SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended June 30, 2010
For the transition period from to
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, including zip code)
Registrants telephone number, including area code: (517) 351-1150
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES þ NO o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
YES o NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in 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 number of shares outstanding of the registrants common stock, no par value per share, as of July 31, 2010, was 9,323,087.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets (In thousands, except share data)
The accompanying notes are an integral part of the condensed consolidated financial statements.
AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Income (Unaudited)
(In thousands, except per share data)
The accompanying notes are an integral part of the condensed consolidated financial statements.
AMERICAN PHYSICIANS CAPITAL, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Shareholders Equity (Unaudited)
(In thousands, except share data)
The accompanying notes are an integral part of the condensed consolidated financial statements.
American Physicians Capital, Inc. and Subsidiaries
Condensed Consolidated Statements of Comprehensive Income (Unaudited)
The accompanying notes are an integral part of the condensed consolidated financial statements.
American Physicians Capital, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
The accompanying notes are an integral part of the condensed consolidated financial statements.
American Physicians Capital, Inc. and Subsidiaries
Notes to unaudited Condensed Consolidated Financial Statements
1. Significant Accounting Policies
Basis of Consolidation and Reporting
The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of American Physicians Capital, Inc. (APCapital) and its wholly owned subsidiaries, APSpecialty Insurance Corporation, Alpha Advisors, Inc., and American Physicians Assurance Corporation (American Physicians). APCapital and its consolidated subsidiaries are referred to collectively herein as the Company. All significant intercompany accounts and transactions are eliminated in consolidation.
The accompanying unaudited Condensed Consolidated Financial Statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP or GAAP) and with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X as they apply to interim financial information. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The December 31, 2009 Condensed Consolidated Balance Sheet of the Company presented in this Report on Form 10-Q was derived from audited financial statements.
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The operating results for the three and six-month periods ended June 30, 2010 are not necessarily indicative of the results to be expected for the year ending December 31, 2010. The accompanying unaudited Condensed Consolidated Financial Statements should be read in conjunction with the annual consolidated financial statements, and notes thereto, contained in the Companys Annual Report on Form 10-K for the year ended December 31, 2009.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The most significant estimates that are susceptible to significant change in the near-term relate to the determination of the liability for unpaid losses and loss adjustment expenses, the fair value of investments, including whether securities are other-than-temporarily impaired, revenue recognition, income taxes, reinsurance assets and liabilities, the reserve for extended reporting period claims and deferred policy acquisition costs. Although considerable judgment is inherent in these estimates, management believes that the current estimates are reasonable in all material respects. The estimates are reviewed regularly and adjusted as necessary. Adjustments related to changes in estimates are reflected in the Companys results of operations, or other comprehensive income, in the period in which those estimates changed.
Nature of Business
The Company is principally engaged in the business of providing medical professional liability insurance to physicians and other health care providers, with an emphasis on markets in the Midwest.
Share and per share data, including dividends paid to shareholders, have been retroactively adjusted in these unaudited Condensed Consolidated Financial Statements and notes thereto to reflect a four-for-three stock split effective on July 31, 2009.
2. Effects of New Accounting Pronouncements
Fair Value Measurements In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This ASU requires additional disclosures and clarifies some existing disclosure requirements about fair value measurement. ASU No. 2010-06 amends Codification Subtopic 820-10 to require a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. A reporting entity should present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3). In addition, ASU No. 2010-06 clarifies the requirements of the existing disclosures. ASU No. 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of guidance effective for fiscal years beginning after December 15, 2009 did not have an impact on the Companys financial position or results of operations. The Company has not had any transfers between Level 1 and Level 2 and therefore has not had to make any additional disclosures to comply with the new guidance. However, such disclosure may be required in future reporting periods.
3. Income Per Share
The following table sets forth the details regarding the computation of basic and diluted net income per common share for each period presented:
The diluted weighted average number of shares outstanding includes an incremental adjustment for the assumed exercise of dilutive stock options. During the three and six months ended June 30, 2010 and 2009 there were no stock options that were considered to be anti-dilutive.
The composition of the Companys available-for-sale investment security portfolio, including unrealized gains and losses, at June 30, 2010 and December 31, 2009 was as follows:
The following table shows the carrying value, gross unrecognized holding gains and losses, as well as the estimated fair value of the Companys held-to-maturity fixed-income security portfolio as of June 30, 2010 and December 31, 2009. The carrying value at June 30, 2010 and December 31, 2009 includes approximately $406,000 and $813,000 of net unrealized gains, respectively, as a result of the transfer of certain securities from the available-for-sale to the held-to-maturity category in previous years. These net unrealized gains continue to be reported as a component of accumulated other comprehensive income in the accompanying unaudited Condensed Consolidated Balance Sheets, and will be amortized over the remaining life of the applicable securities through comprehensive income.
The following tables show the Companys gross, unrealized in the case of available-for-sale securities, or unrecognized for held-to-maturity securities, investment losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized or unrecognized loss position, at June 30, 2010 and December 31, 2009, respectively.
At June 30, 2010 there were a total of 12 securities that were in an unrealized or unrecognized loss position. Eleven of these securities were in an unrealized loss position for less than 12 months and had unrealized or unrecognized loss positions totaling $165,000. These securities are investment grade and there is no publicly available information indicating a concern with the issuers credit worthiness or liquidity. Accordingly, the Companys analyses indicate that the amortized cost of these securities will be fully recovered. The Company has no plan to sell any of these and believes that its future cash flows will be adequate to meet ongoing operating needs without the sale of these securities. Accordingly, these 11 securities were not considered other than temporarily impaired at June 30, 2010.
The last of these 12 securities has an unrealized loss of $33,000 at June 30, 2010 and has been in an unrealized loss position for more than 12 months. This security is a private placement security, and trades at less than amortized cost due to an illiquidity factor rather than concerns regarding the creditworthiness of the issuer. The Company does not plan to sell this security and believes that the
Companys future cash flows will be adequate to meet its ongoing operating needs without the sale of the security. Accordingly, this security was not considered other than temporarily impaired at June 30, 2010.
Although the Company did not sell any securities during the three and six months ended June 30, 2010 and 2009, the Company did recognize a realized gain of $326,000 related to the conversion of a bond for two new bonds of the same issuer during the first six months of 2010.
The estimated fair value of fixed-income securities classified as available-for-sale and the carrying value and estimated fair value of fixed-income securities classified as held-to-maturity at June 30, 2010, by contractual maturity, were:
5. Fair Values
Assets and liabilities reported in the financial statements at fair value are required to be classified according to a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
The following is a description of the Companys valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a recurring or nonrecurring basis:
Valuation of Investments
Fair values for the Companys investment securities are obtained from a variety of independent pricing sources. Prices obtained from the various sources are then subjected to a series of tolerance and validation checks. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and non-binding bid or ask price quotes are just a few of the observable inputs utilized. If pricing vendors are not able 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).
Investments Measured at Fair Value on a Recurring Basis
Available-for-sale fixed-income securities - are recorded at fair value on a recurring basis. With the exception of U.S. Treasury securities, very few fixed-income securities are actively traded. Most fixed-income securities, such as government or agency mortgage-backed securities, tax-exempt municipal or state securities and corporate securities, are priced using a vendors pricing model and fall within Level 2 of the hierarchy.
In determining the fair value of securities with a Level 2 fair value, the Company solicits prices from between four and ten pricing vendors or sources. Typically, each security type, e.g., corporate bonds, mortgage-backed securities or municipal bonds, has a preferred pricing vendor that specializes in that particular security type. In these cases, the preferred vendor price is typically used and the prices from other vendors are used to check the reasonableness of the preferred vendors price by making sure that all prices for a given security fall within a specified tolerance threshold. The tolerance threshold varies by security type. Our fixed-income securities with Level 2 fair value classifications principally consist of tax-exempt state and municipal securities, high-quality corporate securities and government-enterprise sponsored mortgage backed securities, which have tolerance thresholds of 2%, 5% and 10%, respectively. Thresholds are selected that are tight enough to ensure the reasonableness of the price used to determine fair value, while still allowing some tolerance for differences in assumptions used among the various vendors pricing models. As mortgage-backed securities are more sensitive to certain valuation model assumptions, such as anticipated interest rate movements and their related impact on principal repayments, the tolerance threshold for mortgage-backed securities is greater than for other security types where prepayment risk is not as significant.
An algorithm is used to evaluate whether the various prices provided by vendors fall within the tolerance threshold. This algorithm looks for commonality among the various prices by evaluating them in order of a provider preference hierarchy, starting with the preferred pricing vendor. If the algorithm finds that there is commonality among the various vendors prices, the price from the highest level provider, in terms of the provider preference hierarchy, will be selected. The selected price is then
compared to that vendors price from the previous day as an added reasonableness check. If the price passes the previous day comparison check, it will become the final selected price used to determine the fair value of the Level 2 fair value security.
If the algorithm does not indicate commonality, or an algorithm indicated price does not pass the previous day price comparison check, then the security is sent to an exception queue for manual review by an analyst. Such a review will consider the following, among other, factors:
Based on the results of this review, either the preferred providers price will be selected, if it appears reasonable, or the price that represents the least change from the previous days price will be used. If the preferred providers price is not used, the analyst will send a confirmation to each vendor that provided a price and ask them to review their price to ensure that they are comfortable with assumptions used in the vendors pricing model. If a vendor indicates a change in assumptions, the process is repeated using the vendors new price. If the repeat of the tolerance threshold evaluation process indicates a change in the securitys price used to determine its fair value, the Company will adjust the securitys fair value prior to the issuance of the financial statements. Such adjustments are extremely rare.
Prices provided by pricing vendors are based on proprietary pricing models, as described above, which produce an institutional bid evaluation. Institutional bid evaluations are an estimated price that a broker would pay for a security, typically in an institutional round lot. A bid evaluation is not a binding bid quote.
The Companys Level 2 fair value fixed-income securities are not actively traded. However, transactions involving these securities are frequent enough that their markets are deemed to be active. Accordingly, prices obtained from pricing vendors for Level 2 fair value fixed-income securities have not been adjusted by the Company as the prices provided by vendors appear to be based on current information that reflects orderly transactions.
The Company currently has two private placement fixed-income securities that currently have Level 3 fair value classifications. One of these securities 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 other security with a Level 3 fair value is valued based on the present values of cash flows and contemplates interest rate, principal repayment and other assumptions made by the Company. The resulting fair value of the security approximates its par value. There were no significant changes in the assumptions used to value Level 3 fair value securities during the six months ended June 30, 2010 or 2009.
Available-for-sale equity securities - are recorded at fair value on a recurring basis. Our available-for-sale equity security portfolio consists of publicly traded common stocks. As such quoted market prices in active markets are available for these investments, and they are therefore included in the amounts disclosed in Level 1.
Our financial assets with changes in fair value measured on a recurring basis at June 30, 2010 and December 31, 2009 were as follows:
With the exception of a liability for contract termination costs, related to sub-leased real estate in Chicago, Illinois (the sub-lease liability), the Company had no financial liabilities that it measured at fair value at June 30, 2010 or December 31, 2009. The fair value of the sub-lease liability is the present value of the estimated future cash flows associated with the original lease expense, offset by sub-lease rental income for the sub-leased space. The discount rate used in the present value calculation is six-percent (6%). This liability is included in Other Liabilities in in the Unaudited Condensed Consolidated Balance Sheets. Changes in the estimated fair value, as a result of changes in estimated net cash flows, are reported in other expenses in the Unaudited Condensed Consolidated Statement of Income.
The changes in the balances of Level 3 financial assets for the three- and six-month periods ended June 30, 2010 and 2009 were as follows:
Investment Measured at Fair Value on a Nonrecurring Basis
Held-to-maturity fixed-income securities - are recorded at amortized cost. However, the fair value of held-to-maturity securities is measured periodically, following the processes and procedures described above for available-for-sale fixed-income securities, for purposes of evaluating whether any securities are other-than-temporarily impaired, as well as for purposes of disclosing the unrecognized holding gains and losses associated with the held-to-maturity investment security portfolio. Any other-than-temporarily impaired securities would be reported at the fair value used to measure the impairment in a table of nonrecurring assets and liabilities measured at fair value. At June 30, 2010 and December 31, 2009 the Company did not have any held-to-maturity fixed-income securities that were considered to be other-than-temporarily impaired. Accordingly, there are no disclosures concerning assets and liabilities measured at fair value on a nonrecurring basis.
Other Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
Other non-financial assets that are measured at fair value on a nonrecurring basis for the purposes of determining impairment include such long-lived assets as property and equipment, internally developed software and investment real estate. The Companys non-financial liabilities measured at fair value subsequent to initial recognition are limited to those liabilities associated with certain exit costs initiated in previous periods. Due to the nature of these assets and liabilities, inputs used to develop the fair value measurements will generally be based on unobservable inputs, and therefore most of these assets and liabilities would be classified as Level 3. However, recent purchase and/or sales activity with regard to real estate investments adjoining the property owned by the Company may qualify such investments for Level 2 classification. At June 30, 2010 none of the aforementioned non-financial assets and non-financial liabilities were included in the unaudited Condensed Consolidated Financial Statements at fair value in accordance with the fair value redetermination guidance applicable to such assets and liabilities. Therefore, there are no disclosures concerning non-financial assets and liabilities measured at fair value on a nonrecurring basis.
Fair Value of Financial Instruments
The Companys investment securities, limited partnership interests, cash and cash equivalents, premiums receivable, reinsurance recoverable on paid losses, and long-term debt are considered to be financial instruments. With the exception of fixed-income securities classified as held-to-maturity, and certain limited partnership interests, the carrying values, i.e., the amounts they are reported at in the financial statements, of all financial instruments in the unaudited Condensed Consolidated Balance Sheets approximated their fair values at June 30, 2010 and December 31, 2009. The fair value of fixed-income held-to-maturity securities as of both dates is disclosed in Note 4. The carrying amount and fair value of our limited partnership interests are shown in the table below.
6. Unpaid Losses and Loss Adjustment Expenses
Activity in the liability for unpaid loss and loss adjustment expenses for the six months ended June 30, 2010 and the year ended December 31, 2009 was as follows:
Favorable development on prior years loss reserves was experienced during both the six months ended June 30, 2010 and the year ended December 31, 2009, as shown in the table above. Favorable development on prior years loss reserves during a given period represents changes in the estimate of the ultimate net liability for unpaid losses and loss adjustment expenses as of the preceding year end. Such changes in estimates, when they occur, are included in current period earnings.
The favorable development experienced during the six months ended June 30, 2010 and the year ended December 31, 2009 was the result of continued better than expected trends in paid claim severity. The Companys actuarial estimates of loss reserves include projections of higher severity in contemplation of medical loss cost inflation, higher reinsurance retention levels in recent years and a
general change in the composition of the outstanding claim inventory. While the severity of paid claims, i.e., the average payment per claim closed with a payment, has increased, such increases have been less than anticipated in the actuarial projections of ultimate losses. In addition, the historically low levels of reported claims in recent years would typically be indicative that those claims still being reported are of a more meritorious nature. Accordingly, the actuarial projection of ultimate losses includes an assumption that the percentage of claims closed in future periods with a payment should be increasing. However, the trend of increasing paid claim frequency has not materialized to the extent anticipated. As a result the actuarial projection of ultimate losses pertaining to prior accident years has decreased, resulting in positive prior year development during the six months ended June 30, 2010, and the year ended December 31, 2009.
The Company believes that the estimate of the ultimate liability for unpaid losses and loss adjustment expenses at June 30, 2010 is reasonable and reflects the anticipated ultimate loss experience. However, it is possible that the Companys actual incurred loss and loss adjustment expenses will not conform to the assumptions inherent in the estimation of the liability. Accordingly, it is reasonably possible that the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimated amounts included in the accompanying unaudited Condensed Consolidated Balance Sheets. However, the favorable development recorded during the six months ended June 30, 2010 is not necessarily indicative of the results to be expected for the year ended December 31, 2010.
7. Subsequent Events
On July 7, 2010, The Doctors Company, a California-domiciled reciprocal inter-insurance exchange (TDC), and Red Hawk Acquisition Corp., a Michigan corporation and wholly owned subsidiary of TDC (Merger Sub), entered into an Agreement and Plan of Merger pursuant to which Merger Sub will merge with and into the Company and each share of common stock of the Company issued and outstanding immediately prior to the closing will be converted into the right to receive $41.50 in cash. The total consideration to be paid for outstanding shares will be approximately $386.0 million. The closing of the merger is subject to customary conditions, including, among others, (i) the approval of the merger by the holders of a majority in voting power of the outstanding common stock of the Company; (ii) the approval of the merger by the State of Michigan Office of Financial and Insurance Regulation; (iii) the receipt of antitrust approvals, or the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; and (iv) the absence of any order or injunction prohibiting the consummation of the transaction.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the Notes thereto included elsewhere in this report and our Annual Report on Form 10-K for the year ended December 31, 2009, particularly Item 7 - Managements Discussion and Analysis of Financial Condition and Results of Operations. References to we, our and us are references to the Company. References to APCapital are references to the holding company, American Physicians Capital, Inc.
The following discussion of our financial condition and results of operations contains certain forward-looking statements related to our anticipated future financial condition and operating results and our current business plans. In addition, when we discuss our future operating results or plans, or use words such as will, should, likely, believe, expect, anticipate, estimate or similar expressions, we are making forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report.
We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all of our forward-looking statements. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any such forward-looking statements. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Factors that might cause such a difference include, without limitation, the risks and uncertainties discussed from time to time in this report and our other reports filed with the Securities and Exchange Commission, including those listed in our most recent Annual Report on Form 10-K under Item 1A Risk Factors, and the following:
Other factors not currently anticipated by management may also materially and adversely affect our financial position and results of operations. We do not undertake, and expressly disclaim, any obligation to update or alter our statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
Overview of APCapital
APCapital is an insurance holding company whose financial performance is heavily dependent upon the results of operations of our primary insurance subsidiar, American Physicians Assurance Corporation, or American Physicians. American Physicians and our other insurance subsidiary, APSpecialty Insurance Corporation, or APSpecialty, are property and casualty insurers that currently exclusively write medical professional liability insurance for physicians and other healthcare professionals, principally in the Midwest and New Mexico. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
An insurance company earns investment income on what is commonly referred to as the float. The float is money that we hold, in the form of investments, from premiums that we have collected. While a substantial portion of the premiums we collect will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period that we hold the float prior to paying losses can extend over several years, especially with a long-tailed line of business such as medical professional liability. The key factors that determine the amount of investment income we are able to generate are the rate of return, or yield, on invested assets and the length of time we are able to hold the float. We focus on the after-tax yield of our investments, as significant tax savings can be realized on bonds that pay interest that is exempt from federal income taxes.
For further information regarding the operations of our medical professional liability insurance business see Item 1. Business Medical Professional Liability Operations of our most recent Annual Report on Form 10-K.
On July 7, 2010, the Company, The Doctors Company, a California-domiciled reciprocal inter-insurance exchange (TDC), and Red Hawk Acquisition Corp., a Michigan corporation and wholly owned subsidiary of TDC (Merger Sub), entered into an Agreement and Plan of Merger pursuant to which Merger Sub will merge with and into the Company and each share of common stock of the Company issued and outstanding immediately prior to the closing will be converted into the right to receive $41.50 in cash. As discussed more fully in Part II, Item 1A. Risk Factors The Doctors Company Acquisition of this Quarterly Report on Form 10-Q, the merger is expected to close in the fourth quarter of 2010 and is subject to customary closing conditions, including the receipt of regulatory approvals and approval by a majority of APCapitals shareholders. It is possible these approvals will not be received or that the closing does not occur for some other reason.
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 (i.e., related to all accident years). 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 is commonly referred to as book value per share in the property and casualty insurance industry. Evaluating the relationship between the book value per common share and the cost of a common share in the open market helps us compare our stock value with that of our peers and to determine the relative premium that the market places on our stock and the stock of our peers.
The above ratios and other financial measures, 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 the above financial measures of operating performance and capital management, we also use certain non-financial 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.
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 ratio 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 two tables under Results of Operations Three and Six Months Ended June 30, 2010 Compared to the Three and Six Months Ended June 30, 2009.
Critical Accounting Policies
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the accompanying unaudited Condensed Consolidated Financial Statements and notes thereto. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, or that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in our results of operations in the period in which those estimates changed.
Our critical accounting policies are those policies that we believe to be most sensitive to estimates and judgments. These policies are more fully described in Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies of our most recent Annual Report on Form 10-K. There have been no material changes to our critical accounting policies since the most recent year end.
Results of Operations ? Three and Six Months Ended June 30, 2010 Compared to the Three and Six Months Ended June 30, 2009
The following tables show our underwriting results, as well as other revenue and expense items included in our unaudited Condensed Consolidated Statements of Income, for the three and six months ended June 30, 2010 and 2009.
The decreases in net income of $1.6 million and $2.7 million for the three and six months ended June 30, 2010, respectively, when compared to the same periods of last year were primarily attributable to the decrease in investment income as both short and long-term interest rates are at near historic lows. Net income in the second quarter of 2010 was also adversely affected by additional general and administrative (G&A) expenses of $874,000 incurred as we explored the possible sale of the Company. The result of the sale exploration activities discussed above is the pending acquisition of APCapital by TDC for $41.50 per outstanding share of APCapital common stock, or a total of approximately $386 million. The decreases in pre-tax income resulting from the decreases in investment income and the higher G&A expenses were partially offset by decreases in federal income tax expense.
Premiums Written and Earned
The following table shows our direct premiums written (DPW) by major geographical market, as well as the relationship between direct and net premiums written (NPW), for the quarter and year-to-date periods ended June 30, 2010 and 2009.
The medical professional liability insurance market continues to be competitive. This competition, along with favorable claim trends, continues to place downward pressure on premium rates, which is the primary cause for the decreases in DPW. Despite the competition in many of our core markets, we retained 88.2% of our insureds whose policies were up for renewal during the first six months of 2010, and we have had moderate success in the first half of 2010 in attracting new business, particularly in Illinois, where DPW during the three- and six-month periods ended June 30, 2010 increased compared to the same periods a year ago.
We anticipate that DPW will continue to decline as the medical professional liability insurance pricing environment is expected to remain highly competitive in the near future, and additional premium rate decreases are likely.
The favorable development on prior years loss reserves that we have experienced in recent years has resulted in more favorable experience under the reinsurance treaties pertaining to the affected accident years. Treaties for years 2006 and subsequent have a profit sharing component, which while
affected by the experience under the treaties, are not as sensitive to changes in experience on our 2005 and prior treaties, which are truly experience rated.
During the second quarter of 2010, we received the benefit of an adjustment to premiums ceded in prior years related to our experience rated reinsurance treaties, which as shown in the table below, increased our NPW for the three- and six-month periods ended June 30, 2010, compared to the same periods in the prior year. As the ceded premium written (CPW) adjustments pertained to prior treaty years, the adjustments were entirely earned, resulting in the same amount of increase to net premiums earned, as was the impact to NPW.
Absent this CPW adjustment, the ratio of NPW to DPW for both the second quarter and year-to-date periods would have remained consistent year over year. As the 2010 treaty terms are relatively consistent with 2009, the ratio was expected to remain relatively constant.
Loss and Loss Adjustment Expenses
Net incurred loss and loss adjustment expenses, which we refer to collectively as losses, increased during the second quarter of 2010, but decreased for the year-to-date period ended June 30, 2010, compared to the same periods a year ago. Accident year losses decreased in both the second quarter and year-to-date periods due to the impact of the adjustment on experience rated reinsurance treaties recorded in the second quarter 2010, as discussed above, which increased net premiums earned (NPE). Absent the effect of the adjustment, the accident year loss ratios for the second quarter and year-to-date periods actually increased year over year as shown in the table below. The increases in the accident year loss ratios were expected due to the declining premium bases, which were primarily the result of premium rate decreases, as described above.
We continued to experience favorable development on prior years loss reserves in 2010. However, the amount of favorable development for the three and six months ended June 30, 2010 decreased by $1.8 million and $1.9 million, respectively, compared to the same periods a year ago. While the majority of the favorable development on prior accident years loss reserves is generated from our medical professional liability (MPL) line of business, $8.7 million and $17.2 million for the three and six months ended June 30, 2010, respectively, our run-off lines of business also contribute to the overall development on prior years loss reserves.
We continued to experience unfavorable development on workers compensation (WC) loss reserves during 2010, $954,000 and $1.3 million for the quarter and year-to-date periods, respectively. The 2010 WC unfavorable development is primarily due to higher than anticipated losses on the medical services portion of claims in Minnesota on our oldest accident years, 1994 1996. These higher than anticipated paid losses and increased case reserves have caused us to increase our projections of ultimate losses on these accident years.
Historically, the personal and commercial (P&C) line of business has had very little prior year development, favorable or unfavorable. Our four P&C open claims have generated only $15,000 in net loss payments in the last three years as they are virtually 100% reinsured. This combined with the fact that we have not written any P&C business in the last 10 years, and therefore do not anticipate that any new claims will be reported, led to the elimination of our remaining P&C incurred but not reported loss reserves in the second quarter of 2010, which generated $530,000 of favorable development during both the second quarter and year-to-date periods of 2010.
On the MPL line of business, we are beginning to see some of the increases in projected paid severity that our reserve estimates have assumed due to loss cost inflation, higher reinsurance retention and the decreases in the number of claims reported over the last several years. However, lower than anticipated paid indemnity frequency partially offsett the increases in paid severity. As the number of MPL reported claims has decreased in recent years, our reserve estimates contemplated that more of the claims reported would be of a meritorious nature, and a higher percentage of claims closed would have indemnity payments. Our assumption regarding the increase in the percentage of claims closed with an indemnity payment has not materialized to the extent we anticipated. However, we are seeing
increases in average case reserves that indicate that our assumption regarding the increased paid indemnity frequency may occur in the future.
Our current loss reserve estimate represents our best estimate of the ultimate cost to settle our claims obligations as of June 30, 2010. If actual loss trends continue to develop more favorably than our prior estimates, we likely will experience additional favorable development in future periods. Conversely, if the trends we have assumed for purposes of estimating our loss reserve occur, favorable loss development will decrease. Historical favorable prior year development is not indicative of future operating results, as the amount, if any, and timing of future favorable development is contingent upon the continued emergence of the claim trends we have noted n recent years, as well as many other internal and external factors, including those discussed in our most recent Annual Report on Form 10-K.
Underwriting expenses and our underwriting expense ratios for the quarter and year-to-date periods ended June 30, 2010 decreased compared to the same periods a year ago. The decreases in underwriting expenses were primarily attributable to the declines in our premium volume and the corresponding declines in those expenses that relate to premium generation. The decreases in the underwriting expense ratio were primarily attributable to our increase in NPE as a result of the aforementioned adjustment related to experience rated reinsurance treaties. Without the experience rated reinsurance premium adjustment, the underwriting expense ratios for the quarter and year-to-date periods ended June 30, 2010 were relatively consistent with the ratios in the same periods last year.
Investment income was down for the second quarter and year-to-date periods of 2010 compared to the same period a year ago. The decreases in investment income were primarily attributable to the disposition of higher yielding long-term U.S. Government, corporate bonds and mortgage backed securities. During 2009, $117.1 million of our long-term bonds, having a weighted average annual yield of 5.76%, matured, were called or were paid down. In addition, in the fourth quarter of 2009, we sold $29.2 million of long-term corporate bonds with a weighted average annual yield of 6.72%. A portion of the proceeds from long-term bond maturities, calls and sales in 2009 were reinvested in limited partnerships, which focus more on long-term capital appreciation rather than the production of investment income. We continue to hold a significant cash position, which has yielded approximately 0.1% for much of the last 18 months, as we believe that long-term yields will increase as financial markets begin to stabilize in 2010.
Net Realized Losses
Although we did not sell any securities during the first six months of 2010, we did experience a modest realized gain on a bond that was converted to new bonds of the same issuer. We had no net realized gains or losses on investments during the first six months of 2009.
The increases in other expenses were the result of incurring $874,000 of costs as we explored the possibility of selling the Company and other strategic alternatives in the second quarter of 2010. These expenses were partially offset by decreases in the interest expense on our long-term debt. The average interest rate on the debt is 4.14% plus the three-month London Interbank Offered Rate
(LIBOR). The rate is reset quarterly in approximately the middle of February, May, August and November. The weighted average interest rate for the first half of 2010 was 4.34%, compared with 5.41% during the first six months of 2009.
The effective tax rates for the quarter and year-to-date periods ended June 30, 2010 were 25.0% and 26.3%, respectively, down from 28.4% and 28.2% for the same periods of 2009. The decreases in the effective tax rates were attributable to increased tax-exempt interest income combined with a lower pre-tax income denominator.
Liquidity and Capital Resources
The primary sources of our liquidity, on both a short- and long-term basis, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers and proceeds from the maturity or sale of invested assets and principal receipts from our mortgage-backed securities. The primary uses of cash, on both a short- and long-term basis, are losses, loss adjustment expenses, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, interest payments, taxes, and the future repayment of long-term debt. Historically, cash has also been used to pay quarterly cash dividends to APCapitals shareholders and to repurchase shares of APCapitals outstanding common stock.
Based on historical trends, economic, market and regulatory conditions and our current business plans, we believe that our existing resources and sources of funds, including possible dividend payments from our insurance subsidiaries to APCapital, will be sufficient to meet our short- and long-term liquidity needs. However, these trends, conditions and plans are subject to change, and there can be no assurance that our available funds will be sufficient to meet our liquidity needs in the future.
APCapitals only material assets are cash and the capital stock of American Physicians and its other subsidiaries. APCapitals cash flow consists primarily of dividends and other permissible payments from its subsidiaries and investment earnings on funds held. The payment of dividends to APCapital by its insurance subsidiaries is subject to certain limitations imposed by applicable law. These limitations are described more fully in Note 19 of the Notes to Consolidated Financial Statements included in our most recent Annual Report on Form 10-K. In March 2010, American Physicians obtained permission from the State of Michigan Office of Financial and Insurance Regulation to pay extraordinary dividends of $10 million to APCapital. The $10 million dividend, which was paid in March 2010, was deemed extraordinary as a result of the timing, and not the amount. American Physicians paid APCapital another $10 million dividend in June 2010. However, due to the timing and amount of previous dividends, this $10 million dividend was deemed to be ordinary and did not require prior regulatory approval. Given the pending sale of the Company to TDC, the suspension of the quarterly cash dividend to shareholders and the share repurchase program, and APCapitals current cash levels, no additional dividends from American Physicians to APCapital are planned at this time.
We paid a quarterly cash dividend of $0.09 per common share at the end of each of the first two quarters of 2010. The total amount of shareholder dividends paid in 2010 through June 30 was $1.7 million.
We continued to repurchase shares of our outstanding common stock during the first half of 2010. A total of 647,100 shares were repurchased during 2010 at a cost of $19.6 million, or $30.32 per share. Part II Item 2, Unregistered Sales of Equity Securities and Use of Proceeds, of this Report on Form 10-Q, contains additional details of our share repurchase programs. As previously disclosed, we have suspended our cash dividends and share repurchases as required by the Agreement and Plan of Merger with TDC.
APCapital has $25.9 million of outstanding long-term debt. The debt matures in 2033, but is callable, in whole or in part, by us at any time subject to certain notification requirements. The debts rate of interest is 4.14% plus the three-month LIBOR rate. Any repayment of this outstanding long-term debt prior to the closing of the merger, in accordance with the Agreement and Plan of Merger with TDC, would have to be approved by TDC.
While our net cash flows from operations have been decreasing over the last several years, $28.9 million, $41.4 million and $46.0 million for the years ended December 31, 2009, 2008 and 2007, respectively, primarily as a result of decreases in premium receipts and investment income collected, quarterly comparisons of net operating cash flows are frequently distorted. This is especially true for a company such as ours where the payment of claims is the primary cash outflow. Medical professional liability claims are high dollar and low volume. Accordingly, a change in the number of claims paid of even a dozen or less can result in a change in cash flows of several million dollars. As a result, judgment and caution should be employed when using any quarterly cash flow information to project or extrapolate future cash flows.
The $14.5 million decrease in our net cash flow from operations during the six months ended June 30, 2010, to $2.7 million from $17.2 million in the during the first half of 2009 is not necessarily indicative of expected cash flows for future periods. This decrease was primarily the result of an $8.9 million increase in net loss and loss adjustment expense payments as well as decreases in premium receipts and investment income collected of $5.9 million and $4.3 million, respectively. In addition, the net cash flows from operations for the six months ended June 30, 2009 included the receipt of cash from reinsurers of $3.7 million related to the commutation of our 2005 reinsurance treaty, effective December 31, 2008.
At June 30, 2010, our subsidiaries had $119.9 million of cash and cash equivalents on hand to meet short-term cash flow needs. In addition, we had $263.1 million of available-for-sale fixed-income securities that could be sold to generate cash. Our held-to-maturity fixed-income security portfolio includes $12.7 million, $67.0 million, $151.0 million and $34.3 million of securities that mature in the next year, one to five years, five to 10 years, and more than 10 years, respectively. We also have $63.8 million of mortgage-backed securities classified as held-to-maturity that provide periodic principal repayments.
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 A.M. Best rating, which currently stands at A- (Excellent); second, the adequacy of our reserves for unpaid loss and loss adjustment expenses; and third, the quality of assets in our investment portfolio.
Statutory Capital and Surplus
Our statutory capital and surplus (collectively referred to herein as surplus) at June 30, 2010 was $210.5 million, which results in a NPW to surplus ratio of 0.52:1 based on $108.7 million of NPW during the 12 months ended June 30, 2010. In general, we believe that A.M. Best and state insurance regulators prefer to see a NPW to surplus ratio for long-tailed casualty insurance companies, such as ours, of 1:1 or lower. Based on the NPW to surplus ratio, and other financial measures used by state insurance regulators and A.M. Best, we believe that the surplus of our insurance subsidiaries at June 30, 2010 is more than adequate.
Reserves for Unpaid Losses and Loss Adjustment Expenses
Medical professional liability insurance is a long-tailed line of business, which means that claims may take several years from the date they are reported to us until the time at which they are either settled or closed. In addition, we also offer occurrence-based coverage in select markets, primarily Michigan and New Mexico. Occurrence-based policies offer coverage for insured events that occurred during the dates that a policy was in-force. This means that claims that have been incurred may not be reported to us until several years after the insured event has occurred. These claims, and their associated reserves, are referred to as incurred but not reported, or IBNR. IBNR reserves may also be recorded as part of the actuarial estimation of total reserves to cover any deficiency or redundancy in case reserves that may be indicated by the actuarys analyses. Case reserves are established for open claims and represent managements estimate of the ultimate net settlement cost of a claim, and the costs to investigate, defend and settle the claim, based on the current information available about a given claim.
The table below shows net case reserves, open claim counts, average net case reserves per open claim, net IBNR and net total reserves for our medical professional liability line of business as of June 30, 2010 and December 31, 2009. Net reserves include direct and assumed reserves, commonly referred to as gross reserves and are reported as unpaid loss and loss adjustment expenses in the accompanying unaudited Condensed Consolidated Balance Sheets, reduced by the amount of ceded reserves. Ceded reserves are a component of reinsurance recoverables as reported in the balance sheets.
The increase in open claims is not unexpected given recent reported and claim closure trends. The decreases in reported claim counts noted in recent years simply could not continue, and as expected have now leveled-off. Likewise, the rate of claim closure, as measured by the number of claims in our open inventory that are closed during a period, has also slowed. The decrease in the claim closure rate is the result of having now cleaned out of the open inventory the majority of claims that had no merit or that could easily be settled, leaving in the open inventory the more meritorious claims that are more difficult to settle and/or will likely settle for amounts in excess of those noted in recent years. As a result of the anticipated increase in the severity of our remaining open claims, our average net case reserve per open claim continued to increase during the first half of 2010. However, we continue to see less than expected paid severity on claims closed and less than expected frequency of claims closed with indemnity payments, which typically drive the large dollar claim losses. As a result of the less than expected paid severity and frequency trends, our actuarial projections of ultimate losses indicated a reduction in IBNR reserves.
Our run-off workers compensation net reserves at June 30, 2010 were $24.2 million compared with $24.3 million at December 31, 2009. Although we experienced a slight decrease in our workers compensation net total reserves, i.e., case plus IBNR reserves, our average net total reserve per open claim increased to $123,100 at June 30, 2010, compared to $108,800 at December 31, 2009. The increase in the average net total reserve is primarily the result of rising claim costs associated with ongoing medical expenses with a number of claims, especially in Minnesota on older accident years. Workers compensation, like medical professional liability, is a long-tailed line of business, and as a result, it will be several years until we settle all workers compensation claims. Open workers compensation claims decreased 13.1% to 152 at June 30, 2010, from 175 at December 31, 2009.
Although considerable judgment is inherent in the estimation of net loss and loss adjustment expense reserves, we believe that our net reserves for unpaid losses and loss adjustment expenses are adequate. However, there can be no assurance that losses will not exceed the reserves we have recorded, or that we will not later determine that our reserve estimates were inadequate, as future trends related to the frequency and severity of claims, and other factors may develop differently than management has projected. The assumptions and methodologies used in estimating and establishing reserves for unpaid loss and loss adjustment expenses are continually reviewed and any adjustments are reflected as income or expense in the period in which the adjustment is made. Historically, such adjustments have not exceeded eight-percent (8%) of our recorded net reserves as of the beginning of the period, but such adjustments can materially and adversely affect our results of operations when they are made.
Activity in the net liability for unpaid losses and loss adjustment expenses for the six months ended June 30, 2010 and year ended December 31, 2009 can be found in Note 6 of the Notes to unaudited Condensed Consolidated Financial Statements included elsewhere in this report. Such information is incorporated herein by reference.
Our fixed-income investment security portfolio consists principally of high quality corporate, government-sponsored agency, tax-exempt municipal and mortgage-backed securities. The following table shows the total fixed-income investment portfolio allocation of each of these different types of securities as of June 30, 2010 and December 31, 2009.
All of our tax-exempt municipal securities are insured. However, when purchasing municipal and other tax-exempt securities, we do not rely on the insurance, but rather focus on the credit worthiness of the underlying issuing authority. In addition, we purchase only essential purpose tax-exempt bonds. Essential purpose bonds are used to fund projects such as schools, water and sewer, road improvements as well as other necessary services. These bonds are often general obligations and are backed by the full taxing authority of the city, county or state, and have a very low historical rate of default. Our mortgage-backed securities are all issued by government sponsored enterprises, principally the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac. All of the Fannie Mae and Freddie Mac mortgage-backed securities consist of conforming mortgage loans that were issued prior to April 2005, are guaranteed by the issuing government-sponsored agency, and have support tranches designed to promote the predictability of principal repayment cash flows.
The following table shows the distribution of our fixed-income security portfolio by Standard & Poors (S&P) credit quality rating at June 30, 2010 and December 31, 2009.
Non-investment grade securities, which we define as having an S&P credit quality rating of less than BBB, typically bear more credit risk than those of investment grade quality. For additional information regarding the risks inherent in our fixed-income investment security portfolio see Item 3, Quantitative and Qualitative Disclosures About Market Risk. Exhibit 99.1, filed with this Quarterly Report on Form 10-Q, contains a detailed listing of our fixed-income security and cash equivalent investment holdings.
Other investments increased $3.9 million during the six months ended June 30, 2010. This increase was primarily attributable to the purchase of additional stock in one of our equity investments of $2.1 million as well as an increase in the fair value of this equity investment of $1.2 million.
Other Significant Balance Sheet Items
Assets, other than our cash and invested assets, at June 30, 2010 decreased approximately $4.6 million from December 31, 2009. The principal components of this decrease were premiums receivable of $3.1 million and deferred federal income taxes of $1.1 million. The premiums receivable decrease was the result of the decrease in DPW, while the decrease in deferred federal income taxes was the result of decreases in our deferred tax assets for loss and loss adjustment expense reserves, unearned premiums and unamortized goodwill.
Total liabilities at June 30, 2010 decreased $12.6 million compared to December 31, 2009. The decrease was primarily due to the $12.7 million decrease in unpaid loss and loss adjustment expense reserves. The decrease in unpaid loss and loss adjustment reserves was mostly the result of
downward revisions in the estimated reserves associated with prior accident years as discussed in Results of Operations.
Shareholders equity decreased $1.7 million to $235.3 million at June 30, 2010, from December 31, 2009. The decrease was the result of share repurchases and shareholder dividend payments, which totaled $21.3million during the six months ended June 30, 2010, in excess of net income for the period of $18.3 million and a $1.3 million, net of tax, increase in unrealized appreciation on investment securities. Shares outstanding at June 30, 2010 were 9,339,087, a decrease of 647,100 from December 31, 2009, as a result of share repurchases. Book value per share increased 6.1% to $25.20 at June 30, 2010, from $23.74 at December 31, 2009.
Contractual Obligations and Off-Balance Sheet Arrangements
Our contractual obligations and off-balance sheet arrangements are described in Item 7 - Managements Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2009. Except as described elsewhere in this report on Form 10-Q, there have been no material changes to those obligations or arrangements outside of the ordinary course of business since the most recent fiscal year end.
Effects of New Accounting Pronouncements
The effects of new accounting pronouncements are described in Note 2 of the Notes to unaudited Condensed Consolidated Financial Statements included elsewhere in this report. Such information is incorporated herein by reference.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss due to adverse changes in market rates and prices. We invest primarily in fixed-income securities, which are interest-sensitive assets. Accordingly, in addition to the credit risk associated with such assets, the fair value of our fixed-income securities is exposed to a degree of risk associated with changes in the overall interest rate environment. Credit risk is the risk that the issuer will default on interest or principal payments, or both, which could prohibit us from recovering a portion or all of our original investment. Changes in the fair value of fixed-income securities are typically inversely related to changes in overall interest rates.
At June 30, 2010, the majority of our investment portfolio was invested in fixed-income security investments, as well as cash and cash equivalents. The fixed-income securities consisted primarily of U.S. government and agency bonds, high-quality corporate bonds, mortgage-backed securities and tax-exempt U.S. municipal bonds.
Qualitative Information About Market Risk
At June 30, 2010, 97.9% of our fixed-income portfolio, both available-for-sale and held-to-maturity, excluding approximately $6.1 million of private placement issues (which constitutes 1% of our fixed-income security portfolio), was considered investment grade. We consider fixed-income securities with a credit rating of BBB or higher to be investment grade. A table with the allocation of our fixed-income securities, by S&P credit quality rating, may be found in Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations, Financial Condition. Non-investment grade securities are generally considered to be a greater credit risk.
We closely monitor the credit quality of the individual securities in our fixed-income portfolio to help manage credit risk. In addition, our investment guidelines limit our fixed-income security holdings pertaining to any one issuer, other than U.S. Government and agency backed securities, to less than 3% of statutory admitted assets, or 5% of statutory surplus. In practice this has generally resulted in limiting such investments to approximately $6 million per issuer at our American Physicians subsidiary. We also diversify our holdings so that there is not a significant concentration in any one industry or geographical region.
Furthermore, we periodically review our investment portfolio for any potential credit quality or collection issues and for any equity securities whose decline in fair value is deemed to be other than temporary. As a result of these reviews, we have determined that none of our fixed-income or strategic equity security investments were other than temporarily impaired at June 30, 2010.
Held-to-maturity fixed-income securities are not carried at fair value on the balance sheet. As a result, changes in interest rates do not affect the carrying amount of these securities. However, 19.4%, or $63.9 million, of our held-to-maturity investment security portfolio consists of mortgage-backed securities. Mortgage-backed securities, unlike most other fixed-income securities, do not have a fixed maturity date as the individual underlying mortgages that comprise these securities may be prepaid without penalty. So, while the carrying value of these securities is not subject to fluctuations as a result of changes in interest rates, changes in interest rates could impact our cash flows as an increase in interest rates will slow principal payments, and a decrease in interest rates will typically accelerate principal payments. This variability in principal payments is known as prepayment risk.
Quantitative Information About Market Risk
Interest Rate Risk
At June 30, 2010, our available-for-sale fixed-income security portfolio was valued at $263.1 million and had an average modified duration of 2.87 years, compared to a portfolio valued at $205.1 million with an average modified duration of 2.61 years at December 31, 2009. The following tables show the effects of a hypothetical change in interest rates on the fair value and duration of our available-for-sale fixed-income security portfolio at June 30, 2010 and December 31, 2009. We have assumed an immediate increase or decrease of 1% or 2% in interest rate for illustrative purposes. You should not consider this assumption, or the values shown in the table, to be a prediction of actual future results.
Equity Price Risk
At June 30, 2010, the fair value of our available-for-sale equity securities was $21.8 million. These securities are subject to equity price risk, which is the potential for loss in fair value due to a decline in equity prices. The weighted average Beta of this group of securities was 0.98 at June 30, 2010. Beta measures the price sensitivity of an equity security, or group of equity securities, to a change in the broader equity market, in this case the S&P 500 Index. If the value of the S&P 500 Index increased by 10% the fair value of our equity securities would be expected to increase by 9.8% to $23.9 million based on the weighted average Beta. Conversely, a 10% decrease in the S&P 500 Index would result in an expected decrease of 9.8% in the fair value of our equity securities to $19.6 million. The selected hypothetical changes of plus or minus 10% assumed in this illustration are not intended to reflect what could be considered the best or worst case scenarios and are used for illustrative purposes only. In addition, Beta is calculated using historical information and does not take into account current or future changes in a companys financial condition, results of operations or liquidity that may have an impact, either positive or negative, on the companys stock price.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure material information required to be disclosed in the Companys reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SECs rules and forms, and that such information is accumulated and communicated to the Companys management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure. In designing and evaluating the disclosure controls and procedures, the Company recognized that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Companys Disclosure Committee and
management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2010.
Changes in Internal Control Over Financial Reporting
There have been no changes in the Companys internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1A. Risk Factors
As a result of the proposed merger announced on July 8, 2010, the Company is modifying the risk factor from its Form 10-K entitled Our business could be adversely affected by the loss of one or more key employees. As set forth below. In addition, the Company is adding the three additional risk factors set forth below. Other than as set forth herein, there have been no material changes in risk factors as previously disclosed in the Companys Annual Report on Form 10-K for the year ended December 31, 2009.
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 announcement of the merger may have a negative impact on our ability to attract and retain key management and attract and maintain third-party relationships.
APCapital cannot make any assurances that the proposed merger will be consummated.
On July 7, 2010, APCapital, The Doctors Company, a California-domiciled reciprocal inter-insurance exchange we refer to as TDC, and Red Hawk Acquisition Corp., a wholly owned subsidiary of TDC, entered into a merger agreement pursuant to which Red Hawk will merge with and into APCapital and each share of common stock of APCapital issued and outstanding immediately prior to the closing will be converted into the right to receive $41.50 in cash, or approximately $386.0 million. The merger is subject to customary closing conditions, including, among others, (i) the approval of the merger by the holders of a majority in voting power of the outstanding common stock of the Company; (ii) the approval of the merger by the State of Michigan Office of Financial and Insurance Regulation; (iii) the receipt of antitrust approvals, or the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; (iv) the absence of any order or injunction prohibiting the consummation of the transaction, and (v) the absence of a material adverse change in the Company. It is possible that factors outside of the Companys control could require the parties to complete the proposed merger at a later time or not to complete it at all. There is no assurance that all of the various conditions to closing will be satisfied so that the merger closes.
Failure to complete the TDC merger would result in the incurrence of costs, the amounts of which could adversely impact APCapitals future business and financial results.
If the proposed merger is not completed for any reason, APCapital will be subject to numerous expenses, including the following:
being required, under certain circumstances, to pay a termination fee of 3% of the aggregate merger consideration;
having incurred certain costs relating to the proposed merger that are payable whether or not the merger is completed, including legal, accounting, financial advisor and printing fees; and
having had management focused on completing the proposed merger instead of on pursuing another business strategy, including acquisition or investment opportunities that could have been beneficial to the Company.
If the proposed merger is not completed, as a result of these and other factors, the Companys business, financial results and financial condition could be adversely affected.
APCapitals common stock price and business prospects may be adversely affected if the merger is not completed.
If the merger is not completed, the trading price of the common stock may decline, to the extent that the current market prices reflect a market assumption that the merger will be completed. In addition, the Companys businesses and operations may be harmed to the extent that third parties, such as customers, brokers and agents, believe that the Company cannot effectively operate in the marketplace on a stand-alone basis, or there is management or employee uncertainty surrounding the future direction or strategy of the Company on a stand-alone basis. Managements attention may be diverted from conducting the day to day business of the Company, and the Company may lose key employees and ongoing business and prospects, as well as relationships with customers and other third parties as a result of these uncertainties. The Company may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures. Any of these events could have a negative impact on the Companys results of operations and financial condition and could adversely affect the price of its common stock.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
The following table sets forth the repurchases of common stock for the quarter ended June 30, 2010:
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Shareholders on May 11, 2010, at which the shareholders approved the ratification of BDO Seidman, LLP as the Companys independent registered public accountants and elected two directors. All nominees were elected. The following tables set forth the results of the voting at the meeting.
Item 6. Exhibits
The Exhibits included as part of this report are listed in the attached Exhibit Index, which is incorporated herein by reference.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 10, 2010
The following documents are filed as exhibits to this report or were filed previously and are incorporated by reference to the filing indicated. Exhibits not required for this report have been omitted. APCapitals Commission file number is 000-32057.