SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

Commission File Number: 000-32057

American Physicians Capital, Inc.

(Exact name of registrant as specified in its charter)

 

 

1301 North Hagadorn Road, East Lansing, Michigan 48823

(Address of principal executive offices)(Zip Code)

 

Registrant’s telephone number, including area code:
(517) 351-1150

 

Securities registered pursuant to Section 12(b) of the Act:
Common Stock, no par value

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES o     NO þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act  YES o     NO þ

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES þ     NO o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in a definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)  YES o     NO þ

 

The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of June 30, 2009, based on $29.38 per share (the last sale price for the Common Stock on such date as reported on the Nasdaq Global Select Market), was approximately $266.2 million. For purposes of this computation only, all executive officers, directors and 10% beneficial owners of the registrant are assumed to be affiliates.

 

As of February 28, 2010 the registrant had 9,709,687 shares of Common Stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive Proxy Statement pertaining to the 2010 Annual Meeting of Shareholders (the“Proxy Statement”) to be filed pursuant to Regulation 14A are incorporated by reference into Part III.

 

 

Explanatory Note

 

All of the share and per share data included in this Report on Form 10-K has been retroactively adjusted to reflect a four-for-three stock split, which was effective July 31, 2009. References to the Company, we, our and us are references to American Physicians Capital, Inc. and its subsidiaries unless the context otherwise requires. References to APCapital are references to the holding company, American Physicians Capital, Inc.

 

 

General

 

American Physicians Capital, Inc. is an insurance holding company that writes medical professional liability insurance through its primary subsidiary American Physicians Assurance Corporation, or American Physicians. Our principal offices are located at 1301 North Hagadorn Road, East Lansing, Michigan, 48823. Our website address is www.apcapital.com. All of our reports filed under the Securities Exchange Act of 1934 are available free of charge at our website promptly after they are filed. In addition, our code of ethics covering directors, officers and other employees, our corporate governance principles and Board committee charters, and insurance company statutory annual statement filings are also available on our website. Information contained on our website does not constitute part of this report.

 

APCapital was incorporated in Michigan in July 2000 to facilitate the conversion of American Physicians from a mutual insurance company to a publicly owned stock insurance company. APCapital’s stock began trading on the Nasdaq Stock Market’s National Market under the symbol “ACAP” on December 8, 2000. The conversion became effective, the offerings were closed and American Physicians and its subsidiaries became subsidiaries of APCapital on December 13, 2000.

 

American Physicians, our primary insurance subsidiary, was formed in June 1975 under the sponsorship of the Michigan State Medical Society in response to a medical professional liability insurance crisis in Michigan. Today American Physicians focuses on writing physician medical professional liability coverage in four core states: Michigan, Illinois, Ohio and New Mexico. The Company also writes a small amount of business in contiguous states.

Medical professional liability direct premiums written in our four core markets represented approximately 95% of the Company’s total direct premiums written in 2009, 2008 and 2007, as shown in the table below.

 

 

Products and Services.  We underwrite medical professional liability coverage for physicians, their corporations, medical groups, clinics and ancillary healthcare providers. Medical professional liability insurance protects physicians and other health care providers against liabilities arising from the rendering of, or failure to render, professional medical services. We offer claims-made coverage in all states in which we write business, with the exception of New Mexico, and occurrence policies in a limited number of states. Our policies include coverage for the cost of defending claims. Claims-made policies provide coverage to the policyholder for claims reported during the period of coverage. We offer extended reporting endorsements or tails to cover claims reported after the policy expires. Occurrence policies provide coverage to the policyholders for all losses incurred during the policy coverage year regardless of when the claims are reported. Although we generate a majority of our premiums from individual and small group practices, we also insure several major physician groups.

 

We offer separate policy forms for physicians who are sole practitioners and for those who practice as part of a medical group or clinic. The policy issued to sole practitioners includes coverage for professional liability that arises from the medical practice. The medical professional insurance for sole practitioners and for medical groups provides protection against the legal liability of the insureds for injury caused by or as a result of the performance of patient treatment, failure to treat, failure to diagnose and related types of malpractice. We offer two types of policies for medical groups or clinics. Under the first policy type, both the individual physician and the group share the same set of policy limits. Under the second policy type, the individual physician and the group or clinic each purchase separate policy limits. At December 31, 2009, we have approximately 8,800 policies in force in 7 states, with a concentration in our core Midwestern states of Michigan, Ohio, and Illinois, as well as New Mexico.

 

Marketing.  Our marketing philosophy is to sell profitable business in our core states, using a focused, multi-channeled, cost-effective distribution system. In addition to our agency force, we have built our sales and marketing efforts around several strategic business alliances, which primarily include medical society endorsements.

 

Our medical professional liability product line is marketed through approximately 45 agencies in six states. One strategic agency, SCW Agency Group, Inc. and its wholly owned subsidiary, Kentucky Medical Agency, collectively referred to as SCW, accounted for approximately 29% and 30% of medical professional liability direct

premiums written during 2009 and 2008, respectively. This relationship is discussed in more detail in “Item 1- Business-Important Agency Relationship.”

 

The majority of our remaining agents who write our medical professional liability insurance are independent agents. Due to the highly specialized nature of medical professional liability insurance, we are working to build a controlled distribution system to increase the percentage of our business that is produced through captive agents, which makes us less vulnerable to changes in market conditions. In 2009 and 2008, our captive agents generated 45% of our premiums, independent agents generated 40%, and we produced 15% of premiums on a direct basis without agent involvement. Our top ten agencies produced $75.6 million of direct premiums written, or 67% of total premium writings in 2009.

 

The Michigan State Medical Society, or MSMS, has endorsed American Physicians as its exclusive professional liability carrier of choice for 34 years. We compensate MSMS for marketing our professional medical liability products to MSMS members. American Physicians is also endorsed by the Michigan Osteopathic Association, the New Mexico Medical Society, several specialty societies and numerous physician organizations.

 

Underwriting and Pricing.  Most of our initial underwriting work and customer contact is performed through a centralized process based in our home office. The home office underwriting department has final responsibility for the issuance, establishment and implementation of underwriting standards for all of our underwritten coverages. The local office underwriting staff has the authority to evaluate, approve and issue medical professional liability coverage for individual providers and medical groups with annual premiums that do not exceed present threshold amounts or guidelines imposed by the home office.

 

Through our management and actuarial staff, we regularly establish rates and rating classifications for our physician and medical group insureds based on the loss and loss adjustment expense, or LAE, experience we have developed over the past 34 years, and the loss and LAE experience for the entire medical professional liability market. We have various rating classifications based on practice location, medical specialty and other liability factors. We also utilize various discounts, such as claim-free credits, to encourage low risk physicians to insure with American Physicians.

 

The nature of our business requires that we remain sensitive to the marketplace and the pricing strategies of our competitors. Using the market information as our background, we normally set our prices based on our estimated future costs. From time to time, we may reduce our discounts or apply a premium surcharge to achieve an appropriate return. Pricing flexibility allows us to provide a fair rate commensurate with the assumed liability. If our pricing strategy cannot yield sufficient premium to cover our costs on a particular type of risk, we may determine not to underwrite that risk. It is our philosophy not to sacrifice profitability for premium growth.

 

Claims Management.  Our policies require us to provide a defense for our insureds in any suit involving a medical incident covered by the policy. The defense costs we incur are in addition to the limit of liability under the policy. Medical professional liability claims often involve the evaluation of highly technical medical issues, severe injuries and conflicting expert opinions.

 

Our strategy for handling medical professional liability claims combines a basic philosophy of vigorously defending against non-meritorious claims with a commitment to provide outstanding service to our insured physicians. Our claims department is responsible for claims investigation, establishment of appropriate case reserves for loss and loss adjustment expenses, defense planning and coordination, working closely with attorneys engaged by us to defend a claim and negotiation of the settlement or other disposition of a claim. We emphasize early evaluation and aggressive management of claims. A part of our overall claims strategy is to establish regional claims departments in our major markets. This local presence helps to facilitate better defense attorney coordination by allowing us to meet with defense attorneys and policyholders, and to develop claims staff that has experience with the region’s legal environment, which enables us to more accurately establish case reserves.

 

Our insurance subsidiaries are required by applicable insurance laws and regulations to maintain reserves for payment of losses and loss adjustment expenses for reported claims and for claims incurred but not reported, arising from policies that have been issued. Generally, these laws and regulations require that we provide for the ultimate cost of those claims without regard to how long it takes to settle them or the time value of money. We are also required to maintain reserves for extended reporting coverage we provide in the event of a physician’s death,

disability and retirement, or DDR reserves, which are included in our loss reserves as a component of the incurred but not reported, or IBNR, reserves. The determination of reserves involves actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of such claims based on facts and circumstances then known, estimates of future trends in claims severity, and other variable factors such as inflation and changing judicial theories of liability.

 

Our actuaries utilize standard actuarial techniques to project ultimate losses based on our paid and incurred loss information, as well as drawing from industry data. These projections are done using actual loss dollars and claim counts. We analyze loss trends and claims frequency and severity to determine our “best estimate” of the required reserves. We then record this best estimate in the Company’s financial statements. Our reserve methodology is discussed in greater detail in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Statutory accounting principles require reserves to be reported net of reinsurance. Accounting principles generally accepted in the United States of America, or GAAP, require reserves to be reported on a gross basis, i.e., before reinsurance, with a corresponding asset established for the reinsurance recoverable. When compared on a net basis, our statutory and GAAP reserves are identical, with the exception of DDR reserves of approximately $11.8 million and $13 million, at December 31, 2009 and 2008, respectively, which are required to be carried as unearned premium reserves for statutory accounting purposes.

 

Reinsurance.  In accordance with industry practice, we cede to other insurance companies some of the potential liability under insurance policies we have underwritten. This practice, called reinsurance, helps us reduce our net liability on individual risks, stabilize our underwriting results and increase our underwriting capacity. However, if the reinsurer fails to meet its obligations, we remain liable for policyholder obligations. As payment for sharing a portion of our risk, we are also required to share a part of the premium we receive on the related policies. We determine the amount and scope of reinsurance coverage to purchase each year based upon an evaluation of the risks accepted, consultations with reinsurance brokers and a review of market conditions, including the availability and pricing of reinsurance. Our reinsurance arrangements are generally renegotiated annually.

 

The following table identifies our principal reinsurers, their percentage of our aggregate reinsured risk based upon amounts recoverable and their respective A.M. Best ratings as of December 31, 2009. A.M. Best Company classifies an “A” rating as “Excellent” and an “A+” rating as “Superior.”

 

 

The recoverable from Hannover Ruckversicherungs, or Hannover, is secured by assets that Hannover maintains in Master U.S. Reinsurance Trust domiciled in New York. We are not aware of any collectability or credit issues with any of our reinsurers as of December 31, 2009.

 

Capital and Surplus.  To ensure the security of our policyholders, we must maintain an amount of qualifying assets in excess of total liabilities. This excess, or “surplus,” is the principal measure used by state insurance regulators, and rating agencies such as A.M. Best Company, to evaluate our financial strength. Medical professional liability insurers generally attempt to keep this surplus level at least equal to their annual net premiums written. The net premiums written to surplus ratio for our insurance subsidiaries were 0.53:1 and 0.59:1 at December 31, 2009 and 2008, respectively.

 

Competition

 

The medical professional liability insurance industry is highly competitive. We compete with numerous insurance companies and various self-insurance mechanisms. We believe that the principal competitive factors in

our insurance business are service, quality, name recognition, breadth and flexibility of coverages, financial stability and, to a lesser degree, price. We believe we compare favorably with many of our competitors based on our excellent service to customers, our close relationship with the medical community, primarily through various medical societies, which affords us a high degree of name recognition, our ability to customize product features and programs to fit the needs of our customers and our long history of financial stability. These factors will vary by state based on the relative strength of our competitors in each market.

 

A.M. Best Company Rating

 

A.M. Best Company, or A.M. Best, rates the financial strength and ability to meet policyholder obligations of our insurance subsidiaries. Our primary insurance subsidiary, American Physicians, has an A.M. Best rating of A-, which is the fourth highest of 15 rating levels. The A- rating is considered Excellent, and according to A.M. Best, companies rated A- are deemed “secure.” A.M. Best assigns an A- rating to insurers that have, on average, excellent balance sheet strength, operating performance and business profiles when compared to the standards established by A.M. Best, and in A.M. Best’s opinion, have an excellent ability to meet their ongoing obligations to policyholders. An insurance company’s rating is a potential source of competitive advantage or disadvantage in the marketplace.

 

Rating agencies such as A.M. Best evaluate insurance companies based on their financial strength and ability to pay claims, factors that are more relevant to policyholders and potential customers who are purchasing insurance, as well as agents who are advising customers, than investors. Financial strength ratings by rating agencies are not ratings of securities or recommendations to buy, hold, or sell any security.

 

Important Agency Relationship

 

One of the primary agencies through which we write medical professional liability insurance is SCW Agency Group, Inc., or SCW. SCW is principally owned by William B. Cheeseman, our former president and chief executive officer and director. Mr. Cheeseman ceased to be an employee of the Company at the end of 2003 and ceased to be a director in 2004.

 

Direct premiums written for us by SCW during 2009, 2008 and 2007 totaled $32.6 million, $37.6 million and $43.1 million respectively, representing 28.8%, 30.0% and 31.9% of the Company’s direct premiums written during such years. Commission expense we incurred related to SCW approximated $2.6 million, $2.9 million and $3.3 million in 2009, 2008 and 2007, respectively. The commission rates we have paid to SCW have been the same as the commission rates we paid to our other agents.

 

Effective January 2009, we renewed for another five years our contract with SCW. The agreement provides for American Physicians to be the exclusive medical professional liability carrier SCW represents in the states of Michigan, Illinois and Ohio, subject to limited exceptions, such as a downgrade of our A.M. Best rating. We continue to have the right to appoint other agents in all three of these states. SCW may continue to represent other insurance companies in states other than Michigan, Illinois and Ohio for lines of business other than medical professional liability. The contract provides for SCW to be paid commissions consistent with the marketplace.

 

Insurance Regulatory Matters

 

General.  Insurance companies are subject to supervision and regulation relating to numerous aspects of their business and financial condition in the states in which they transact business. The nature and extent of such regulation varies from jurisdiction to jurisdiction. Our insurance companies are subject to supervision and regulation by the Office of Financial and Insurance Regulation for the State of Michigan, or OFIR, and other state departments of insurance. These regulators establish standards of solvency, license insurers and agents, establish guidelines for investments by insurers, review premium rates, review the provisions which insurers must make for current losses and future liabilities, review transactions involving a change in control and require the filing of periodic reports relating to financial condition. In addition, state regulatory examiners, including OFIR, perform periodic financial examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders.

American Physicians is licensed to write insurance in a total of 16 states. However, our current focus of operations is on our core states in the Midwest and New Mexico.

 

Holding Company Regulation.  Most states, including Michigan, have enacted legislation that regulates insurance holding company systems such as ours. Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. These laws permit OFIR or any other relevant insurance departments to examine APCapital’s insurance subsidiaries at any time, to require disclosure of material transactions between APCapital and its insurance subsidiaries, and to require prior approval of sales or purchases of a material amount of assets and the payment of extraordinary dividends. OFIR conducted a financial examination as of December 31, 2006 of each of our insurance subsidiaries. No adjustments were proposed as a result of the examinations.

 

Holding company laws also limit the amount of dividends payable by insurance subsidiaries to the parent company. Under Michigan law, the maximum dividend that may be paid to APCapital from its insurance subsidiaries during any twelve-month period, without prior approval of OFIR, is the greater of 10% of each insurance company’s statutory surplus, as reported on the most recent annual statement filed with OFIR, or the statutory net income, excluding realized gains, for the period covered by such annual statement. Accordingly, $40.2 million of dividends can be paid in 2010 without prior regulatory approval. However, as dividends totaling $45.0 million were paid in 2009, the $40.2 million that can be paid in 2010 is subject to limitation based on the timing and amount of the dividends that were paid in the preceding 12 months.

 

Change of Control.  The Michigan Insurance Code requires that OFIR receive prior notice of and approve a change of control for APCapital or any of its Michigan-domiciled insurance subsidiaries. The Michigan Insurance Code contains a complete definition of “control.” In simplified terms, a person, corporation, or other entity would obtain “control” of American Physicians or APCapital if they possessed, had a right to acquire possession, or had the power to direct any other person acquiring possession, directly or indirectly, of 10% or more of the voting securities of either company. To obtain approval for a change of control, the proposed acquirer must file an application with OFIR containing detailed information such as the identity and background of the acquirer and its affiliates, the sources of and amount of funds to be used to effect the acquisition, and financial information regarding the proposed acquirer.

 

Risk-Based Capital Requirements.  In addition to other state-imposed insurance laws and regulations, OFIR enforces requirements developed by the National Association of Insurance Commissioners, or NAIC, that require insurance companies to calculate and report information under a risk-based formula that attempts to measure capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. Under the formula, we first determine our risk-based capital base level by taking into account risks with respect to our assets and underwriting risks relating to our liabilities and obligations. We then compare our “total adjusted capital” to the base level. Our “total adjusted capital” is determined by subtracting our liabilities from our assets in accordance with rules established by OFIR.

 

A ratio of total adjusted capital to risk-based capital of less than 2.0 may give rise to enhanced regulatory scrutiny or even a regulatory takeover of the insurer, depending on the extent to which the ratio is less than 2.0. The risk-based capital ratio for American Physicians has always exceeded 2.0. As of December 31, 2009, American Physicians’ risk-based capital base level was $42.7 million and its total adjusted capital was $208.7 million, for a ratio of 4.9.

 

IRIS Requirements.  The NAIC has also developed a series of 13 financial ratios, referred to as the Insurance Regulatory Information System, or IRIS, for use by state insurance regulators in monitoring the financial condition of insurance companies. The NAIC has established an acceptable range of values for each of the IRIS financial ratios. Generally, an insurance company will become the subject of increased scrutiny when four or more of its IRIS ratio results fall outside the range deemed acceptable by the NAIC. The nature of increased regulatory scrutiny resulting from IRIS ratio results outside the acceptable range is subject to the judgment of the applicable state insurance department, but generally will result in accelerated reviews of annual and quarterly filings. In 2009, American Physicians did not generate any IRIS ratios that varied from values within the NAIC’s acceptable range.

Guaranty Fund.  We participate in various guaranty associations in the states in which we write business that protect policyholders and claimants against losses due to insolvency of insurers. When an insolvency occurs, the associations are authorized to assess member companies up to the amount of the shortfall of funds, including expenses. Member companies are assessed based on the type and amount of insurance written during the previous calendar year. We make estimated accruals for our portion of the assessments as information becomes available.

 

Employees

 

As of December 31, 2009, we had 145 employees.  None of the employees are covered by a collective bargaining unit and we believe that employee relations are good.

 

Uncertainties Relating To Forward-Looking Statements

 

Our reports, filings and other public announcements contain certain statements that describe our management’s beliefs concerning future business conditions and prospects, growth opportunities and the outlook for our business and industry based upon information currently available. Such statements are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. Wherever possible, we have identified these statements with words such as “will,” “should,” “likely,” “believes,” “expects,” “anticipates,” “estimates,” “plans” or similar expressions. Our forward-looking statements are subject to risks and uncertainties and represent our outlook only as of the date of this report.

 

We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all of our forward-looking statements. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any such forward-looking statements, which speak only as of the date made. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Factors that might cause such a difference include, without limitation, the risks and uncertainties discussed from time to time in our reports filed with the Securities and Exchange Commission, including those listed in “Item 1A — Risk Factors” in this report.

 

Other factors not currently anticipated by management may also materially and adversely affect our financial condition, liquidity or results of operations. Except as required by applicable law, we do not undertake, and expressly disclaim, any obligation to publicly update or alter our statements whether as a result of new information, events or circumstances occurring after the date of this report or otherwise.

 

 

An investment in our common stock involves numerous risks and uncertainties. You should carefully consider the following information about these risks. Any of the risks described below could result in a significant or material adverse effect on our future results of operations, cash flows or financial condition. We believe the most significant of these risks and uncertainties are as follows:

 

Increased competition could adversely affect our ability to sell our products at premium rates we deem adequate, which may result in a decrease in premium volume.

 

The medical professional liability insurance business tends to cycle through what are often referred to as “hard” and “soft” markets. A hard market is generally characterized as a period of rapidly raising premium rates, tightened underwriting standards, narrowed coverage and the withdrawal of insurers from certain markets. Soft markets are usually characterized by relatively flat or moderate decreases in premium rates, less stringent underwriting standards, expanded coverage and strong competition among insurers. The medical professional liability insurance market is currently in a soft market. Recent industry wide favorable claim trends and the accompanying competitive pressures they bring could adversely impact our ability to obtain rate increases we deem necessary to adequately cover insured risks, which could ultimately result in a decrease in premium volume as physicians currently insured with us elect to place their coverage elsewhere.

Our reserves for unpaid losses and loss adjustment expenses are based on estimates that may prove to be inadequate to cover our losses.

 

The process of estimating the reserves for unpaid losses and loss adjustment expenses involves significant judgment and is complex and imprecise due to the number of variables and assumptions inherent in the estimation process. These variables include the effects on ultimate loss payments of internal factors such as changes in claims handling practices and changes in the mix of our products, as well as external factors such as changes in loss frequency and severity trends, economic inflation, judicial trends and legislative and regulatory changes. In addition, medical professional liability claims may take several years to resolve due to typical delays in reporting claims to us, the often lengthy discovery process, and the time necessary to defend the claim. Also, claims with similar characteristics may result in very different ultimate losses depending on the state or region where the claim occurred. All of these factors contribute to the variability in estimating ultimate loss payments, especially since the effects of many of these variables cannot be directly quantified, and may require us to make significant adjustments in our reserves from time to time. Any such adjustments could materially and adversely affect our results of operations for the period with respect to which the adjustment is made. Due to the current volatility of losses in the medical professional liability and workers’ compensation markets, adjustments have occurred in each of the last several years.

 

Market illiquidity and volatility associated with the recent financial crisis makes the fair values of our investments increasingly difficult to estimate, and may have other unforeseen consequences that we are currently unable to predict.

 

Investment securities traded in active markets are valued at quoted market prices. All other investment securities are valued based on broker quotes or through the use of various pricing models that require the application of judgment in selecting the appropriate assumptions based on observable or unobservable market data. Volatile and illiquid markets increase the likelihood that investment securities may not behave in historically predictable manners, resulting in fair value estimates that are either over or understated compared with actual amounts that could be realized upon disposition or maturity of the security.

 

In addition, the ultimate effects of the recent market volatility, credit crisis, and overall economic downturn may have unforeseen consequences on the credit quality, liquidity and financial stability of the issuers of securities we hold, or reinsurers with which we do business. As recent market experience indicates, such deteriorations in financial condition can occur rapidly, leaving us unable to react to such a scenario in a prudent manner consistent with our historical practices in dealing with more orderly markets. This in turn could adversely and negatively affect our results of operations, liquidity or financial condition.

 

An interruption or change in current marketing and agency relationships could reduce the amount of premium we are able to write.

 

We currently carry the endorsement of the Michigan State Medical Society, the New Mexico Medical Society, and other such organizations, which we believe provides us with a competitive advantage. If the endorsement of these organizations were to lapse, we could see a reduction in our premium volumes in markets such as Michigan and New Mexico, where such organizations carry influence. In addition, approximately 67% of our medical professional liability direct premiums written are produced by 10 agencies. One agency in particular, the SCW Agency Group, Inc., produced approximately 29% or more of our medical professional direct premiums written during each of the last several years. An interruption or change in the relationship with any of these agencies could adversely and materially impact the amount of premiums we are able to write.

 

If we are unable to obtain or collect on ceded reinsurance, our results of operations and financial condition may be adversely affected.

 

We use reinsurance arrangements to limit and manage the amount of risk we retain and stabilize our underwriting results. The amount and cost of reinsurance available to us is subject, in large part, to prevailing market conditions beyond our control. Our ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends in large part upon our ability to secure adequate reinsurance in amounts and at

rates that are commercially reasonable. Furthermore, we are subject to credit risk with respect to our reinsurers because reinsurance does not relieve us of liability to our insureds for the risks ceded to reinsurers. A significant reinsurer’s inability or refusal to reimburse us under the terms of our reinsurance agreements would result in a charge to income that could materially and adversely affect our results of operations and financial condition for the period in which the charge is incurred. The risk of a reinsurer defaulting on its obligations to us is typically greater in times of economic uncertainty, such as are currently being experienced around the world. Accordingly, we cannot be assured that we will continue to be able to obtain affordable reinsurance from creditworthy reinsurers.

 

Our geographic concentration in certain Midwestern states and New Mexico ties our performance to the business, economic, regulatory and legislative conditions in those states.

 

Nearly all of our medical professional liability direct premiums written in the last several years were written in the states of Illinois, Michigan, Ohio and New Mexico. Because of this concentration, unfavorable business, economic or regulatory conditions in these states could adversely impact the amount of premiums we are able to write, the costs associated with loss settlement and other expenses.

 

A downgrade in the A.M. Best Company rating of our primary insurance subsidiary could reduce the amount of business we are able to write.

 

Rating agencies, such as A.M. Best Company, rate insurance companies based on financial strength as an indication of a company’s ability to meet policyholder obligations. Our primary insurance subsidiary, American Physicians, has an A.M. Best rating of A- (Excellent). An insurance company’s rating, and in particular its A.M. Best rating, can be a potential source of competitive advantage or disadvantage in the marketplace. Accordingly, a downgrade in our A.M. Best rating could adversely affect our position in the marketplace and could result in a reduction in the amount of business we are able to write.

 

Changes in interest rates could adversely impact our results of operation, cash flows and financial condition.

 

A significant portion of our assets are invested in interest bearing fixed-income securities. In recent years, we have earned our investment income primarily from interest income on these investments. A decrease in prevailing interest rates, as recently experienced, will reduce the return on our investment portfolio as we reinvest the proceeds of securities that mature at rates below those of the securities that mature and our cash and cash equivalent assets earn less interest. The reduced investment income will also reduce our operating cash flows. Conversely, an increase in interest rates would reduce the carrying value of our available-for-sale fixed-income securities as the market value of these securities is typically inversely related to interest rates, which could result in a charge to income if determined to be other than temporary. An increase in short-term interest rates would also increase the interest payments associated with our long-term debt as those obligations pay a variable rate of interest that is in part based on the three-month London Inter-Bank Offered Rate. Any of these consequences may have a material adverse effect on our revenues, cash flows and assets, including the amount of net unrealized appreciation on investments shown on our balance sheet.

 

The unpredictability of court decisions could have a material impact on our operations.

 

The financial position or results of operations of our insurance subsidiaries may also be adversely affected by court decisions that expand insurance coverage beyond the intention of the insurer at the time it originally issued an insurance policy. In addition, a significant jury award, or series of awards, against one or more of our insureds could require us to pay large sums of money in excess of our reserve amounts.

 

Our business could be adversely affected by the loss of one or more key employees.

 

We are heavily dependent upon our senior management and the loss of the services of our senior executives could adversely affect our business. Our success has been, and will continue to be, dependent on our ability to retain the services of existing key employees and to attract and retain additional qualified personnel in the future. The loss

of the services of key employees or senior managers, or the inability to identify, hire and retain other highly qualified personnel in the future, could adversely affect the quality and profitability of our business operations.

 

The insurance industry is subject to regulatory oversight that may impact the manner in which we operate our business, our ability to obtain future premium rate increases, the type and amount of our investments, the levels of capital and surplus deemed adequate to protect policyholder interests, or the ability of our insurance subsidiaries to pay dividends to the holding company .

 

Our insurance business is subject to extensive regulation by the applicable state agencies in the jurisdictions in which we operate, and especially by OFIR, as our insurance companies are domiciled inMichigan. These state agencies have broad regulatory powers designed to protect policyholders, not shareholders or other investors. These powers include, but are not limited to, the ability to:

 

 

Failure to comply with these regulations could result in consequences resulting from a regulatory examination to a regulatory takeover. If we fail to comply with insurance industry regulations, or if those regulations become more burdensome to us, we may not be able to operate profitably or may be more limited in the amount of dividends our insurance subsidiaries can make to APCapital.

 

Our status as an insurance holding company with no direct operations could adversely affect our ability to meet our debt obligations and fund future share repurchases.

 

APCapital is an insurance holding company. As such, it has no ongoing operations and its primary assets are the stock of its insurance subsidiaries. The availability of cash needed by APCapital to meet its obligations on its outstanding debt, repurchase outstanding shares of its common stock and pay its operating expenses is largely dependent upon dividends that it receives from its insurance subsidiaries. The payment of dividends by our insurance subsidiaries is regulated by state insurance laws, which restrict the amount of dividends that can be made without prior approval by OFIR.

 

Legislative or judicial changes in the tort system may have adverse or unintended consequences that could materially and adversely affect our results of operations and financial condition.

 

Changes in laws, at either the national or state level, that limit jury awards for non-economic damages relating to medical malpractice claims, commonly referred to as tort reform, could have unintended adverse consequences for insurers. For example, tort reform legislation in Illinois was recently overturned. In addition, coverage for legal business entities, other than hospitals and outpatient health care facilities, under New Mexico’s Patient Compensations Fund, or PCF, is currently being challenged in the courts. As a consequence of the overturned Illinois tort reform or if the courts decide that legal business entities are not covered under the New Mexico PCF, we may see an increase in claims frequency or severity in our Illinois and New Mexico markets, which may adversely affect our results of operations.

Applicable law and various provisions in our articles and bylaws may prevent and discourage unsolicited attempts to acquire APCapital that you may believe are in your best interests or that might result in a substantial profit to you.

 

APCapital is subject to provisions of Michigan corporate and insurance laws that have the effect of impeding a change of control by requiring prior approval of a change of control transaction by the OFIR and the board of directors. In addition, APCapital’s articles of incorporation and bylaws include provisions which: (1) allow for the issuance of “blank check” preferred stock without further shareholder approval; (2) set high vote requirements for certain amendments to the articles of incorporation and bylaws; (3) establish a staggered board; (4) limit the ability of shareholders to call special meetings; and (5) require unanimity for shareholder action taken without a meeting. These provisions may discourage a takeover attempt that you consider to be in your best interests or in which you would receive a substantial premium over the then-current market price. In addition, approval by the OFIR of a change of control transaction may be withheld even if the transaction would be in the shareholders’ best interests if OFIR determines that the transaction would be detrimental to policyholders. As a result you may not have an opportunity to participate in such a transaction even if it would benefit shareholders.

 

 

Not applicable.

 

 

We own our home office in East Lansing, Michigan which comprises approximately 89,000 square feet. In addition, we lease office space as needed in our major markets to provide a local presence. Our leases tend to be five to ten years in length. We currently lease and occupy a total of approximately 10,500 square feet of space in Chicago, Illinois and Albuquerque, New Mexico. We also own a parcel of investment property in East Lansing, Michigan as part of our investment portfolio.

 

 

We are not currently subject to any material litigation. Though we have many routine litigation matters in the ordinary course of our insurance business, we do not expect these cases to have a material adverse effect on our financial condition and results of operations.

 

PART II

 

 

The following table sets forth the high and low sale price per share of the common stock as reported on the Nasdaq Global Select Market and the dividends paid per share for the periods indicated.

 

Our Board declared a dividend of $0.09 per share payable March 31, 2010. Our current intention is to continue to pay a comparable cash dividend on a quarterly basis for the foreseeable future. However, the payment of future dividends will depend on the availability of cash resources at APCapital, prevailing business conditions, our financial condition and results of operations, and such other factors as are deemed relevant by the Board of Directors. Our ability to pay dividends may be also contingent on the receipt of cash dividends from our subsidiaries. The payment of any dividends from our insurance subsidiaries to APCapital is subject to a number of regulatory conditions described above under “Item 1. Business — Insurance Regulatory Matters.” In addition, under the documents relating to the debentures issued by APCapital, we would not be able to pay dividends during any period during which we delay our obligation to pay interest payments to the related trusts pursuant to our rights under those documents. See Note 9 of the Notes to Consolidated Financial Statements for further information regarding these debentures.

 

As of January 31, 2010, there were 103 shareholders of record and approximately 5,500 beneficial shareholders of our common stock, based on the records of our transfer agent and securities listing information.

 

The information contained in the Equity Compensation Plan table under Item 12 of this Report is incorporated herein by reference.

 

The Company may from time to time repurchase shares of its outstanding common stock. The Company’s repurchase of any of its shares is subject to limitations that may be imposed by applicable laws and regulations and rules of the Nasdaq Global Select Market. The timing of the purchase and the number of shares to be bought at any one time depend on market conditions and the Company’s capital requirements. The following table sets forth our recent repurchase activity.

 

 

 

 

 

The following selected financial data, other than the selected statutory data, is derived from our Consolidated Financial Statements which were prepared in accordance with GAAP. The data should be read in conjunction with the Consolidated Financial Statements, related Notes and other financial information included elsewhere in this report. The selected statutory data is derived from our annual statements which were prepared in accordance with statutory accounting practices as required by insurance regulatory authorities. See Note 19 of the Notes to Consolidated Financial Statements for a discussion of the principal differences between GAAP and statutory accounting practices. Such information is incorporated herein by reference.

 

 

 

 

 

 

 

 

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. References to “we,” “our” and “us” are references to the Company.

 

The following discussion of our financial condition and results of operations contains certain forward-looking statements. See “Item 1 — Business — Uncertainties Relating To Forward-Looking Statements” elsewhere in this report for important information regarding forward-looking statements, which is incorporated herein by reference.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect amounts reported in the accompanying Consolidated Financial Statements and related Notes. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in the Company’s earnings in the period those estimates changed. The following policies are those we believe to be the most sensitive to estimates and judgments or involve revenue recognition. Our significant accounting policies are more fully described in Note 1 to our Consolidated Financial Statements. Such information is incorporated herein by reference.

 

Unpaid Losses and Loss Adjustment Expenses

 

Our Consolidated Financial Statements include estimated reserves for unpaid losses and loss adjustment expenses related to our various insurance lines of business. Our actuaries utilize standard actuarial techniques to project ultimate losses. These projections are prepared using the Company’s data, including the number of claims

reported and paid, and the average severity of reported and paid claims, as well as industry data. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Based on these quantitative as well as other qualitative factors, such as a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and the current reserving practices of the Company’s claims department, we select a “best estimate” of ultimate future losses, and then record this best estimate in the Company’s Consolidated Financial Statements. We receive an annual statement of opinion by an independent consulting actuary concerning the adequacy of our reserves, as required by insurance regulatory authorities.

 

When a claim is reported to us, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The process of estimating the case reserves reflects an informed judgment based upon insurance reserving practices appropriate for the relevant line of business and on the experience and knowledge of the estimator regarding the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. We also maintain reserves for claims incurred but not reported, commonly referred to as IBNR, to provide for future reporting of already incurred claims and development on reported claims. These two components, case reserves and the reserve for IBNR claims, constitute the liability for unpaid losses and loss adjustment expenses, and together represent our best estimate of the ultimate cost of settling our claims obligations. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses is an inherently uncertain process and does not represent an exact calculation of that liability. Many internal and external factors can influence the estimation process, and even minor changes in assumptions regarding these factors can have a substantial impact on the projection of the ultimate liability.

 

With lines of business like medical professional liability that often have claims with complex and technical facts and circumstances that take many years to investigate and close, the lack of information available to the claims personnel when a claim is first reported often makes establishing accurate case reserves difficult. As the discovery phase of the claim proceeds, better information regarding the nature and severity of the claim becomes available, enabling claims personnel to establish a more accurate, often higher, case reserve for the claim. This process of periodically evaluating and adjusting case reserves results in case reserve development. This case reserve development is one of the factors that our actuaries consider when establishing ultimate loss estimates. Some of the variables that may impact how they view case reserve development and its impact include internal factors such as our underwriting and claims handling practices and changes in the mix of our products and policy limits offered. However, our actuaries also consider other factors such as the frequency and severity of reported and IBNR claims.

 

Loss frequency and severity trends are considered in the estimation of the ultimate liability of losses and loss adjustment expenses. Claim frequency is measured in various ways. The most common measure is the number of claims reported to us and is typically adjusted for the relative exposure, either in terms of the number of insureds or earned premiums. Claim frequency is also measured in terms of the number of claims reported to us on which we make loss payments, also known as indemnity payments, as opposed to claims on which we pay only expenses or close without any payment. Claim frequency impacts not only our projection of the number of IBNR claims associated with our occurrence business, but is also evaluated to determine the cause of changes in frequency. In periods where claims frequency is declining, we consider whether this means that non-meritorious claims are no longer being filed, which would have an impact on the percentage of claims that will ultimately have loss or indemnity payments and which could impact the projection of ultimate losses.

 

Claim severity is often measured on a paid, reported and ultimate basis. Paid severity represents the cost of payments associated with loss settlement and is typically measured as an average of paid losses per claim closed, per claim closed with payment, and per claim closed with a loss settlement payment. Reported severity is usually measured as our average case reserve per open claim. Ultimate severity takes into account not only the severity of losses currently being paid and losses in our open claims inventory, but also a variety of qualitative and quantitative factors. One such factor considered by the actuaries with low-frequency, high-severity lines of business such as medical professional liability is a supposition that if fewer claims are reported to us, those claims are likely to have a higher average severity than the average severity of claims associated with a larger population of claims. Implicit in this supposition is an assumption that the claims that are still being reported to us are those of greater merit and

potential severity, and the claims that are no longer being reported were the non-meritorious claims that were closed at little or no cost.

 

Other external factors such as economic inflation, judicial trends and legislative and regulatory changes can also have a substantial impact on our reserve estimate assumptions. For example, when tort reform legislation is passed in a state, we estimate its impact on both the frequency and severity of losses. In addition, we evaluate whether or not the legislation will stand if it is legally challenged in the courts.

 

As it often takes several years for medical professional liability claims to be resolved (three to six years on average from the time the loss is reported) the ultimate payment can be difficult to project due to typical delays in reporting claims to us, the often lengthy discovery process, and the time necessary to defend the claim. In the intervening time, changes in the judicial climate in a given jurisdiction can occur, which can impact the ultimate amount of loss settlement. Substantial changes in the economic environment can also occur during this period.

 

Our actuaries also consider the effects of our various reinsurance treaties, and the varying retention levels and co-participations we have on any given year as these will have an impact on the loss reserves we cede to our reinsurers.

 

All of the above factors contribute to the variability inherent in estimating ultimate loss payments, especially since the effects of many of these variables cannot be directly quantified on a prospective basis. In accordance with standard actuarial practices, we use a variety of methods when making our reserve estimate projections. These methods include:

 

 

The paid development method estimates ultimate losses by reviewing paid loss patterns and applying them to accident years with further expected changes in paid loss. The incurred development method is similar to the paid development method, but it uses case incurred losses instead of paid losses. Case incurred losses are defined as paid losses plus the claims department’s provision for open claims (case reserves). The average loss method multiplies a projected number of ultimate claims by an estimated ultimate average loss for each accident year to produce ultimate loss estimates. The Bornhuetter-Ferguson method is a combination of the paid or incurred development method and the average loss method.

 

The various reserving methods described above produce a range of possible reserve amounts. The selection of the best estimate reserve within the range requires careful actuarial judgment and analysis of diagnostic statistics such as those described above. In an effort to better explain the inherent uncertainty in our net loss and loss adjustment expense reserves, we have developed a reasonable range of estimates around the net carried reserves as of December 31, 2009. The range is disclosed and explained in “— Financial Condition.”

 

With long-tailed, low-frequency, high-severity lines of business such as medical professional liability, changes in the actuarially projected ultimate loss frequency and severity can have an even greater impact on the balance of recorded reserves than with most other property and casualty insurance lines. While we believe that our estimates of ultimate projected losses are adequate based on information known to us, there can be no assurance that additional significant reserve changes will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.

 

The assumptions and methodologies used in estimating and establishing the reserve for unpaid losses and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded 8% of our recorded net reserves as of the beginning of the period, but they can materially affect our results of operations when an adjustment is made. Due to the current volatility of losses in the medical professional liability industry, adjustments were necessary in each of the last several years. See Note 8 of Notes to Consolidated Financial Statements for a table

showing changes in the loss reserve during each of the last three years, which table is incorporated herein by reference.

 

With the exception of reserves for extended reporting period claims discussed below, we do not discount our reserves to recognize the time value of money.

 

Investments

 

The Company classifies all investment securities as either held-to-maturity or available-for-sale at the date of purchase based on the Company’s ability and intent to hold individual securities until they mature. In addition, on a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. Based on such a review in 2005, we transferred a significant portion of our fixed-income security portfolio from the available-for-sale category to the held-to-maturity category. Securities were transferred at their estimated fair value. Any unrealized gains or losses, net of taxes, at the date of transfer continue to be reported as a component of accumulated other comprehensive income, and are being amortized over the remaining life of the securities through other comprehensive income.

 

Available-for-sale fixed-income and equity securities are reported at their estimated fair value, with any unrealized gains and losses reported net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized appreciation or depreciation, net of any related tax effects, in other comprehensive income. Held-to-maturity securities, other than those transferred to the held-to-maturity category as described above, are carried at amortized cost. Investment income includes amortization of premium and accrual of discount for both held-to-maturity and available for sale securities on the yield-to-maturity method if investments are acquired at other than par value.

 

The fair values of our investment securities are determined as follows. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and quoted bid or ask prices are just a few of the observable inputs utilized. Prices determined by the model are then compared with prices provided by other pricing vendors and against prior prices to confirm that deviations are within tolerance thresholds. If the pricing vendors are unable to provide a current price for a security, a fair value is developed using alternative sources based on a variety of less objective assumptions and inputs (Level 3).

 

We currently have only two securities in our available-for-sale investment portfolio that have Level 1 fair values. These securities are publicly traded equity securities with a total fair value of $18.0 million at December 31, 2009. We also have two available-for sale securities with Level 3 fair values, one of which is valued by a non-preferred pricing vendor using a pricing model as discussed above. However, due to a lack of comparable values from other pricing vendors with which to validate the fair value of this security, we have elected to classify the fair value of this security as a Level 3. The fair value of this security at December 31, 2009 was $4.0 million. The other security with a Level 3 fair value is valued based on the present value of expected cash flows associated with the security. The assumptions implicit in fair values based on the present value of cash flows, such as the discount rate, interest rate, and principal repayments, are deemed to be unobservable due to the structure and nature of this security. However, the resulting fair value of the security approximates its par value, which was $2.2 million at December 31, 2009. There were no material changes in the assumptions we used to determine the fair value of this security during the twelve months ended December 31, 2009. The rest of our available for sale fixed-income security portfolio, $198.9 million at December 31, 2009, consists of securities deemed to be Level 2.

 

The means and methods we use to select and validate the prices provided by pricing vendors are described in Note 4 of the Notes to unaudited Condensed Consolidated Financial Statements. Such cross-referenced information is included herein by reference.

 

With the exception of our two fixed-income securities with Level 3 fair values, we have determined that the markets for our other fixed-income securities are active. Accordingly, prices obtained from pricing vendors for our Level 2 fair value fixed-income securities have not been adjusted as the prices provided by vendors appear to be

based on current information that reflects orderly transactions. The market for our Level 3 fair value securities, both of which are private placement securities, is inactive due to the nature of and restrictions associated with private placement securities. The determination of whether a market is inactive is made on a security-by-security basis using factors such as the following.

 

 

We have made no adjustment to the fair value of our one Level 3 fair value security that is priced by a pricing vendor. Our other Level 3 fair value security is not priced by vendors, but rather is priced by us as described above.

 

We periodically review our investment portfolio for any potential credit quality or collection issues that may be indicative of an other than temporary impairment, or OTTI. Recent changes in GAAP have required us to modify the manner in which we conduct such evaluations with respects to our fixed-income securities. We must now positively affirm for all impaired securities, i.e., a security whose fair value is less than its amortized cost, that we do not intend to sell the security and that it is more likely than not that we will not be required to sell an impaired security before its entire amortized cost is recovered. Evaluating whether a security is more likely than not to be required to be sold before its full amortized cost is recovered requires judgment in assessing the reasons that a sale may be required, such as to maintain regulatory compliance or to meet liquidity needs, and the likelihood and timing of such events occurring. If both criteria cannot be positively affirmed, the security is deemed to be OTTI and must be written down to its fair value as of the end of the reporting period through a charge to income.

 

In determining if the full amortized cost of an impaired security is recoverable, we must make a best estimate of the present value of the security’s expected cash flows. In making our best estimate of the cash flows related to a particular security, we consider the following:

 

 

If an impaired security’s full amortized cost is not expected to be recovered, then the security is deemed to be OTTI and must be written down to its fair value as of the reporting date. The security’s amortized cost is written down for the portion of the OTTI due to credit losses, which is the difference between the original amortized cost of the security and the present value of its expected cash flows. This write down is charged to income and the new amortized cost basis of the security is accreted to the present value of the security is expected cash flows as interest income. Any remaining difference between the security’s fair value and the present value of the expected cash flows is deemed to be the non-credit loss portion of the OTTI and is recognized in other comprehensive income, net of taxes, separately from unrealized gains and losses on available-for-sale securities. Subsequent increases or decreases, if not deemed to be OTTI, in the fair value of available-for-sale securities shall be included in other comprehensive income. If the OTTI security is a held-to-maturity security, the non-credit loss portion of the OTTI is accreted from accumulated other comprehensive income to the new amortized cost basis of the security over its remaining life in a prospective manner. This accretion will increase the carrying value of the OTTI held-to-maturity security with no effect on income.

There have been no changes in the manner in which we evaluate equity securities for other than temporary impairments. Equity securities, if impaired, continue to be evaluated based on the following criteria.

 

 

At December 31, 2009 we had approximately $418,000 of unrealized losses on our available-for-sale investment security portfolio and $158,000 of unrecognized losses on our held-to-maturity investment security portfolio. Approximately $150,000 of the held-to-maturity unrecognized losses pertained to securities that had been in an unrecognized loss position for more than twelve months. All unrealized or unrecognized losses at December 31, 2009 were considered to be temporary in nature. For further information regarding the nature and amounts of these unrealized and unrecognized losses, see Note 3 of the Notes to Consolidated Financial Statements included elsewhere in this report.

 

We did, however, record realized losses of $4.5 million and $858,000 in 2009 and 2008, respectively, related to the impairment of investments whose decline in fair value was deemed to be other than temporary. The $4.5 million of OTTI recorded in 2009 related to a single common stock issue and is more fully discussed in “— Financial Condition, Investments.” The OTTI charge in 2008 related to the write down of CIT bonds, and resulted from a decision to sell the bonds in the first quarter of 2008, but the actual disposition not occurring until the second quarter of 2008. The subsequent sale of the CIT bonds resulted in a small gain, approximately $10,000, based on the new written down cost basis.

 

Reserve for Extended Reporting Period Claims

 

A portion of the coverage that physicians purchase under claims-made policies is for an additional death, disability and retirement, or DDR, insurance benefit. This DDR coverage provides coverage to the physician for any prior incidents occurring during the coverage period that are reported after their death, disability or retirement. The loss exposure associated with this product is known as extended reporting period claims. The reserve for extended reporting period claims coverage is recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including morbidity and mortality assumptions, less the present value of expected future premiums associated with this DDR coverage. The reserves for these claims fluctuate based on the number of physicians who are eligible for this coverage and their age. Any changes in the DDR reserves are reflected as an expense in the period in which we become aware that an adjustment is necessary. At December 31, 2009 and 2008, our recorded DDR reserves were $11.8 million and $13.0 million, respectively, which include a discount related to the present value calculation of approximately $3.2 million and $3.6 million, respectively.

 

Revenue Recognition

 

Insurance premium income is generally recognized on a daily pro rata basis over the respective terms of the policies in-force, which is generally one year. Certain extended reporting endorsements, often referred to as tail coverage, allow extended reporting of insured events after the termination of the original claims-made policy by modifying the exposure period of the underlying contract. Tail coverage can modify the exposure period for a definite or indefinite period. Premiums associated with tail policies that provide coverage for a definite period are earned over the period additional coverage is provided using the daily pro rata method. Premiums for tail policies that provide additional coverage for an indefinite period are fully earned at the date of issuance. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in-force.

Reinsurance

 

Reinsurance premiums and losses related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other companies are reported as a reduction of premium income. Reinsured losses incurred are reported as a reduction of gross losses incurred.

 

Prior to 2006, a portion of the policyholder premium ceded to the reinsurers under our primary professional liability reinsurance contract was “swing-rated,” or experience rated, on a retrospective basis. These swing-rated contracts were subject to a minimum and maximum premium range to be paid to the reinsurers depending upon the extent of losses ultimately paid by the reinsurers. Under these treaties, we paid a provisional premium during the initial policy year, and recorded a liability that represented our best estimate of the additional premium due under the treaty based on the reinsurers’ expected ultimate experience under the treaty. As this estimated liability for future premium payments relied upon our ceded reserve estimates to project the reinsurers’ anticipated ultimate experience under the treaty, changes in our actuarially estimated ceded loss and loss adjustment expense reserves would also have an impact on the estimated liability for additional premiums. We have historically accrued the maximum premium under these treaties. However, recent claim trends have caused us to revise downward our estimate of the reinsurers’ ultimate experience under these treaties. As a result, we reduced our accrued ceded premiums during 2009 by approximately $1.1 million, the effect of which is a $1.1 million increase in both net premiums written and earned. At December 31, 2009 we had approximately $9.0 million of accrued ceded premiums under these treaties.

 

Our reinsurance treaties effective on or after January 1, 2006, although no longer swing-rated, do contain profit sharing provisions. In accordance with these provision, if the reinsurers’ experience under the treaties is favorable, that is the treaties are profitable from the reinsurers’ perspective, a percentage of the reinsurers’ profit would be due back to us. Our reinsurers’ experience under treaty years 2009, 2008 and 2007 indicated profits of $43,000, $110,000 and $78,000, respectively, as of December 31, 2009.

 

We commuted our 2005 medical professional liability reinsurance treaty agreement effective December 31, 2008. The $16.6 million of consideration under the commutation, consisting of $8.5 million in cash and the reduction of swing-rated premiums payable of $8.1 million, were recorded as a reduction of losses and loss adjustment expenses paid (thereby reducing losses and loss adjustment expenses incurred) during 2008. In connection with the commutation we released the reinsurers from their obligations under the treaty of $16.0 million (thereby increasing losses and loss adjustment expenses incurred in 2008). The net effect of the commutation was a decrease in losses and loss adjustment expenses in 2008 of $633,000.

 

We evaluate each of our ceded reinsurance contracts at inception to determine if there is sufficient risk transfer to allow the contract to be accounted for as reinsurance under current accounting guidance. At December 31, 2009 all ceded contracts are accounted for as risk transferring contracts.

 

We review the financial stability of all of our reinsurers each quarter. This review includes a ratings analysis, as well as the most recent financial information, of each reinsurer participating in a reinsurance contract. At December 31, 2009, there were no known issues with the financial solvency of our reinsurers or their ultimate ability to pay amounts due to us. If we determine that the ultimate ability of a reinsurer is uncertain, we would be required to recognize a reserve and a corresponding expense in the period in which the determination is made. Our reinsurance arrangements are discussed in more detail in “Item 1. Business — Medical Professional Liability Operations” and in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — 2009 Compared to 2008” and in Note 10 of the Notes to Consolidated Financial Statements included elsewhere in this report.

 

Income Taxes

 

We estimate our income tax expense based on the best information available to us at year end. This income tax expense includes a provision for those income taxes that are currently payable, as well as a provision for the deferred impact of certain deductible and taxable temporary differences. In the months subsequent to the calendar year end, we prepare and file our income tax returns and evaluate any differences between the provisions we recorded in the

previous year and the actual amounts per the filed tax returns. These “return to provision” differences are recorded as adjustments to income tax expense in the period in which they are identified. Return to provision adjustments for each of the three years ended December 31, 2009 were less than $50,000.

 

Deferred federal income tax assets and liabilities are recognized for the estimated future tax consequences attributable to the difference between financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

 

A determination must be made for deferred tax assets regarding whether it is more likely than not that sufficient taxable income will exist in future periods when deductible temporary differences are expected to reverse to enable the Company to realize the benefit of its deferred tax assets. If it is determined that it is more likely than not that sufficient taxable income will not exist, a valuation allowance must be recorded for the portion of deferred tax assets the Company likely will not realize. At December 31, 2009 and 2008 all deferred tax assets were deemed to be recoverable and no valuation allowance was recorded.

 

We record any excess tax benefits related to employee share-based awards as a credit to additional paid in capital in the year that they are currently deductible in the Company’s consolidated tax return.

 

Management is also required to identify, estimate and disclose positions they have taken where the income tax treatment of the position taken is not 100% certain. Our evaluation of the deductibility or taxability of items included in the Company’s tax returns has not resulted in the identification of any material, uncertain tax positions.

 

Deferred Policy Acquisition Costs

 

Deferred policy acquisition costs, or DAC, are those costs that vary with and are primarily related to the production of new or renewal business. Costs such as commissions and premium taxes are 100% related to new or renewal business production. Other costs, such as employee salaries, bonuses and benefits, must be allocated between that portion that pertains to new or renewal business production and that which does not. Such cost estimates are made on a department by department basis and are based on time studies.

 

These policy acquisition costs are deferred and amortized over the period in which the related premiums are earned. Under GAAP, the premiums that will be earned in future periods, to which these deferred costs relate, must produce sufficient profits to offset the future expense that will be recognized from the amortization of the DAC; that is, the DAC must be recoverable. In evaluating the recoverability of DAC, we have made certain assumptions regarding the future amount and timing of costs associated with the business written, such as costs to maintain the policies and the ultimate projected loss and loss adjustment expense payments associated with these policies. In addition, we have considered future investment income, at an assumed 3.1% yield, in determining the recoverability of DAC. Based on our analysis as of December 31, 2009, the DAC of $6.1 million carried on the Consolidated Balance Sheets, included elsewhere in this report, was deemed to be fully recoverable.

 

Overview of APCapital

 

We are an insurance holding company whose financial performance is heavily dependent upon the results of operations of our insurance subsidiaries. Our insurance subsidiaries are property and casualty insurers that write medical professional liability insurance for physicians and other healthcare professionals throughout the United States, but principally in the Midwest and New Mexico. Prior to 2005, we also wrote workers’ compensation, health and personal lines and we continue to carry reserves relation to claims made under these policies as this business runs off. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.

An insurance company earns investment income on what is commonly referred to as the “float.” The float is money that we hold, in the form of investments, from premiums that we have collected. While a substantial portion of the premiums we collect will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period that we hold the float prior to paying losses can extend over several years, especially with a long-tailed line of business such as medical professional liability. The key factors that determine the amount of investment income we are able to generate are the rate of return, or yield, on invested assets and the length of time we are able to hold the float. We focus on the after-tax yield of our investments, as significant tax savings can be realized on bonds that pay interest that is exempt from federal income taxes.

 

For further information regarding the operations of our medical professional liability insurance business is discussed in detail in “Item 1. Business — Medical Professional Liability Operations.”

 

Description of Ratios and Other Metrics Analyzed

 

We measure our performance using several different ratios and other key metrics. These ratios and other metrics are calculated in accordance with accounting principles generally accepted in the United States of America, which we refer to as GAAP, and include:

 

Underwriting Gain or Loss:  This metric measures the overall profitability of our insurance underwriting operations. It is the gain or loss that remains after deducting net loss and loss adjustment expenses and underwriting expenses incurred from net premiums earned. We use this measure to evaluate the underwriting performance of our insurance operations in relation to peer companies.

 

Loss Ratio:  This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year, regardless of the year in which the incident giving rise to the claim occurred. The lower the loss ratio percentage is, the more profitable our insurance business is, all other factors being equal.

 

Underwriting Expense Ratio:  This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and managing our underwriting operations. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio and overall profitability. The determination of which expenses should be classified as underwriting expenses can vary from company to company. Accordingly, comparability of underwriting expense ratios among and between various companies may be limited.

 

Combined Ratio:  This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income. As the underwriting expense ratio is a component of the overall combined ratio, comparability between companies may be limited for the reasons discussed above.

 

Investment Yield:  Investment yield represents the average return on investments as determined by dividing investment income for the period, annualized if necessary, by the average ending monthly investment balance for the period. As we use average month ending balances, the yield for certain individual asset classes that are subject to fluctuations in a given month, such as cash and cash equivalents, may be skewed slightly. However, we believe that when calculated for the cash and invested asset portfolio in its entirety, the overall investment yield is an accurate and reliable measure for evaluating investment performance. Our calculation of investment yields may differ from those employed by other companies.

 

Return on Equity:  As a way of evaluating our capital management strategies we measure and monitor our return on equity, or ROE, in addition to our results of operations. We measure ROE as our net income for the period, annualized if necessary, divided by our total shareholders’ equity as of the beginning of the year. Other companies sometimes calculate ROE by dividing annualized net income by an average of beginning and ending shareholders’ equity. Accordingly, the ROE percentage we provide may not be comparable with those provided by other companies. We use a modified version of ROE as the basis for determining performance-based compensation.

Book Value per Share:  We also track the net asset value per common share outstanding, which is calculated by dividing shareholders’ equity as of the end of the period by the total number of common shares outstanding at that date. This measure is commonly referred to as “book value per share.” Book value per share is used in the property and casualty insurance industry as a means of evaluating the relationship between the book value per common share and the cost of a common share in the open market. It is used by management, investors and analysts to compare our stock value with that of our peers and to determine the relative premium that the market places on our stock and the stock of our peers.

 

These ratios, when calculated using our reported statutory results, will differ from the GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, compared to net premiums written for the statutory underwriting expense ratio.

 

In addition to these measures of operating performance, we also use certain measures to monitor our premium writings and price level changes. We measure policy retention by comparing the number of policies that were renewed during a given period with the number of policies that expired. This retention ratio helps us to measure our success at retaining insured accounts. We also monitor our insured physician count, which counts the number of doctor equivalents associated with all policies. For this purpose a corporation or ancillary health care provider on a policy is assigned a value of one doctor equivalent. When used in conjunction with the retention ratio, the insured physician count helps us to monitor the overall increase or decrease in insureds that comprise our premium base. The insured physician count is also used to calculate the average in-force premium, which helps us in measuring overall premium level changes. In-force premium is the written premium in effect at the end of a reporting period.

 

Non-GAAP Financial Measures

 

Accident Year Loss Ratio:  In addition to the loss ratio, which uses calendar year incurred losses as described above, we also use an accident year loss ratio, which is a non-GAAP financial measure, to evaluate our loss experience. The accident year loss ratio uses only those loss and loss adjustment expenses incurred that relate to the current accident year, and therefore excludes the effect of development on prior year loss reserves. We believe the accident year loss ratio is useful in evaluating our current underwriting performance, as it focuses on the relationship between premiums earned in the current year and losses incurred related to the exposure represented by the premiums earned in the current year related to those policies. As with the calendar year loss ratio, a lower accident year loss indicates that the premiums currently being earned will result in a greater profit, all other factors being equal. Accident year loss ratios are reconciled to calendar loss ratios in the first table in “— Results of Operations.”

Results of Operations

 

The following table sets forth our results of operations for the years ended December 31, 2009, 2008 and 2007 on a consolidated basis. The discussion that follows should be read in connection with the Consolidated Financial Statements, and Notes thereto, included elsewhere in this report.

 

 

 

 

2009 Compared to 2008.  Net income for 2009 was down $4.6 million, or 10.3%, from 2008. The decrease was primarily the result of a $6.0 million decline in investment income, which was due to declines in the overall interest rate environment, especially short-term rates, and our increased allocation to cash and short-term securities compared to 2008. Our underwriting operations remained strong in 2009, generating a pre-tax gain of $28.8 million compared with $31.5 million in 2008. The decrease in our underwriting gain was mostly due to a decrease in net premiums earned, which decreased 7.6% decrease in net premiums earned, year over year, mostly due to premium rate decreases.

Premiums

 

The following table shows our direct premiums written by major geographical market as well as total net premiums written and earned for the years ended December 31, 2009 and 2008.

 

 

The decline in direct premiums written in 2009 was primarily the result of decreases in the average policy premiums, which decreased an average of 7% for policies that renewed in 2009. Our average in-force premium, which contemplates new business written and endorsements or changes in renewal policies, decreased 6.4% to approximately $12,520 at December 31, 2009, from $13,380 at December 31, 2008. The rate decreases instituted over the last two to three years have been in response to favorable claim trends noted in virtually all markets of the medical professional liability industry. As these favorable claim trends appear to be industry wide, other medical professional liability insurers lowered their rates in 2009 as well, increasing the overall level of price competition in the industry, particularly in our Michigan and Ohio markets.

 

Rate reductions in 2009 were partially offset by our strong retention ratio of 88% for the year. Our Illinois market was particularly strong in 2009 with a retention ratio of nearly 90% and several million dollars of new business premium. We ended 2009 with 8,821 insureds, down 2.7% from December 31, 2008.

 

We anticipate that the medical professional liability insurance pricing environment will remain highly competitive in 2010, and that if current claim trends hold, additional premium rate decreases are likely. However, we remain committed to our philosophy of underwriting discipline and adequate pricing, and will continue to focus on retaining our quality book of business. This strategy may result in the additional loss of premium volume. However, we remain focused on the overall underwriting results, and not merely top-line revenue growth.

 

Net premiums written as a percentage of direct premiums written increased in 2009 due to approximately $1.1 million of ceded premium credits on reinsurance treaties for years prior to 2005, which were experience rated. These reductions to ceded premiums were due to favorable ceded loss experience on these older accident years. Partially offsetting the ceded premium credits was a $0.5 million assessment by the Workers’ Compensation Reinsurance Association, a mandatory reinsurance facility run by the State of Minnesota, for premium deficits associated with prior years. Otherwise, the terms of our 2009 reinsurance treaty were very similar to those in the 2008 treaty, both in terms of coverage and premium rates. Our 2010 reinsurance treaty contains terms and rates that are similar to those of the treaty effective in 2009. As such, we anticipate that our net premiums written, as a percentage of direct, will remain at approximately 96%.

 

Net premiums earned in 2009 decreased 7.6% from 2008, compared with a year over year decrease in net premiums written of 8.7%. In periods of declining written premiums, earned premiums typically decrease less than written premiums as a portion of the higher premium volume written in the prior year is recognized in the current year over the policy term, which is typically 12 months.

Loss and Loss Adjustment Expenses

 

Net incurred loss and loss adjustment expenses, which we refer to collectively as losses, decreased in 2009. The decrease in losses was principally the result of increased favorable development on prior years’ loss reserves. However, current accident year losses also decreased despite increases in the accident year loss ratio. The increase in the accident year loss ratio for 2009 was principally the result of decreases in the average policy premium and the resulting decreases in net premiums earned, partially offset by the continued favorable claim trends that have resulted in the favorable development on prior years’ loss reserves.

 

Of the $36.6 million of 2009 favorable prior year development, $42.2 million was attributable to medical professional liability reserves, partially offset by $5.6 million of unfavorable development on workers’ compensation reserves. This compares with $33.4 million of favorable development and $1.9 million of unfavorable development on medical professional liability and workers’ compensation loss reserves, respectively, in 2008.

 

As discussed in “— Critical Accounting Policies,” the effect of a change in either claims frequency or severity can introduce a great deal of variability in our reserve estimation process. We have a practice of being cautious with the assumptions we make concerning emerging trends in claim frequency and severity and do not immediately reflect the impact that any short-term declines in frequency may have on our ultimate losses. In addition, because the historical claims data we use to project future expected results covers more than 30 years, the impact of recent claims trends is often moderated by the substantial pool of historical data.

 

The following table shows our medical professional liability reported claim frequency, average net paid loss and average net case reserve per open claim over the last five years. We calculate the average net paid loss by dividing net paid losses for the year by the number of claims closed with a payment, either indemnity or expense.

 

 

The number of reported claims in 2009 increased 1.2% compared to 2008. However, the increase was less than expected and reported claim counts remain at historically low levels. As we have now experienced historically low, but relatively stable, claim frequency for the last three years, the decline in claim frequency is being more fully reflected in our reserve assumptions. However, our reserve assumptions have also contemplated that as the number of reported claims and our open claims counts have decreased in recent years, there would also be a decrease in the number of non-meritorious claims. As a result, our reserve assumptions assumed the remaining claims in our outstanding inventory would be more severe and have a higher likelihood of loss.

 

In addition to an increase in paid severity due to a general change in the composition of our outstanding claims inventory, our reserve estimates also include projections of higher severity contemplating medical loss cost inflation and our higher reinsurance retention levels in recent years. As noted in the table above, our average net paid loss, which is one measure of claim severity, has increased in recent years. However, the increases noted were not as great as those anticipated in our reserve estimates, and as a result we have recognized favorable development on our prior year medical professional liability loss reserves in each of the last several years.

 

In February 2010, the Illinois Supreme Court ruled that caps on non-economic damages in medical malpractice lawsuits, commonly referred to as tort-reform, were unconstitutional. Our practice has historically been to not fully reflect the effects of tort-reform in our reserve estimates until the law is established and appears that it won’t be overturned upon judicial review. Accordingly, the impact of the overturning of the Illinois tort-reform is not expected to adversely affect our carried reserves. However, we may see an increase in the frequency of claims reported. The severity of claims may also increase as a result of the repeal of the $500,000 cap on non-economic damages, though the severity impact, as it relates to our book of Illinois business, would be mitigated by the policy

limits we have in Illinois, which typically do not exceed $1.0 million. Nevertheless, if either claim frequency or severity trend upwards as a result of the repeal of the Illinois tort-reform, it could result in an increase in our incurred loss and loss adjustment expenses related to the Illinois market.

 

We recorded $5.6 million of unfavorable development on our workers’ compensation run-off reserves. The rate of claim payments has not declined as quickly as we had anticipated and claims are being closed slower than anticipated. With lines of business such as workers’ compensation where it can take a long time for claims to ultimately be resolved and settled, it is often difficult to ascertain whether increases in case reserves represent a strengthening of the case reserves or if the increases are indicative of an increase in the ultimate severity of the claims. While we believe that the reserve increases in 2009 represent reserve strengthening, we have taken a reasonably cautious approach with regard to the overall reserve levels, which is the reason for the adverse development in 2009.

 

As noted in the section “— Critical Accounting Policies, Unpaid Loss and Loss Adjustment Expenses,” reserves are inherently uncertain and the ultimate cost to settle claims will likely be more or less than currently anticipated. Actual claim experience will dictate the magnitude and nature, whether favorable or unfavorable, of any future development. Our reserve estimate at December 31, 2009 reflects our best estimate of the future liability as of that date. However, if current trends continue, we believe that the actual claim experience is more likely to emerge favorably than unfavorably.

 

Underwriting Expenses

 

The increase in underwriting expenses in 2009 was primarily attributable to amortization expense associated with the implementation of significant portions of our new policy, accounting and claims system in the fourth quarter of 2008 and the first quarter of 2009. Amortization expense attributable to the new system was $1.6 million and $0.2 million during 2009 and 2008, respectively. In the first quarter of 2009, once the development phase of the software project was completed, we also discontinued the capitalization of salary and other benefit costs associated with staff working on the development of the new system. The underwriting expense portion of staff salaries and benefit costs capitalized in 2009 was approximately $01 million, compared with $1.2 million in 2008. As a result of these increases in underwriting expenses, and the decline in net premiums earned, the underwriting expense ratio increased in 2009 to 24.8% from 22.1% in 2008.

 

We anticipate that our underwriting expense ratio will continue at elevated levels, compared to historic norms, until the end of 2013 as we amortize the cost of the new system. If our premium volume continues to decrease, however, the underwriting expense ratio will continue to increase as there will be a lower premium base over which to spread certain fixed overhead and other costs. We believe that the new system will allow us to operate our business more efficiently, ultimately enabling us to reduce expenses in the future. For further discussion of the amortization expense relating to the system, see “-Other Assets” in Note 1 of the Notes to Consolidated Financial Statements.

 

Investment Income

 

The decrease in investment income in 2009 was primarily due to the historically low short-term interest rates during 2009, combined with an increase in our cash and cash equivalents position throughout 2009. During 2009, $146.3 million of our fixed-income securities, having a weighted average annual yield of 5.95%, matured, were called or were paid down, The proceeds from these disposals, other than the $56.1 million spent on share repurchases and $30.0 million invested in limited partnerships, remained principally in cash and cash equivalents at December 31, 2009. The proceeds from the maturity, call or pay down of higher-yielding corporate, government agency and mortgage-backed securities in 2008 were used to purchase lower-yielding tax-exempt bonds throughout 2008, which also contributed to the decrease in investment income during 2009.

 

Overall our pre-tax investment yield for 2009 was 3.85%, a decrease of 53 basis points compared to a yield of 4.38% for 2008. Our increased cash and cash equivalents position in 2009 was the result of our reluctance to lock in the low longer-term rates available in 2009. If short-term interest rates remain at the historically low levels seen in 2009, and longer-term rates do not improve in 2010, our investment income for 2010 could decrease further, but not as significantly as the decrease noted in 2009.

Net realized losses of $0.5 million in 2009 were principally the result of a pre-tax charge of $4.5 million for the impairment of one of our equity investments. Due to a significant decline in the fair value of this investment during the fourth quarter of 2009, we believed it was necessary to write-down our carrying value of this investment to the current market value. This loss was partially offset by $3.8 million of gains that were realized as we restructured a portion of our portfolio at the end of 2009 when we made a $30.0 million investment in limited partnerships. The net realized losses reported in 2008 were principally attributable to a pre-tax impairment charge of $0.9 million on bonds that were subsequently sold. Partially offsetting the 2008 impairment charge were realized gains on bonds that were called during 2008.

 

Other Expenses

 

Other expenses consisted of the following for the years ended December 31, 2009 and 2008.

 

 

The decrease in other expenses in 2009 was mostly the result of a decrease in short-term interest rates and the repayment of $5.0 million of our outstanding long-term debt in the third quarter of 2008. Both of these factors reduced the amount of interest expense in 2009. In addition, general and administrative expenses, which are costs of the holding company, decreased in 2009 as a result of cost monitoring and reduction measures, principally in the area of fees for professional services.

 

Federal Income Taxes

 

The decrease in effective tax rate in 2009 was mostly the result of the increased allocation of our investment portfolio to tax-exempt securities in 2008. We purchased approximately $118.0 million of tax-exempt securities in 2008, primarily in the first and second quarters. The full year effect of interest on these securities, combined with the lower pre-tax income in 2009, resulted in a decrease in the effective tax rate to 28.2% in 2009, compared with 29.4% in 2008. Our tax-exempt security purchases have tapered off in 2009. As a result, we anticipate that our effective tax rate in future periods will be similar to the rate in 2009. See Note 11 of the Notes to Consolidated Financial Statements included elsewhere in this report for a complete reconciliation of the effective tax rate.

 

2008 Compared to 2007.  Net income for 2008 decreased $7.6 million compared to 2007. The decrease was the result of a decrease in net premiums earned, which was partially offset by decreases in incurred losses and underwriting expenses, but still resulted in a decrease in underwriting gains for 2008 of $7.9 million. In addition in 2008 we increased the allocation of our investment portfolio invested in tax-exempt securities. As a result of the lower yield on these tax-exempt securities, and the decline in short-term interest rates throughout 2008, investment income decreased $6.6 million in 2008 compared to 2007. However, the additional tax benefit of the tax-exempt securities purchased in 2008, combined with lower pre-tax income, resulted in a decrease in tax expense of approximately $6.6 million in 2008 compared to 2007.

Premiums

 

The following table shows our direct premiums written by major geographical market as well as total net premiums written and earned for the years ended December 31, 2008 and 2007.

 

 

The 7.7% decrease in direct premiums written in 2008, compared to 2007, was almost exclusively the result of premium rate reductions, which averaged 8.2% for policies that renewed in 2008. The decrease in net premiums written was relatively consistent with the decrease in direct premiums written. The terms of our 2008 reinsurance treaty were very similar to those in the 2007 treaty, both in terms of coverage and premium rates. The decrease in net premiums written as a percentage of direct premiums written was due to a 0.5% increase in the premium rate charged in 2008 compared with 2007. Our retention ratio in 2008 was 87%, improving from 85% in 2007, and we ended 2008 with 9,068 insureds, down 1.6% from year end 2007.

 

In periods of declining written premiums, earned premiums typically decrease less than written premiums as a portion of the higher premium volume written in the prior year is recognized in the current year since premiums are earned over the policy term, which is typically 12 months. In addition, the timing of writings in a given year can affect the amount of premiums earned in that year. Net premiums written during the two-year period ended December 31, 2008 decreased 9.6% compared with net premiums written during the two-year period ended December 31, 2007. This decrease in net premiums written, combined with an increase in the percentage of premiums written in the fourth quarter of 2008, compared with the same period of 2007, accounts for the 10.5% decrease in net premiums earned in 2008 compared to 2007, which exceeds the decrease in net premiums written of 8.2% when comparing only the annual periods ended December 31, 2008 and 2007.

 

Loss and Loss Adjustment Expense

 

Net incurred loss and loss adjustment expenses decreased $4.1 million in 2008 compared to 2007. Approximately $0.6 million of this decrease was the result of the commutation of our 2005 medical professional liability reinsurance treaty in 2008. As discussed in “-Critical Accounting Policies,” our reinsurance treaties for policy years 2005 and prior were swing-rated. As the swing-rated premiums under the 2005 treaty were accrued at the maximum, we recognized a gain on the commutation as the profit margin required by the reinsurers under the terms of the commutation was slightly less than additional accrued premiums.

 

Absent the gain on the commutation, incurred losses decreased $3.5 million. Of the $3.5 million decrease, $6.2 million pertained to the 2008 accident year, partially offset by a $2.7 million decrease in favorable development on prior accident years’ loss reserves. The decrease in current accident year losses was attributable to the decrease in net earned premium volume, partially offset by a 3.9% increase in the accident year loss ratio to 78.5% for 2008. The increase in the accident year loss ratio was due to the premium rate decreases taken in recent years, partially offset by the favorable claims frequency and severity trends that contributed to the favorable development on prior years’ loss reserves.

Of the $31.5 million of 2008 favorable prior year development, excluding the $0.6 million effect of the 2005 treaty year commutation, $33.4 million was attributable to medical professional liability reserves, partially offset by $1.9 million of unfavorable development on workers’ compensation reserves. This compares with $38.2 million of favorable development and $4.2 million of unfavorable development on medical professional liability and workers’ compensation loss reserves, respectively, in 2007.

 

Underwriting Expenses

 

Underwriting expenses decreased $2.7 million, or 8.9%, in 2008. The decrease in underwriting expenses was primarily attributable to the decline in our premium volume and the corresponding decline in those expenses that vary with premium volume. The underwriting expense ratio increased 0.4% to 22.1% in 2008, from 21.7% in 2007. The increase in the underwriting expense ratio was also attributable to our decline in premiums, as we had a lower premium base over which to spread underwriting costs that do not vary with premium volume, such as depreciation, property taxes and other overhead related costs, as well as certain personnel related expenses.

 

Investment Income

 

Investment income decreased $6.6 million, or 15.3% in 2008. There were two primary factors driving the decrease in investment income. The first was the decline in short-term interest rates throughout 2008, which accounted for approximately $2.7 million of the decrease. The second factor was our continued purchase of tax-exempt securities in 2008. These securities replaced higher-yielding, taxable corporate and government agency securities that matured, were called, sold or paid down during 2008. Overall our pre-tax investment yield for 2008 was 4.38%, a decrease of 62 basis points compared to a yield of 5.00% for 2007.

 

Net realized losses of $0.7 million in 2008 included a pre-tax charge of $0.9 million for the impairment of bonds. There were no investment impairment charges in 2007.

 

Other Expenses

 

Other expenses for the years ended December 31, 2008 and 2007 consisted of the following.

 

 

The decrease in other expenses was primarily attributable to the decrease in short-term interest rates, which reduced the amount of interest expense associated with our long-term debt. We repaid $5.0 million of our outstanding $30.9 million in long-term debt in the third quarter of 2008, which also reduced our interest expense in 2008 compared to 2007. The decrease in general and administrative expenses was the result of reduced legal and other professional service expenses as we have worked to reduce these fees where possible.

 

Federal Income Taxes

 

The effective tax rate for 2008 was 29.4% compared with 32.5% for 2007. The decrease in effective tax rate was mostly the result of the increase allocation of our investment portfolio to tax-exempt securities. In 2008, we purchased $118.0 million of tax-exempt securities, primarily in the first and second quarters. See Note 11 of the Notes to Consolidated Financial Statements included elsewhere in this report for a complete reconciliation of the effective tax rate.

Liquidity and Capital Resources

 

The primary sources of our liquidity, on both a short and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers, proceeds from the maturity or sale of invested assets and principal receipts from our mortgage-backed securities. The primary uses of cash, on both a short and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, the repayment of long-term debt, the payment of cash dividends on APCapital common stock and the repurchase of APCapital’s outstanding common stock.

 

Based on historical trends, market and regulatory conditions and our current business plans, we believe that our existing resources and sources of funds, including possible dividend payments from our insurance subsidiaries to APCapital, will be sufficient to meet our short and long-term liquidity needs. However, these trends, conditions and plans are subject to change, and there can be no assurance that our available funds will be sufficient to meet our liquidity needs in the future. In addition, any acquisition or other extraordinary transaction we may pursue outside of the ordinary course of business could require that we raise additional capital.

 

Parent Company

 

APCapital’s only material assets are cash and the capital stock of American Physicians and Alpha Advisors. APCapital’s cash flow consists primarily of dividends and other permissible payments from American Physicians and investment earnings on funds held. During 2009, APCapital received dividends of $30.0 million in June and $15.0 million in December. The payment of dividends to APCapital by its insurance subsidiaries is subject to certain limitations imposed by applicable law. These limitations are described more fully in Note 19 of the Notes to Consolidated Financial Statements. Such cross-referenced information is incorporated herein by reference. The June 2009 dividend required and received regulatory approval as due to its timing it exceeded ordinary dividend limits imposed by the State of Michigan. In accordance with these limits, American Physicians could pay “ordinary” dividends to APCapital of approximately $40.0 million in 2010 without prior regulatory approval. On March 2, 2010, American Physicians requested and received permission from regulators to pay $10.0 million of extraordinary dividends to APCapital. This dividend was deemed extraordinary as a result of the timing, and not the amount. Without regulatory approval dividends otherwise could not have been paid until June 2010. It is our intent, pending regulatory approval, for American Physicians to pay APCapital a quarterly dividend of $10.0 million in June, September and December 2010, or $40.0 million in total during 2010. Although the $40.0 million total in 2010 falls within the ordinary dividend limits, the $10.0 million in both September and December 2010 would be extraordinary as a result of the timing.

 

At December 31, 2009, APCapital’s cash and cash equivalent resources totaled approximately $21.4 million.

 

We continued the repurchase of shares of our outstanding common stock in 2009. A total of 1,863,833 shares were repurchased in 2009 at a total cost of $56.1 million. See Note 12 of the Notes to Consolidated Financial Statements as well as “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for further details regarding our share repurchase plans. Such cross-referenced information is included herein by reference.

 

In addition to our share repurchases, APCapital typically pays a quarterly cash dividend. The cash dividend for the fourth quarter of 2009 was $0.09, up from the $0.0825 paid in each of the first three quarters of 2009. Cash dividends paid to shareholders totaled approximately $3.6 million for the year. On February 11, 2010, APCapital’s Board of Directors declared a first quarter cash dividend of $0.09 per share, payable on March 31, 2010 to shareholders of record on March 15, 2010, which is expected to result in a total cash payout of approximately $0.9 million.

 

The Board’s current intention is to continue to pay a comparable cash dividend on a quarterly basis for the foreseeable future. However, the payment of future dividends will depend on the availability of cash resources at APCapital, prevailing business and market conditions, our financial condition and results of operations, and such other factors as are deemed relevant by the Board of Directors.

We made net federal income tax payments of approximately $16.5 million in 2009. Substantially all of our taxable income is generated by American Physicians. As such, in accordance with inter-company tax allocation agreements, it is primarily American Physicians’ responsibility to provide the cash resources to fund our tax obligations. APCapital generally has had a net positive cash flow from income taxes as it is reimbursed by its subsidiaries for the tax benefit of the loss it generates in accordance with inter-company tax allocation agreements.

 

At December 31, 2009, we had $25.9 million of long-term debt obligations, which are described in greater detail in Note 9 of the Notes to Consolidated Financial Statements. This debt is the obligation of APCapital and pays a variable interest rate of approximately 4.15% plus the three month LIBOR rate. In May 2008 this debt became callable, in whole or in part, and we repaid $5.0 million of the original outstanding $30.9 million in August 2008. We frequently evaluate our capital management strategies with the intention of providing the most value to APCapital shareholders and making prudent use of APCapital’s cash resources. Any decision to make further repayments would be based on such evaluations, as well as changes in our available cash resources, capital needs and other relevant factors.

 

Consolidated

 

Our net cash flow provided by operations was approximately $28.9 million for the year ended December 31, 2009, compared to $41.4 million provided by operations in 2008 and $46.0 million in 2007. The decreases in operating cash flows are primarily attributable to declines in premiums received, as our direct premiums written have been decreasing, and investment income received, as a result of the declines in short-term interest rates and the increased allocation of our investment portfolio to lower-coupon tax-exempt securities. However, our loss and loss adjustment expense payments have also decreased in each of the last two years, which partially offset the decreases in premiums received and investment income collected.

 

At December 31, 2009, we had $172.2 million of cash and cash equivalents and approximately $205.1 million of available-for-sale fixed-income securities and $18.0 million of available-for-sale equity securities that could be sold to meet short-term cash flow needs. On a long-term basis, fixed-income securities are purchased on a basis intended to provide adequate cash flows from future maturities to meet future policyholder obligations and ongoing operational expenses. As of December 31, 2009, we had approximately $9.9 million, $74.5 million, $157.0 million and $18.1 million of held-to-maturity fixed-income securities that mature in the next years, one to five years, five to ten years and more than ten years, respectively. We also have approximately $109.3 million of mortgage-backed securities that provide periodic principal repayments. See Note 3 of the Notes to Consolidated Financial Statements for further information regarding the anticipated maturities of our fixed-income securities.

 

In December 2009 American Physicians, our primary insurance subsidiary, invested $30.0 million in limited partnerships, which were organized for the purpose of conducting investment activities. In accordance with the partnership agreements, we cannot request a cash withdraw from the partnerships until December, 2011, and even then the distribution of cash is subject to the approval of the general partner. These limited partnership investments are discussed more fully in “— Financial Condition, Investments.”

 

Financial Condition

 

In evaluating our financial condition, three factors are the most critical: first, the availability of adequate statutory capital and surplus to satisfy state regulators and to support our current A.M. Best rating, which currently stands at A- (Excellent); second, the adequacy of our reserves for unpaid loss and loss adjustment expenses; and lastly the quality of the assets in our investment portfolio.

 

Statutory Capital and Surplus

 

Statutory capital and surplus, collectively referred to as surplus, increased $3.7 million to $208.7 million at December 31, 2009, from $205.0 million at year end 2008. The increase in surplus in 2009 was due to $40.2 million of income and an increase in surplus related to the adoption of SSAP 10R of $6.4 million, partially offset by $45.0 million of dividend payments made by American Physicians to APCapital. Our net premiums written to surplus ratios at December 31, 2009 and 2008 were 0.53 and 0.59, respectively. In general, we believe that A.M. Best and state insurance regulators prefer to see a net premium written to surplus ratio for long-tailed casualty

insurance companies, such as ours, of 1:1 or lower. The Company’s Risk Based Capital and IRIS Ratios, other measures considered by regulators in evaluating the capital and surplus adequacy of our insurance subsidiaries are discussed under “Item 1. Business — Insurance Regulatory Matters.”

 

Reserves for Unpaid Losses and Loss Adjustment Expenses

 

The following table shows various claim statistics and reserve averages for our medical professional liability line of business at or for the years ended December 31, 2009, 2008 and 2007.

 

 

 

 

Throughout 2009 we continued to experience better than expected loss trends. The decline in claim frequency noted over the last several years has leveled-off, but reported claims remain at historically low levels. The average net paid claim has begun to move up after several years of stability. Our open claim count continues to decrease as we close older claims and the frequency of new reported claims has decreased. Our average net case reserve per open claim, as well as the average net total reserve per open and IBNR claims, continued to increase in 2009, despite net case reserves remaining stable and a decrease in total net reserves.

 

The following table shows our net case, IBNR and total reserves at December 31, 2009, 2008 and 2007 for our medical professional liability line of business, as well as our net total reserves for our other lines of business that are in run-off.

 

 

Activity in the net liability for unpaid loss and loss adjustment expenses, including favorable development on prior accident years’ loss reserves and the reasons therefor, for the years ended December 31, 2009, 2008 and 2007 can be found in Note 8 of the Notes to Consolidated Financial Statements. Such cross-referenced information is included herein by reference.

The following table shows the development of the net liability for unpaid loss and loss adjustment expenses from 1999 through 2008. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. The (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.