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| ACAP > SEC Filings for ACAP > Form 10-Q on 10-Nov-2008 | All Recent SEC Filings |
10-Nov-2008
Quarterly Report
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, 2007, particularly "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations". References to "we," "our" and "us" are references to the Company.
The following discussion of our financial condition and results of operations contains certain forward-looking statements related to our anticipated future financial condition and operating results and our current business plans. When we 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:
• Increased competition could adversely affect our ability to sell our products at premium rates we deem adequate, which may result in a decrease in premium volume.
• Our reserves for unpaid losses and loss adjustment expenses are based on estimates that may prove to be inadequate to cover our losses.
• An interruption or change in current marketing and agency relationships could reduce the amount of premium we are able to write.
• If we are unable to obtain or collect on ceded reinsurance, our results of operations and financial condition may be adversely affected.
• Our geographic concentration in certain Midwestern states and New Mexico ties our performance to the business, economic, regulatory and legislative conditions in those states.
• A downgrade in the A.M. Best Company rating of our primary insurance subsidiary could reduce the amount of business we are able to write.
• Changes in interest rates could adversely impact our results of operation, cash flows and financial condition.
• Market illiquidity and volatility associated with the current financial crisis makes the fair values of our investments more difficult to estimate, and may have other unforeseen consequences that we are currently unable to predict.
• The unpredictability of court decisions could have a material impact on our operations.
• Our business could be adversely affected by the loss of one or more key employees.
• The insurance industry is subject to regulatory oversight that may impact the manner in which we operate our business, our ability to obtain future premium rate increases, the type and amount of our investments, the levels of capital and surplus deemed adequate to protect policyholder interests, or the ability of our insurance subsidiaries to pay dividends to the holding company.
• Our status as an insurance holding company with no direct operations could adversely affect our ability to meet our debt obligations and fund future cash dividends and share repurchases.
• Legislative or judicial changes in the tort system may have adverse or unintended consequences that could materially and adversely affect our results of operations and financial condition.
• Applicable law and various provisions in our articles and bylaws may prevent and discourage unsolicited attempts to acquire APCapital that you may believe are in your best interests or that might result in a substantial profit to you.
Other factors not currently anticipated by management may also materially and adversely affect our financial position and results of operations. We do not undertake, and expressly disclaim, any obligation to update or alter our statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
Overview of the Company's Operations
We are an insurance holding company whose financial performance is heavily dependent upon the results of operations of our insurance subsidiaries. Our insurance subsidiaries are property and casualty insurers that write almost exclusively medical professional liability insurance for physicians and other healthcare professionals, principally in the Midwest and New Mexico. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.
An insurance company earns investment income on what is commonly referred to as the "float." The float is money that we hold, in the form of investments, from premiums that we have collected. While a substantial portion of the premiums we collect will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period that we hold the float prior to paying losses can extend over several years, especially with a long-tailed line of business such as medical professional liability. The key factors that determine the amount of investment income we are able to generate are the rate of return, or yield, on invested assets and the length of time we are able to hold the float. We focus on the after-tax yield of our investments, as significant tax savings can be realized on bonds that pay interest that is exempt from federal income taxes.
For further information regarding the operations of our medical professional liability insurance business see "Item 1. Business - Medical Professional Liability Operations" of our most recent Annual Report on Form 10-K.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts reported in the accompanying unaudited Condensed Consolidated Financial Statements and Notes thereto. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, or that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in our results of operations in the period in which those estimates changed.
Our "critical" accounting policies are those policies that we believe to be most sensitive to estimates and judgments. These policies are more fully described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, Significant Accounting Policies" of our Annual Report on Form 10-K for the year ended December 31, 2007, and in Note 1 to our Consolidated Financial Statements contained in that report. There have been no material changes to these policies since the most recent year end.
Although we have not changed our accounting policies with respect to determining the fair values of our investment securities, we believe it is beneficial, given the recent market turmoil, to once again explain our accounting policies regarding the determination of the fair value of our investment securities.
The fair values of our investment securities are determined by following the guidance and hierarchy in SFAS No. 157. 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 tolerable limits. 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 one Level 1 security in our investment portfolio, which is a publicly traded equity security. We have two Level 3 securities, one of which is valued by a 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 this security as a Level 3. The remaining Level 3 security is valued based on cash flow, interest rate and other assumptions made by us, and results in a fair value for the security that approximates its par value. The rest of our fixed-income security portfolio is valued in accordance with the processes and procedures discussed above and in Note 5 of the Notes to unaudited Condensed Consolidated Financial Statements included elsewhere in this report for Level 2 fair values.
Description of Ratios and Other Metrics Analyzed
We measure our performance using several different ratios and other key metrics. These ratios and other metrics are calculated on a GAAP basis, unless otherwise indicated, and include:
Underwriting Gain or Loss: This metric measures the overall profitability of our insurance underwriting operations. It is the gain or loss that remains after deducting net loss and loss adjustment expenses and underwriting expenses incurred from net premiums earned. We use this measure to evaluate the underwriting performance of our insurance operations in relation to peer companies.
Loss Ratio: This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The calendar year loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The accident year loss ratio, which is a non-GAAP financial measure, uses only those loss and loss adjustment expenses that relate to the current accident year (i.e., excludes the effect of development on prior year loss reserves). We believe the accident year loss ratio is useful in evaluating our current underwriting performance, as it focuses on the relationship between current premiums earned and losses incurred related to the current year. Our method of calculating accident year loss ratios may differ from the method used by other companies, and therefore, comparability may be limited. In the case of each loss ratio, accident year or calendar year, the lower the percentage, the more profitable our insurance business is, all other things being equal.
Underwriting Expense Ratio: This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and managing our underwriting operations. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio, and overall profitability.
Combined Ratio: This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income.
Investment Yield: Investment yield represents the average return on investments as determined by dividing investment income for the period by the average ending monthly investment balance for the period. As we use average month ending balances, the yield for certain individual asset classes that are subject to fluctuations in a given month, such as cash and cash equivalents, may be skewed slightly. However, we believe
that when calculated for the cash and invested asset portfolio in its entirety, the overall investment yield is an accurate and reliable measure for evaluating investment performance. We calculate investment yields on both a pre-tax and net-of-tax basis. Pre-Tax investment yields are calculated using pre-tax investment income. Net-of-tax investment yields are calculated using after-tax investment income, which is pre-tax investment income, less tax expense, calculated at the statutory rate, on taxable investment income. Our calculation of investment yields may differ from those employed by other companies.
These ratios, when calculated using our reported statutory results, will differ from the GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, compared to net premiums written for the statutory underwriting expense ratio.
In addition to these measures of operating performance, we also use certain measures to monitor our premium writings and price level changes. We measure policy retention by comparing the number of policies that renew during a given period with the number of policies that expire. This retention ratio helps us to measure our success at retaining insured accounts. We also monitor our insured physician count, which counts the number of doctor equivalents associated with all policies, where a corporation or ancillary health care providers on a policy are assigned a value of one doctor equivalent. When used in conjunction with the retention ratio, the insured physician count helps us to monitor the overall increase or decrease in insureds that comprise our premium base.
One of the ways that we measure price level changes is by comparing the average in-force premium per physician at one period end to that of a prior period end. The in-force premium represents, at a point in time, the overall annual premium associated with policies that are in-force, or active, as of that point in time. Accordingly, it is a somewhat imprecise measure of price level changes as the in-force premium represents the annual premium associated with policies written over the last 12 months. In addition, the average in-force premium measure does not contemplate changes in mix of business, or specialty classes, that we write. Despite its limitations, the average in-force premium is an understandable and easy to obtain measure that management finds useful in evaluating overall changes in premium levels.
As a way of evaluating our capital management strategies we measure and monitor our return on equity, or ROE, in addition to our results of operations. We measure ROE as our net income for the period, annualized if necessary, divided by our total shareholders' equity as of the beginning of the period. Other companies sometimes calculate ROE by dividing annualized net income by an average of beginning and ending shareholders' equity. Accordingly, the ROE percentage we provide may not be comparable with those provided by other companies. We also use a modified version of ROE as the basis for determining performance-based compensation.
We also track the book value per common share outstanding, which is calculated by dividing shareholders' equity as of the end of the period by the total number of common shares outstanding at that date. Evaluating the relationship between the book value per common share and the cost of a common share in the open market helps us compare our stock value with that of our peers and to determine the relative premium that the market places on our stock and the stock of our peers.
Results of Operations - Three and Nine Months Ended September 30, 2008 Compared to Three and Nine Months Ended September 30, 2007
The following tables show our underwriting results, as well as other revenue and expense items included in our unaudited Condensed Consolidated Statements of Income, for the three and nine-months ended September 30, 2008 and 2007.
For the Three Months Ended September 30,
Change
2008 2007 Dollar Percentage
(Dollars in thousands)
Direct premiums written $ 37,820 $ 45,213 $ (7,393 ) (16.4 )%
Net premiums written $ 36,257 $ 43,626 $ (7,369 ) (16.9 )%
Net premiums earned $ 30,497 $ 35,516 $ (5,019 ) (14.1 )%
Losses and loss adjustment expenses
Current year losses 24,085 26,191 (2,106 ) (8.0 )%
Prior year losses (7,548 ) (7,958 ) 410 (5.2 )%
Total 16,537 18,233 (1,696 ) (9.3 )%
Underwriting expenses 6,366 7,275 (909 ) (12.5 )%
Total underwriting gain 7,594 10,008 (2,414 ) (24.1 )%
Other revenue (expense) items
Investment income 8,886 10,737 (1,851 ) (17.2 )%
Net realized losses 22 (73 ) 95 (130.1 )%
Other income 158 186 (28 ) (15.1 )%
Other expenses(1) (990 ) (1,361 ) 371 (27.3 )%
Total other revenue and expense items 8,076 9,489 (1,413 ) (14.9 )%
Income before federal income taxes 15,670 19,497 (3,827 ) (19.6 )%
Federal income tax expense 4,502 6,216 (1,714 ) (27.6 )%
Net income $ 11,168 $ 13,281 $ (2,113 ) (15.9 )%
Loss Ratio:
Accident year 79.0 % 73.7 % 5.3 %
Prior years (24.8 )% (22.4 )% (2.4 )%
Calendar year 54.2 % 51.3 % 2.9 %
Underwriting expense ratio 20.9 % 20.5 % 0.4 %
Combined ratio 75.1 % 71.8 % 3.3 %
Pre-tax investment yield 4.21 % 4.93 % (0.7 )%
Net-of-tax investment yield 3.25 % 3.56 % (0.3 )%
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(1) Other expenses includes investment expenses, interest expense, general and administrative expenses and other expenses as reported in the unaudited Condensed Consolidated Statements of Income included elsewhere in this report.
For the Nine Months Ended September 30,
Change
2008 2007 Dollar Percentage
(Dollars in thousands)
Direct premiums written $ 97,935 $ 109,362 $ (11,427 ) (10.4 )%
Net premiums written $ 93,931 $ 105,487 $ (11,556 ) (11.0 )%
Net premiums earned $ 93,564 $ 105,444 $ (11,880 ) (11.3 )%
Losses and loss adjustment expenses
Current year losses 73,373 78,632 (5,259 ) (6.7 )%
Prior year losses (22,971 ) (25,121 ) 2,150 (8.6 )%
Total 50,402 53,511 (3,109 ) (5.8 )%
Underwriting expenses 20,005 22,202 (2,197 ) (9.9 )%
Total underwriting gain 23,157 29,731 (6,574 ) (22.1 )%
Other revenue (expense) items
Investment income 28,078 33,066 (4,988 ) (15.1 )%
Net realized losses (686 ) (139 ) (547 ) 393.5 %
Other income 553 574 (21 ) (3.7 )%
Other expenses(1) (3,322 ) (4,030 ) 708 (17.6 )%
Total other revenue and expense items 24,623 29,471 (4,848 ) (16.5 )%
Income before federal income taxes 47,780 59,202 (11,422 ) (19.3 )%
Federal income tax expense 14,195 19,083 (4,888 ) (25.6 )%
Net income $ 33,585 $ 40,119 $ (6,534 ) (16.3 )%
Loss Ratio:
Accident year 78.4 % 74.5 % 3.9 %
Prior years (24.5 )% (23.8 )% (0.7 )%
Calendar year 53.9 % 50.7 % 3.2 %
Underwriting expense ratio 21.4 % 21.1 % 0.3 %
Combined ratio 75.3 % 71.8 % 3.5 %
Pre-tax investment yield 4.43 % 5.05 % (0.6 )%
Net-of-tax investment yield 3.32 % 3.59 % (0.3 )%
Return on beginning equity (annualized) 17.0 % 19.9 % (2.9 )%
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(1) Other expenses includes investment expenses, interest expense, general and administrative expenses and other expenses as reported in the unaudited Condensed Consolidated Statements of Income included elsewhere in this report.
Overview
Net income for the three and nine-month periods ended September 30, 2008 was less than the same periods of 2007 by $2.1 million and $6.5 million, respectively. The decreases in net income were largely attributable to decreases in the amount of favorable development on prior years' loss reserves recognized during the three and nine months ended September 30, 2008, compared with 2007, as well as decreases in our net premiums earned and investment income. Partially offsetting these negative influences on net income were decreases in current accident year incurred losses, underwriting expenses and interest expense.
Premiums Written and Earned
The following table shows our direct premiums written by major geographical
market, as well as the relationship between direct and net premiums written, for
the three and nine months ended September 30, 2008 and 2007.
For the Three Months Ended September 30, For the Nine Months Ended September 30,
Change Change
2008 2007 Dollar Percentage 2008 2007 Dollar Percentage
(Dollars in thousands) (Dollars in thousands)
Direct premiums written
Michigan $ 14,030 $ 16,898 $ (2,868 ) (17.0 )% $ 33,279 $ 36,312 $ (3,033 ) (8.4 )%
Illinois 11,407 12,944 (1,537 ) (11.9 )% 27,213 30,281 (3,068 ) (10.1 )%
Ohio 5,093 7,087 (1,994 ) (28.1 )% 17,370 21,138 (3,768 ) (17.8 )%
New Mexico 5,207 5,842 (635 ) (10.9 )% 14,231 14,794 (563 ) (3.8 )%
Kentucky 809 987 (178 ) (18.0 )% 3,520 4,343 (823 ) (19.0 )%
Other 1,274 1,455 (181 ) (12.4 )% 2,322 2,494 (172 ) (6.9 )%
Total $ 37,820 $ 45,213 $ (7,393 ) (16.4 )% $ 97,935 $ 109,362 $ (11,427 ) (10.4 )%
Net premiums written $ 36,257 $ 43,626 $ (7,369 ) (16.9 )% $ 93,931 $ 105,487 $ (11,556 ) (11.0 )%
Ratio of net premiums
written to direct 95.9 % 96.5 % (0.6 )% 95.9 % 96.5 % (0.6 )%
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The medical malpractice insurance market remains highly competitive. However, we retained 87% of our insureds whose policies expired during the first nine months of 2008. Overall, our insured physician count was down 1.2% to 9,108 at . . .
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