diluted
weighted average shares.
18
12. EARNINGS PER SHARE (CONTINUED)
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 nine-month periods ended September 30, 2005
and 2004. Prior to the 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 nine-month periods ended September 30,
2004 as $0.66 and $1.75, respectively.
13. SUBSEQUENT EVENT
On November 4, 2005 ProAssurance entered into a definitive agreement to
sell its wholly owned subsidiaries, MEEMIC Insurance Company, Inc. and MEEMIC
Insurance Services (collectively, the MEEMIC Companies) to Motors Insurance
Corporation (Motors), a subsidiary of GMAC Insurance Holdings, Inc., for total
consideration of $400 million ($327 million from Motors and $73 million in
dividends from the MEEMIC Companies), before transaction expenses, to be paid in
cash. The transaction is expected to close early in the first quarter of 2006;
however, the transaction is contingent upon obtaining certain insurance and
anti-trust regulatory approvals.
ProAssurance's personal lines segment is wholly comprised of the
operations of the MEEMIC Companies. At September 30, 2005 the ProAssurance
consolidated balance sheet includes the following balances attributable to the
MEEMIC Companies.
<Table>
<Caption>
in thousands
Fixed maturities available for sale, at fair value $300,198
Cash and cash equivalents 12,660
Premiums receivable 16,030
Receivable from reinsurers on unpaid losses and loss
adjustment expenses 141,791
Other assets 59,179
--------
Total assets $529,858
========
Reserve for losses and loss adjustment expenses $219,001
Unearned premiums 67,932
Other liabilities 19,679
--------
Total liabilities $306,612
========
</Table>
ProAssurance condensed consolidated statement of income includes the
following amounts attributable to the operations of the MEEMIC Companies.
<Table>
<Caption>
Nine Months Ended
September 30
------------------------
2005 2004
-------- --------
in thousands, except
per share amounts
Gross premiums written $166,848 $162,101
======== ========
Net premiums written $143,359 $142,636
======== ========
Net premiums earned $141,082 $135,749
Net investment income 9,337 7,942
Other revenues 2,371 1,874
-------- --------
Total revenues 152,790 145,565
-------- --------
Net losses and loss adjustment expenses 81,458 83,279
Underwriting, acquisition and insurance expenses 33,430 31,251
-------- --------
Total expenses 114,888 114,530
-------- --------
Income before income taxes 37,902 31,035
Provision for income taxes (12,242) (10,022)
-------- --------
Net income $ 25,660 $ 21,013
======== ========
</Table>
19
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 thereto (unaudited) accompanying
this report and ProAssurance's Annual Report on Form 10-K/A for the year ended
December 31, 2004, (filed June 13, 2005) 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.
20
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 September
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 other 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.
21
RECENT SIGNIFICANT EVENTS
On August 3, 2005 ProAssurance acquired all of the outstanding common
stock of NCRIC Corporation (NCRIC). 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. The primary purpose for the transaction was to expand marketing
opportunities for our professional liability insurance products. The following
chart summarizes the acquisition:
($ in millions)
Fair value of 1.7 million ProAssurance
common shares issued $ 67.2
Other acquisition costs 3.9
------
Aggregate purchase price 71.1
Fair value of net assets acquired 46.1
------
Excess of purchase price over fair value
of net assets acquired, recognized as goodwill $ 25.0
======
A more detailed description of the merger transaction is included in Note
2 of the Notes to the Condensed Consolidated Financial Statements included
herein. Additional information about NCRIC is available in NCRIC's annual report
on Form 10K/A for the year ended December 31, 2004 which was included as an
exhibit to our registration statement on Form S-4/A dated June 23, 2005.
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 $282.4 million for the nine months
ended September 30, 2005, which is comparable to cash provided by operations of
$284.8 million for the nine months ended September 30, 2004. Our September 30,
2005 operating cash flow includes $3.6 million generated by NCRIC operating
activities from the August 3 purchase date forward. 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 nine months ended
September 30, 2005 (including NCRIC activity) and 2004 are 45.5% and 48.6%,
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 cash flows from our investments as well as the expected cash flows to
be generated by our operations. 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 may
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 foresee any such shortfall.
22
While cash balances remained flat, total investments have increased by
approximately $460.2 million, of which $224.2 million is attributable to the
NCRIC acquisition. We transfer most of the cash generated from operations into
our investment portfolio. We held cash and cash equivalents of approximately
$30.1 million at both September 30, 2005 and at December 31, 2004. Approximately
$493,000 of the total held at September 30, 2005 is attributable to NCRIC.
At September 30, 2005 our investment in fixed maturity securities is
$2.613 billion representing 89.6% of our total investments. Of this total,
$184.1 million is attributable to NCRIC. 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 have a dollar weighted average rating of
"AA" at September 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 September 30, 2005 is 3.93 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 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 loss of $3.3 million at September 30, 2005.
At September 30, 2005, available-for-sale and trading portfolio equity
investments total $24.2 million, representing approximately 0.8% of our total
investments, and approximately 3.2% of our capital. These holdings decreased
from $39.4 million at December 31, 2004 principally due to calls of preferred
equity securities. Our equity investments are diversified primarily among
domestic growth and value holdings through common and preferred stock.
Our investment in short-term securities at September 30, 2005 is $150.4
million as compared to $41.4 million at December 31, 2004. Approximately $40.1
million of this increase is attributable to NCRIC. We have elected to hold more
funds in short-term securities during 2005 in order to increase our investment
flexibility in an improving rate environment. As our investment managers
identify investment opportunities that are consistent with our 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 net reserves for losses at September 30, 2005 are $1.9 billion,
including NCRIC net reserves of $144 million, an increase of $309 million over
net reserves at December 31, 2004. These amounts are net of $465.3 million
receivable from reinsurers, of which $44.3 million is attributable to NCRIC.
Substantially all of this increase is in our professional liability segment,
which is 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.
23
Our long-term debt increased by $15.5 million as a result of the NCRIC
transaction. NCRIC's 2032 Subordinated Debentures are included in our
consolidated long-term debt at September 30, 2005. The 2032 Subordinated
Debentures mature in 2032, carry a floating variable rate equal to the
three-month Libor rate plus 4%, and are redeemable at our option after December
4, 2007. See Note 9 of the Notes to the Condensed Consolidated Financial
Statements for additional information.
As a result of the acquisition of NCRIC, ProAssurance assumed the risk of
loss for a judgment entered against NCRIC on February 20, 2004 by a District of
Columbia Superior Court in favor of Columbia Hospital for Women Medical Center,
Inc. ("CHW") in the amount of $19.5 million (the "CHW judgment") which includes
costs associated with pursuing the post-trial motions and any appeal of a final
judgment and projected post-trial interest. NCRIC timely filed post-trial
motions requesting the trial court to set aside the CHW judgment or in the
alternative, to grant a new trial. In connection with the filing of the
post-trial motions, NCRIC posted a $19.5 million appellate bond and associated
letter of credit to secure payment of the CHW judgment. By order of September
30, 2005, the trial court denied all post-trial relief sought by NCRIC and NCRIC
has appealed the judgment. In accordance with SFAS 141, ProAssurance has
established a liability of $19.5 million for this judgment; this amount has been
included as a component of the fair value of assets acquired and liabilities
assumed in the allocation of the NCRIC purchase price.
As outlined in Note 3 to the Notes to the Condensed Consolidated Financial
Statements we plan to sell NCRIC's ConsiCare subsidiary and therefore ConsiCare
operating results are reported in Loss from Discontinued Operations. ConsiCare
principally provides administrative and financial services to physician
practices and such a business focus is not consistent with our strategy as a
specialty insurance company.
Off Balance Sheet Arrangements/Guarantees
As discussed in Note 9 of the Notes to the Condensed Consolidated
Financial Statements, our 2032 and 2034 Debentures are held by, and are the sole
assets of, related business trusts. The NCRIC Trust purchased the 2032
Debentures and the PRA Trust purchased the 2034 Debentures with proceeds from
related trust preferred stock (TPS) issued and sold by each trust. The terms and
maturities of the 2034 and 2032 Subordinated Debentures mirror those of the
related TPS. The NCRIC and PRA Trusts will use the debenture interest and
principal payments we pay into each trust to meet their TPS obligations. In
accordance with the guidance given in Financial Accounting Standards Board
Interpretation No. 46R, "Variable Interest Entities," (FIN 46R) the NCRIC and
PRA Trusts are not included in our consolidated financial statements because we
are not the primary beneficiary of either trust.
NCRIC and ProAssurance have issued guarantees that amounts paid to the
NCRIC and PRA Trusts related to the 2032 and 2034 Subordinated Debentures will
subsequently be remitted to the holders of the related TPS. The amounts
guaranteed are not expected to at any time exceed our obligations under the 2032
and 2034 Subordinated Debentures, and we have not recorded any additional
liability related to the guarantee.
24
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. The
personal lines segment primarily provides auto and homeowner insurance to
members of the Michigan educational community and their families.
The professional liability segment is our largest segment and contributed
75% of our consolidated total revenues during the nine-month period ended
September 30, 2005. The professional liability segment holds 85% of consolidated
total assets at September 30, 2005 and 96% of our consolidated net loss reserves
at September 30, 2005 are professional liability reserves. The professional
liability segment principally operates through four insurance subsidiaries: The
Medical Assurance Company, Inc., ProNational Insurance Company, NCRIC, Inc. and
Red Mountain Casualty Insurance Company, Inc.
Our personal lines segment includes the operations of a single insurance
company, MEEMIC Insurance Company. As discussed in Note 13 to the accompanying
Condensed Consolidated Financial Statements (unaudited) ProAssurance has
entered into a definitive agreement to sell the subsidiaries that comprise its
personal lines segment. The transaction is expected to close early in the first
quarter of 2006; however, the transaction is contingent upon obtaining certain
insurance and anti-trust regulatory approvals.
Revenues and expenses from continuing operations are attributable to the
operating segments with the exception of corporate income, which for all periods
presented, consists solely of investment income and net realized investment
gains (losses) earned directly by the parent holding company as well as interest
expense related to long-term debt. Operating results by segment for the three
and nine months ended September 30, 2005 and 2004 are summarized below. The
operating results below include the operating results of NCRIC since the date of
acquisition on August 3, 2005.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
----------------------------------- -----------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- --------- --------- --------- --------- ---------
In thousands
Income from continuing operations
before income taxes:
Professional liability segment $ 28,715 $ 14,905 $ 13,810 $ 76,028 $ 37,629 $ 38,399
Personal lines segment 13,826 10,496 3,330 37,902 31,035 6,867
Corporate (not attributed to
segments) (1,671) (44) (1,627) (4,681) (1,183) (3,498)
--------- --------- --------- --------- --------- ---------
Consolidated $ 40,870 $ 25,357 $ 15,513 $ 109,249 $ 67,481 $ 41,768
========= ========= ========= ========= ========= =========
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 in response to those
trends. However, 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 or to maintain existing margins on renewal business.
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.
25
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. While we focus on increasing the current
yield of the portfolio, we consider total 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 liability 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.
26
RESULTS OF OPERATIONS - THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005
COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004
Selected consolidated financial data for each period is summarized in the
table below.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------------------- -------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- --------- ---------- --------- ------- ----------
$ in thousands
Revenues:
Gross premiums written $ 224,559 $ 217,812 $ 6,747 $ 601,589 $ 600,295 $ 1,294
========= ========= ========== ========= ========= =========
Net premiums written $ 203,405 $ 198,370 $ 5,035 $ 539,794 $ 538,085 $ 1,709
========= ========= ========== ========= ========= =========
Premiums earned $ 214,547 $ 196,185 $ 18,362 $ 601,457 $ 569,583 $ 31,874
Premiums ceded (24,208) (20,839) (3,369) (64,818) (60,497) (4,321)
--------- --------- ---------- --------- -------- ---------
Net premiums earned 190,339 175,346 14,993 536,639 509,086 27,553
Net investment income 28,078 22,659 5,419 79,646 63,192 16,454
Net realized investment
gains (losses) (635) 3,063 (3,698) 1,761 7,346 (5,585)
Other income 1,539 827 712 4,612 3,069 1,543
--------- --------- ---------- --------- -------- ---------
Total revenues 219,321 201,895 17,426 622,658 582,693 39,965
--------- --------- ---------- --------- -------- ---------
Expenses:
Losses and loss adjustment
expenses 158,625 163,583 (4,958) 460,084 477,966 (17,882)
Reinsurance recoveries (15,980) (19,302) 3,322 (47,153) (54,986) 7,833
--------- --------- ---------- --------- -------- ---------
Net losses and loss
adjustment expenses 142,645 144,281 (1,636) 412,931 422,980 (10,049)
Underwriting, acquisition
and insurance expenses 33,516 30,355 3,161 94,021 87,695 6,326
Interest expense 2,290 1,902 388 6,457 4,537 1,920
--------- --------- ---------- --------- -------- ---------
Total expenses 178,451 176,538 1,913 513,409 515,212 (1,803)
--------- --------- ---------- --------- -------- ---------
Income from continuing
operations before income taxes 40,870 25,357 15,513 109,249 67,481 41,768
Income taxes 11,488 5,839 5,649 30,465 16,179 14,286
--------- --------- ---------- --------- -------- ---------
Income from continuing operations 29,382 19,518 9,864 78,784 51,302 27,482
Loss from discontinued
operations, net of tax (45) - (45) (45) - (45)
--------- --------- ---------- --------- -------- ---------
Net Income $ 29,337 $ 19,518 $ 9,819 $ 78,739 $ 51,302 $ 27,437
========= ========= ========== ========= ========= ==========
Net loss ratio 74.9% 82.3% (7.4) 76.9% 83.1% (6.2)
Underwriting expense ratio 17.6% 17.3% 0.3 17.5% 17.2% 0.3
--------- --------- ---------- --------- -------- ---------
Combined ratio 92.5% 99.6% (7.1) 94.4% 100.3% (5.9)
Less: Investment income ratio 14.8% 12.9% 1.9 14.8% 12.4% 2.4
--------- --------- ---------- --------- -------- ---------
Operating ratio 77.7% 86.7% (9.0) 79.6% 87.9% (8.3)
========= ========= ========== ========= ======= =========
Return on equity * 16.8% 13.6% 3.2 15.6% 12.0% 3.6
========= ========= ========== ========= ======= =========
* Net income, annualized, divided by the average of beginning and ending
stockholders' equity.
27
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 long-term average 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 professional liability 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.
EFFECT OF NCRIC ACQUISITION
We acquired NCRIC on August 3, 2005 and our results for the three- and
nine-month periods ended September 30, 2005 include NCRIC results since the date
of acquisition only. As a means of illustrating the effect of the NCRIC
transaction on our September 30, 2005 results for the period, the tables that
follow reflect NCRIC results as a separate line item. Unless otherwise
indicated, explanations of variances between operating periods are presented
exclusive of the amounts attributed to NCRIC operations.
PREMIUMS
GROSS PREMIUMS WRITTEN
------------------------------------------------------------------ --------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
----------------------------------------------- -------------------------------- ---------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
--------- ----------- -------------------- ---------- ---------- -----------------
$ in thousands
PROFESSIONAL LIABILITY:
Without NCRIC $ 156,419 $ 160,461 $ (4,042) (2.5%) $ 423,852 $ 438,194 $ (14,342) (3.3%)
NCRIC 10,889 - 10,889 n/a 10,889 - 10,889 n/a
--------- ----------- ------------ ---------- ---------- ---------
167,308 160,461 6,847 4.3% 434,741 438,194 (3,453) (0.8%)
PERSONAL LINES 57,251 57,351 (100) (0.2%) 166,848 162,101 4,747 2.9%
--------- ----------- ------------ ---------- ---------- ---------
CONSOLIDATED $ 224,559 $ 217,812 $ 6,747 3.1% $ 601,589 $ 600,295 $ 1,294 0.2%
========= =========== ============ ========== ========== =========
Professional liability premiums written have increased in both the three-
and nine-month periods of 2005 as a result of the acquisition of NCRIC. This
acquisition is consistent with our stated strategy to grow premiums both
organically and through selective acquisitions.
28
Professional liability premiums written 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.
Excluding the effect of NCRIC, declines in the premiums written for tail
policies are the primary reason that professional liability premiums have
decreased overall in both the three- and the nine-month periods of 2005 as
compared to the same periods of 2004, even though these premiums comprise less
than 10% of total premiums written in any period of 2005 or 2004. 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 ranged from $4.9 million to
$15.3 million per quarter. The three- and nine-month periods in 2005 included
tail premiums of $7.2 million and $20.3 million, which is $2.7 million and $9.7
million lower, respectively, than in the same periods in 2004. Physician lines
comprise more than 85% of our total professional liability premiums written in
both the three- and nine-month periods of 2005 and 2004. Physician premiums
related to non-tail coverages increased $2 million in the three months ended
September 30, 2005 as compared to the same period last year. On a year-to-date
basis, 2005 non-tail physician coverages are approximately $3 million lower than
in 2004.
We believe our rates are now adequate to support our ROE goals. While we
continue our focus on premium adequacy, the cumulative increase in our rates
during the past several years means that we do not generally require the same
level of rate increases in 2005 that we have required in prior years. During the
three and the nine months ended September 30, 2005, rates on renewed physician
policies averaged 12% to 13% higher than the expiring premiums. Retention
improved in 2005, averaging 87% in the third quarter and 86% year-to-date as
compared to an average of 85% and 84% for the three and nine months ended
September 30, 2004. The decline in our professional liability premiums for the
year-to-date period is due to a number of different factors. We are writing more
of our premiums in states in which we charge a lower rate per unit of risk and
some of our insureds are purchasing policies with smaller coverage limits. In
some markets, we are experiencing strong price-based competition for physician
business.
A decrease in hospital premiums also contributed to the total decline in
premiums written for both the three- and the nine-month periods. Such business
is highly price sensitive. As in all our lines, we choose not to compete
primarily on price because our focus is on maintaining adequate margins in the
policies we sell. Thus, our hospital premiums fluctuate based on competitive
forces largely beyond our control.
Personal lines premium revenues are almost entirely comprised of auto and
homeowner premiums with auto premiums representing between 77% and 80% of
written premiums in each period. For the quarter ended September 30, 2005 auto
premiums decreased by approximately $1.1 million due both to a 1.4% decrease in
the number of insured autos and the implementation of additional policy
discounts for qualifying insureds. On a year-to-date basis, as compared to 2004,
auto premiums are up $1.7 million due to increases in the value of insured
autos. Homeowner premiums grew by approximately $1.0 million for the quarter and
$3.0 million for the year-to-date period. The increase in homeowner premiums is
attributable both to an increase in the number of insured homes and to higher
home values.
29
PREMIUMS EARNED
------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
---------------------------------------------- --------------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
------------ ------------ ------------------ ------------ ------------ ----------------
$ in thousands
PROFESSIONAL LIABILITY:
Without NCRIC $ 145,245 $ 142,588 $ 2,657 1.9% $ 423,079 $ 414,382 $ 8,697 2.1%
NCRIC 13,822 - 13,822 n/a 13,822 - 13,822 n/a
------------ ------------ ------------ ------------ ------------ ----------
159,067 142,588 16,479 11.6% 436,901 414,382 22,519 5.4%
PERSONAL LINES 55,480 53,597 1,883 3.5% 164,556 155,201 9,355 6.0%
------------ ------------ ------------ ------------ ------------ ----------
CONSOLIDATED $ 214,547 $ 196,185 $ 18,362 9.4% $ 601,457 $ 569,583 $ 31,874 5.6%
============ ============ ============ ============ ============ ==========
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. Auto policies typically carry a six-month policy
period; other policies generally carry a policy period of one year. 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 late 2004,
reduced by lower tail premiums written in 2005 as discussed in the section on
premiums written.
PREMIUMS CEDED
-------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------------------------------- -------------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
----------- ---------- ------------------- ---------- ---------- --------------------
$ in thousands
PROFESSIONAL LIABILITY:
Without NCRIC $ 13,167 $ 13,413 $ (246) (1.8%) $ 39,030 $ 41,045 $ (2,015) (4.9%)
NCRIC 2,314 - 2,314 n/a 2,314 - 2,314 n/a
----------- ---------- ----------- ---------- ---------- -----------
15,481 13,413 2,068 15.4% 41,344 41,045 299 0.7%
PERSONAL LINES 8,727 7,426 1,301 17.5% 23,474 19,452 4,022 20.7%
----------- ---------- ----------- ---------- ---------- -----------
CONSOLIDATED $ 24,208 $ 20,839 $ 3,369 16.2% $ 64,818 $ 60,497 $ 4,321 7.1%
=========== ========== =========== ========== ========== ===========
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. The decrease in premiums ceded shown for the comparative three-month and
nine-month periods is principally related to small shifts in the geographic and
coverage mix of premiums earned in our professional liability segment 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.
30
LOSSES AND LOSS ADJUSTMENT EXPENSES
The estimation of medical professional liability losses is inherently
difficult. Injuries may not be discovered until years after an incident, or the
claimant may delay pursuing the recovery of damages. Ultimate loss costs, even
for similar events, vary significantly depending upon many factors, including
but not limited to the nature of the injury and the personal situation of the
claimant or the claimants' family, the judicial climate where the insured even
occurred, general economic conditions and the trend of health care costs.
Medical liability claims are typically resolved over an extended period of time,
often five years or more. The combination of changing conditions and the
extended time required for claim resolution results in a loss cost estimation
process that requires actuarial skill and the application of judgment, and such
estimates require periodic revision.
Losses for the personal lines segment primarily result from property
claims. Such claims are typically settled and paid without litigation within one
year after the claim is reported. The personal lines segment also incurs losses
due to personal liability claims. Personal liability losses more closely
resemble medical professional liability losses and are more complex to estimate.
Injuries and their severity are subject to litigation and may take some years to
determine.
In establishing reserves for loss and loss adjustment expenses 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 indicate. Any adjustments necessary are reflected in the then
current operations.
As a result of the variety of factors that must be considered by
management there is a significant risk that actual incurred losses will develop
differently from these estimates. We use a variety of actuarial methodologies in
performing these analyses. Among the methods that we have used are:
- Paid development method
- Reported development method
- Bornhuetter-Ferguson method (professional liability)
- Average paid value method (professional liability)
- Average reported value method (professional liability)
- Backward recursive method (professional liability)
- Paid Cape Cod method (personal lines)
- Incurred Cape Cod method (personal lines)
- Expected loss ratio method (personal lines)
31
Generally, methods such as the Bornheutter-Ferguson method and the Cape
Cod method are used on more recent accident years where we have less development
on which to base our analysis. As business seasons and we have an increased
amount of data for a given accident year we begin to give more confidence to the
development and average methods as these methods typically rely more heavily on
our own historical data. Each method is used because it has its own set of
assumptions or provides a different perspective on the particular business under
review.
The various actuarial methods discussed above are applied in a consistent
manner from period to period. In addition, we perform statistical reviews of
claim data such as claim counts, average settlement costs and severity trends.
In performing these analyses we partition our business by type, coverage
type, geography, layer of coverage and accident year. This procedure is intended
to balance the use of the most representative data for each partition, capturing
its unique patterns of development and trends. For each partition the results of
the various methods, along with the supplementary statistical data regarding
such factors as the current economic environment are used to develop a point
estimate based upon management's judgment and past experience. The process of
selecting the point estimate from the set of possible outcomes produced by the
various actuarial methods is based upon the judgment of management and is not
driven by formulaic determination. For each partition of our business we select
a point estimate with due regard for the age, characteristics and volatility of
the partition of the business, the volume of data available for review and past
experience with respect to the accuracy of estimates for business of a similar
type. This series of selected point estimates is then combined to produce an
overall point estimate for ultimate losses for each segment of our operations.
In order to provide additional information regarding the loss estimation
process we are in the process of developing a sensitivity analysis that will
help to highlight the potential variability of our estimates and will disclose
them in future reports when we have completed our analysis.
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.
32
The following tables summarize net losses and net loss ratios for the
three and nine months ended September 30, 2005 and 2004 by separating losses
between the current accident year and all prior accident years.
NET LOSSES
-------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------------------------- ---------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
---------- ----------- ------------ ------------ ---------- ------------
$ In thousands
CALENDAR YEAR
PROFESSIONAL LIABILITY:
Without NCRIC $ 107,734 $ 116,682 $ (8,948) $ 321,309 $ 339,701 $ (18,392)
NCRIC 10,164 - 10,164 10,164 - 10,164
---------- ----------- ------------ ------------ ---------- ------------
117,898 116,682 1,216 331,473 339,701 (8,228)
PERSONAL LINES 24,747 27,599 (2,852) 81,458 83,279 (1,821)
---------- ----------- ------------ ------------ ---------- ------------
CONSOLIDATED $ 142,645 $ 144,281 $ (1,636) $ 412,931 $ 422,980 $ (10,049)
========== =========== ============ ============ ========== ============
CURRENT ACCIDENT YEAR
PROFESSIONAL LIABILITY:
Without NCRIC $ 112,734 $ 116,682 $ (3,948) $ 331,309 $ 339,701 $ (8,392)
NCRIC 10,164 - 10,164 10,164 - 10,164
---------- ----------- ------------ ------------ ---------- ------------
122,898 116,682 6,216 341,473 339,701 1,772
PERSONAL LINES 27,489 31,016 (3,527) 87,916 92,190 (4,274)
---------- ----------- ------------ ------------ ---------- ------------
CONSOLIDATED $ 150,387 $ 147,698 $ 2,689 $ 429,389 $ 431,891 $ (2,502)
========== =========== ============ ============ ========== ============
PRIOR ACCIDENT YEAR
PROFESSIONAL LIABILITY:
Without NCRIC $ (5,000) $ - $ (5,000) $ (10,000) $ - $ (10,000)
NCRIC - - - - - -
---------- ----------- ------------ ------------ ---------- ------------
(5,000) - (5,000) (10,000) - (10,000)
PERSONAL LINES (2,742) (3,417) 675 (6,458) (8,911) 2,453
---------- ----------- ------------ ------------ ---------- ------------
CONSOLIDATED $ (7,742) $ (3,417) $ (4,325) $ (16,458) $ (8,911) $ (7,547)
========== =========== ============ ============ ========== ============
33
NET LOSS RATIOS*
--------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
--------------------------------------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
---- ---- ---------- ---- ---- ---------
CALENDAR YEAR
PROFESSIONAL LIABILITY:
Without NCRIC 81.6% 90.3% (8.7) 83.7% 91.0% (7.3)
NCRIC 88.3% - n/a 88.3% - n/a
Total professional liability 82.1% 90.3% (8.2) 83.8% 91.0% (7.2)
PERSONAL LINES 52.9% 59.8% (6.9) 57.7% 61.3% (3.6)
CONSOLIDATED 74.9% 82.3% (7.4) 76.9% 83.1% (6.2)
CURRENT ACCIDENT YEAR
PROFESSIONAL LIABILITY:
Without NCRIC 85.4% 90.3% (4.9) 86.3% 91.0% (4.7)
NCRIC 88.3% - n/a 88.3% - n/a
Total professional liability 85.6% 90.3% (4.7) 86.3% 91.0% (4.7)
PERSONAL LINES 58.8% 67.2% (8.4) 62.3% 67.9% (5.6)
CONSOLIDATED 79.0% 84.2% (5.2) 80.0% 84.8% (4.8)
FAVORABLE DEVELOPMENT
RELATED TO PRIOR ACCIDENT YEARS
PROFESSIONAL LIABILITY:
Without NCRIC (3.8%) - (3.8) (2.6%) - (2.6)
NCRIC - - n/a - - n/a
Total professional liability (3.5%) - (3.5) (2.5%) - (2.5)
PERSONAL LINES (5.9%) (7.4%) 1.5 (4.6%) (6.6%) 2.0
CONSOLIDATED (4.1%) (1.9%) (2.2) (3.1%) (1.7%) (1.4)
* Net losses as specified divided by net premiums earned.
Professional liability current accident year net loss ratios are lower in
2005 as compared to 2004 due to several factors. We have focused for several
years on developing and maintaining adequate rates. As premium adequacy has
improved, loss ratios have decreased. Also, our expected loss ratios vary based
upon geographic location, coverage type and coverage limits. In 2005 as compared
to 2004, changes in the mix of insured risks reduced expected loss ratios.
During both the second and third quarters of 2005 we recognized favorable
development of $5 million related to our previously established professional
liability reserves, primarily to reflect small reductions in our estimates of
claim severity for accident years 2002 and prior.
Personal lines current accident year loss ratios have decreased because
the frequency of auto damage claims has decreased, particularly for bodily
injury claims. Also, the frequency and severity of homeowner damage claims have
decreased as compared to 2004, largely due to more favorable weather conditions
in 2005. We experienced favorable development in the personal lines segment of
$2.7 million and $3.4 million for the three months, and $6.5 million and $8.9
million for the nine months ended September 30, 2005 and 2004, respectively,
primarily related to prior year loss reserves for auto bodily injury claims for
accident years 2004 and prior.
34
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.
NET INVESTMENT INCOME
-------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
---------------------------------- -------------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
-------- -------- -------------- -------- -------- -----------------
$ in thousands
PROFESSIONAL LIABILITY:
Without NCRIC $ 22,914 $ 19,480 $ 3,434 17.6% $ 67,276 $ 54,569 $ 12,707 23.3%
NCRIC 1,341 - 1,341 n/a 1,341 - 1,341 n/a
-------- -------- ------- -------- -------- --------
24,255 19,480 4,775 24.5% 68,617 54,569 14,048 25.7%
PERSONAL LINES 3,230 2,645 585 22.1% 9,337 7,942 1,395 17.6%
Not attributed to segments 593 534 59 11.0% 1,692 681 1,011 >100.0%
-------- -------- ------- -------- -------- --------
CONSOLIDATED $ 28,078 $ 22,659 $ 5,419 23.9% $ 79,646 $ 63,192 $ 16,454 26.0%
======== ======== ======= ==== ======== ======== ======== ======
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 maturing 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, including NCRIC, was 4.26% and 4.16% for the
three and nine months ended September 30, 2005 as compared to 4.07% and 4.05%
for the three and nine months ended September 30, 2004. Our average tax
equivalent income yield on a consolidated basis, including NCRIC, was 4.86% and
4.76% for the three and nine months ended September 30, 2005 as compared to
4.53% and 4.47% for the three and nine months ended September 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.
The components of net realized investment gains (losses) are shown in the
following table.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ -------------------
2005 2004 2005 2004
-------- ------- --------- -------
$ in thousands
Net gains (losses) from sales $ 52 $ 1,839 $ 2,828 $ 4,776
Other-than-temporary impairment losses (728) - (1,072) -
Trading portfolio gains (losses) 41 1,224 5 2,570
------- ------- -------- -------
Net realized investment gains (losses) $ (635) $ 3,063 $ 1,761 $ 7,346
======= ======= ======== =======
35
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 expenses.
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. The
small increase in the personal lines expense ratio for the comparative three-
and nine-month periods principally reflects higher costs related to our required
participation in Michigan's program for high-risk insureds.
UNDERWRITING, ACQUISITION AND INSURANCE EXPENSES
------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
----------------------------------- ----------------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
------- ------- --------------- ------- ------- --------------
$ in thousands
PROFESSIONAL LIABILITY:
Without NCRIC $19,430 $19,054 $ 376 2.0% $58,545 $56,444 $ 2,101 3.7%
NCRIC 2,046 - 2,046 n/a 2,046 - 2,046 n/a
------- ------- ------- ------- ------- -------
21,476 19,054 2,422 12.7% 60,591 56,444 4,147 7.3%
PERSONAL LINES 12,040 11,301 739 6.5% 33,430 31,251 2,179 7.0%
------- ------- ------- ------- ------- -------
CONSOLIDATED $33,516 $30,355 $ 3,161 10.4% $94,021 $87,695 $ 6,326 7.2%
======= ======= ======= ======= ======= =======
EXPENSE RATIO
-------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
-------------------------- --------------------------
Increase Increase
2005 2004 (Decrease) 2005 2004 (Decrease)
----- ----- ---------- ----- ----- ----------
PROFESSIONAL LIABILITY:
Without NCRIC 14.7% 14.8% (0.1) 15.2% 15.1% 0.1
NCRIC 17.8% - n/a 17.8% - n/a
Total professional liability 15.0% 14.8% 0.2 15.3% 15.1% 0.2
PERSONAL LINES 25.8% 24.5% 1.3 23.7% 23.0% 0.7
CONSOLIDATED 17.6% 17.3% 0.3 17.5% 17.2% 0.3
* Underwriting, acquisition and insurance expenses divided by net premiums
earned.
Guaranty fund assessments (refunds) were approximately $458,000 and
$343,000 for the three and nine months ended September 30, 2005 as compared to
approximately $171,000 and $704,000 for the three and nine months ended
September 30, 2004, respectively.
INTEREST EXPENSE
Interest expense increased for the three and nine months ended September
30, 2005 as compared to the same periods in 2004 primarily because the average
amount of debt outstanding was higher in 2005. Our 2034 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. In August 2005, the NCRIC transaction further increased outstanding
debt by $15.5 million. Thus, our average outstanding debt was higher during both
the three-and the nine-month periods of 2005 as compared to the same periods of
2004.
36
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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
------------------ -----------------
2005 2004 2005 2004
---- ---- ---- ----
Statutory rate 35% 35% 35% 35%
Tax-exempt income (6%) (8%) (8%) (8%)
Other (1%) (4%) 1% (3%)
-- -- -- --
Effective tax rate 28% 23% 28% 24%
== == == ==
RECENT ACCOUNTING PRONOUNCEMENTS AND GUIDANCE
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), which superseded APB 25, Accounting for Stock Issued
to Employees (APB 25) and amends SFAS 95, Statement of Cash Flows. The
provisions of SFAS 123(R) require all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements based on their fair values. SFAS 123(R) also requires that 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. ProAssurance plans to adopt SFAS 123(R) on
January 1, 2006, the required effective date, using the "modified prospective"
method permitted by the statement and expects to value future grants of stock
options using the Black Scholes valuation method.
Under the "modified prospective" method stock-based compensation is
recognized under the requirements of SFAS 123(R) for all share-based payments
granted after the effective date of SFAS 123(R) and for the non-vested portion
of share-based payments granted prior to the adoption of SFAS 123(R). Under SFAS
123(R) compensation for non-vested share-based payments granted prior to
adoption shall continue to be calculated as disclosed under SFAS 123, except
that the effect of forfeitures is required to be estimated rather than
considered as forfeitures occur.
As permitted by SFAS 123, ProAssurance currently values employee
stock-based payments using APB 25's intrinsic value method. Accordingly,
ProAssurance generally recognizes no compensation cost related to such payments
but does provide pro forma disclosure of the effect on net income and earnings
per share of applying the fair value provisions of SFAS 123 to such payments
granted.
Had ProAssurance's SFAS 123 pro forma disclosures been prepared in
accordance with the provisions of SFAS 123(R) the effect would have been
different, however, the effect that SFAS 123(R) would have had on prior periods
is not readily determinable. SFAS 123(R) provides more extensive guidance than
does SFAS 123 with regard to factors that should be considered in valuing
share-based payments. Under SFAS 123(R), entities are required to "aggregate
individual awards into relatively homogeneous groups with respect to exercise
and post-vesting employment termination behaviors." Under SFAS 123, ProAssurance
utilized a single set of valuation assumptions for all employees. Additionally,
under SFAS 123(R), awards that vest upon retirement granted to employees who are
eligible for retirement should be expensed on the date of grant. Under SFAS 123,
ProAssurance calculated compensation expense (for pro forma disclosure) for all
awards based upon the vesting schedule for the award, and did not consider the
retirement eligibility of the recipient. Adoption of SFAS 123(R) will require
ProAssurance to establish numerous assumptions regarding the expected behavior
of ProAssurance employees as to continued employment, retirement, and option
exercises. ProAssurance's own history with regard to employee stock awards is
not sufficient to allow such assumptions to be developed statistically, and data
from other sources must also be considered. ProAssurance is in the process of
finalizing these assumptions, however, the selection of all assumptions is not
yet complete.
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 groups of employees to whom
the awards are granted, the terms of any future awards, as well as the methods
and assumptions used to determine the fair value of those share-based payments.
37
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 SFAS 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 nine months ended September
30, 2004 has been restated; the restatement reduced previously reported diluted
earning per share by $0.03 and $0.08, 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.
38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET 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. These risks are interest rate risk, credit risk
and equity price risk. We believe that we are principally exposed to three types
of market risk related to our investment operations.
As of September 30, 2005, the fair value of our investment in fixed
maturity securities was $2.613 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.
SEPTEMBER 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 $2,406 $(207) 4.25 $2,082 4.11
100 basis point rise $2,509 $(104) 4.13 $2,170 4.00
Current rate* $2,613 $ - 3.93 $2,258 3.81
100 basis point decline $2,715 $ 102 3.76 $2,344 3.70
200 basis point decline $2,818 $ 205 3.68 $2,434 3.79
* Current rates are as of September 30, 2005 and December 31, 2004
At September 30, 2005, the fair value of our investment in preferred
stocks was $5.1 million, including net unrealized losses of $130,000. 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 September 30,
2005 was on a cost basis which approximates its fair value. This portfolio lacks
significant interest rate sensitivity due to its short duration.
39
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 September 30, 2005, 98.0% 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 September 30, 2005 the fair value of our investment in common stocks
was $19.1 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 value of the S&P 500 Index increased by 10%, the fair value of
these securities would be expected to increase by 9.8% to $21.0 million.
Conversely, a 10% decrease in the S&P 500 Index would imply a decrease of 9.8%
in the fair value of these securities to $17.2 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 September 30, 2005. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures are effective.
Other than described below, there have been no significant changes in our
internal controls over financial reporting that have materially affected, or are
reasonably likely to materially affect those controls during the quarter.
Our management has concluded that it will exclude NCRIC's systems and
processes from the scope of ProAssurance's assessment of internal control over
financial reporting as of December 31, 2005 in reliance on the guidance set
forth in Question 3 of a "Frequently Asked Questions" interpretive release
issued by the staff of the Securities and Exchange Commission's Office of the
Chief Accountant and the Division of Corporation Finance in June 2004 (and
revised on October 6, 2004). We are excluding NCRIC from that scope because we
expect substantially all of its significant systems and processes to be
converted to those of ProAssurance during 2006.
40
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 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. Further, forward looking statements may also relate to our
recently announced sale of our personal lines subsidiaries, MEEMIC Insurance
Company and MEEMIC Insurance Services Corporations (the MEEMIC Companies),
including without limitation, the consideration to be received from the sale,
dividends to be declared in anticipation of the sale, the gain realized on the
sale and the use of proceeds derived from the sale, and our goals and
expectations with respect to the sale.
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.
41
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.
Risks that could adversely affect our sale of the MEEMIC companies include
but are not limited to the following:
- The transaction may not occur as expected or it may take longer to
accomplish than we expect;
- governmental approvals of the transaction may not be obtained, or adverse
regulatory conditions may be imposed in connection with governmental
approvals of the transaction;
- the sale is subject to the satisfaction or waiver of certain conditions
which are beyond the control of ProAssurance; and the distribution of
proceeds arising from the sale to
- ProAssurance may not be approved by governmental authorities, or such
approval may be for an amount less than requested.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Note 11 to the condensed consolidated financial statements.
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).
42
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
November 8, 2005
/s/ Edward L. Rand, Jr.
--------------------------------------------
Edward L. Rand, Jr., Chief Financial Officer
(Duly authorized officer and principal financial officer)
43